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micro economicsMicro economics
Micro vs. Macro EconomicsMicro – focuses in organization Macro – fiscal & monetary policy macro economics careers in macro economics: global macro hedge funds
Economics is the study of scarcity - Limited resources. Opportunity cost is the losing the opportunity to purchase a product because you need to choose between scarce resources. There is a limited amount of products. There is not enough supply of something. Economics is about choices people make. It is a social science how individuals deal with the fact that wants are greater than the choices they have. It is the science of scarcity. You have unlimited needs /wants with limited resources. You have to make choices. Economics examine the choices that are made. Questions:What do we need to product, how and for whom do we need to procduce.
1. Efficiency: optimal use of resources ex) Study of 10 Central American countries to solve problem of energy 2. Equity: Equal distribution of Income. ie. Apply policies that will level the field for the low income segment of the population to get education to become more productive 3. Economic Growth and Stability – smooth and sustained growth in production, income, employment. Ex) slogan Mexican president used during his campaign. “We will create more jobs.” Government don’t create jobs that need to “settle the fields” in a way that jobs are created.
Economic systemsWho make the decisions to the key questions: What?, How? For Whom? • Centralized Economy – Government make all important decision about what how and for whom to produce. Government make the decisions. Now they are looking more to the market signasl ex) Venezuela, China, Cuba, North Korea • Market Economy – Decisions are made by the buyers and seller ie. the private sector • Mixed Economy – Market economy with government intervention. Coexist in a market. Ex) Very common in Latin America. Oil is handled by govt.and you have private companies.
The Market• Consumers give you the Demand with tastes, necessities and income. • Producers provide the Supply with technology, resource & market of factors
Demand Function
Demand Core You need to understand demand because the business process needs to make deccions according to what the market is demanding. To make good decisions, it is important to understand demand.
Negative Slope is explained by Diminishing Marginal Utility on consumption (Satisfaction that was very high starts diminishing with more supply, every time I increase one unit of what I am buying, I am less excited). As quantity consumed increases, the satisfaction added to the each unit is smaller.
Demand DeterminentsThe factors that determine my demand are population, weather, taste and preferences, demographics (gender, age, etc.), Culture, Religion. • Price of Substitutes Prs (+) • Income M (+ or -) can go both ways. With more income you may just choose to buy something else. Ex) Eating hamburgers until funds are received, Filet mignon is consumes instead. Income - It can be both ways, positive or negative in Demand • Taste & Preferences for X can be both T (+ or -), ex) VHS and DVD. Few people were willing to pay for the new DVD but now that VHS is no longer available. In the beginning it was a matter of taste & preferences. Ex) of a negative effect – consumption of red meat after publication of article saying that red meat causes cholesterol ex)fashion & trends • Advertising A(+) Expenditure increase demand positively because that is the whole purpose of marketing and more people is subject to information of the product. • Price of Complement Products - Prc (+) ex) Price of gas vs. size of cars. • Expected price of X - Pe (+) • Price of X - PX(-) • Population N (+)
Change of price can be caused by reacting to external factors. Change in price will have two effects: 1) Income effect – price decrease and with the same income I have I can now afford more 2) Substitution Effect – price increases or decreases and you change the product you purchase. If the prices increases, then with the same income you have to buy less or buy product that is less expensive.
How do govt affect the demand core? Govt. do affect demand. A tax is considered an increase in product. A subsidy can be considered as a price decrease. Also, bans on product will affect the variables. Ex) ban on advertisement on liquor, age restriction for smoking.
Supply Function
Determinants of Supply • Taxes TX (-) and Subsidies S(+) • Number of Firms F (+) • Expectation in Prices Pe (+) • Price of X Px(+) • Price of Inputs Pi (-) • Price of Complements or Subsitutions Prc (+) • Tecnology T (+)
Elasticity
A change in taste of preference is able or not to affect demand and supply. A buyer demanding the product, according to price change in direct proportion with velocity. There is a change in demand for every single change in demand. Types of E 1) Elastic >1 2) Inelastic <1 3) Unitary Determinents of Elasticity • # Substitutes • Time • Necessity Ex) The car insurance demand as an absolute value does not vary.
Elasticity of DemandI = P decreases Q increases • Price Elasticity • Income Elasticity • Cross-Price Elasticity
Demand & Consumer Behavior
CHOICE AND UTILITY THEORYTo describe the way consumers choose among different consumption possibilities, economics developed the notion of utility. Utility is used to understand how rational consumers divide their limited resources among the commodities that provide them with satisfaction. The term “marginal” is a term in economics that means “extra”. Marginal Utility denotes the additional utility you get from the consumption of an additional unit of a commodity. The law of diminishing marginal utility states that, as the amount of a good consumed increases, the marginal utility of that good tends to diminish therefore has a downward slope (sample of ice cream). Total utility is the sum of all the marginal utilities added from the beginning. Ordinal utility can not be measured in numbers. Ordinal means that consumers need to determine their preference ranking of commodities. “A” vs “B”?
EQUIMARGINAL PRINCIPLE:EQUAL MARGINAL UTILITIES PER DOLLAR FOR EVERY GOOD
Equimarginal principle: It states that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfaction or utility when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good. The marginal utility of income measures the additional utility that would be gained if the consumer could enjoy an extra dollar’s worth of consumption. A higher price for a good reduces the consumer’s desired consumption of that commodity. That is why demand curves slope downward. The principles of consumer choice suggest that you will make the best use of your time when you equalize the marginal utilities of the last minute spent on each activity.
AND ALTERNATIVE APPROACH:SUBSTITUTION EFFECT AND INCOME EFFECT
Indifference analysis asks about the substitution effect and the income effect of a change in price. By looking at these, we can see why the quantity demanded of a good declines as its price rises. The substitution effect says that when the price of a good rises, consumers will tend to substitute other goods for the more expensive good in order to satisfy their desires more inexpensively. In addition, when your money income is fixed, a price increase is just like a reduction in your “real income”. This produces the income effect, which denotes the impact of a price change on a good’s quantity demanded due the effect of the price change on real incomes. To obtain a quantity measure of the income effect, we examine a good’s income elasticity. This term denotes the percentage change in quantity demanded divided by the percentage change in income, holding other things constant.
FROM INDIVIDUAL TO MARKET DEMANDThe demand curve for a good for the entire market is obtained by summing up the quantities demanded by all consumers. In other words, the market demand curve is the sum of individuals demand at each price. The demand curve can shift for different reasons, for example substitution of goods or increase/decrease of income. The substitution effect occurs when a higher price leads to substitution of other goods for the good whose price has risen. The income effect is the change in the quantity demanded of a good because the change in its price has the effect of changing a consumer’s real income. Income elasticity is the percentage change in quantity demanded of a good divided by the percentage change in income.
Goods are substitutes if an increase in the price of one increases the demand for the other. Goods are complements if an increase in the price of one decreases the demand for the other. Goods are independent if a price change for one has no effect on the demand of the other.
ECONOMICS OF ADDICTIONIn some cases, but sparingly and with great hesitation, the government decides to overrule private adult decisions. These are the cases of merit goods, whose consumptions is thought intrinsically worthwhile, and the opposite, which are demerit goods, whose consumption is deemed harmful.
THE PARADOX OF VALUEThe more there is of a commodity, the less is the relatively desirability of its last little unit. It is therefore clear why water has a low price and why an absolute necessity like air can become a free good.
CONSUMER SURPLUSThe gap between the total utility of a good and its total market value is called consumer surplus. The surplus arises because we “receive more that we pay for as a result of the law of diminishing marginal utility. Because consumers pay the price of the last unit for all units consumed, they enjoy a surplus of utility over cost. Economists use the consumer surplus when they are performing a cost-benefit analysis, which attempts to determine the costs and benefits of a government program.
INDIFFERENCE CURVESThe points on the curve represent consumption bundles among which the consumer is indifferent; all are equally desirable. The curves are drawn as bowl-shaped, or convex to the origin. The slope of the indifference curve is the measure of the goods’ relative marginal utilities The scarcer a good, the greater its relative substitution value; its marginal utility rises relative to the marginal utility of the good that has become plentiful. The slopes of the curve at a certain point are the substitution ratios (sometimes called the marginal rates of substitution) between the two goods. As the size of the movement along the curve becomes very small, the closer the substitution ratio comes to the actual slope of the indifference curve.
PRODUCTION
Productive capacity is determined by the size and quality of the labor force, by the quantity and quality of the capital stock, by the nation’s technical knowledge along with the ability to use that knowledge, and by the nature of public and private institutions. Production theory also helps us understand why productivity and living standards have risen over time and how firm manage their internal activities.
THEORY OF PRODUCTION AND MARGINAL PRODUCTS
BASIC CONCEPTS
We need to assume that all companies always attempt to produce the maximum level of output for a given dose of inputs, avoiding waste whenever possible. The production function specifies the maximum output that can be produced with a give quantity of inputs. It is defined for a given state of engineering and technical knowledge. There are millions of different production functions. The concept of the production function is a useful way of describing the productive capabilities of a firm. Total product designates the total amount of output produced in physical units. The marginal product of an input is the extra output produced by 1 additional unit of that input while other inputs are held constant.
The final concept is the average product, which equals total output divided by total units of input. The law of diminishing returns holds that we will get less and less extra output when we add additional doses of an input while holding other inputs fixed. In other words, the marginal product of each unit of input will decline as the amount of that input increases, holding all other inputs constant. Diminishing returns are a key factor in explaining why many countries in Asia are so poor. Living standards in those countries are low because there are so many workers per acre of land and not because farmers are ignorant.
RETURNS TO SCALEMust of the times, we are interested in the effect of increasing all inputs. Returns of scale help us understand the effects of scale increases of inputs on the quantity produced. Three important cases should be distinguished: Constant, Increasing and Decreasing. Constant Return of Scale denotes a case where a change in all inputs leads to a proportional change in output. For example if all inputs are double, then output will also be double. Increasing Return of Scale (also called economies of scale) arise when an increase in all inputs leads to a more than proportional increase in the level of output. Decreasing Return of Scale occurs when a balanced increase of all inputs leads to a less than proportional increase in total output. In many processes, scaling up may eventually reach a point beyond which inefficiencies set in.
SHORT RUN AND LONG RUNEfficient production requires time as well as conventional inputs like labor. We therefore distinguish between two different time periods in production and cost analysis. The short run is the period of time in which only some inputs (variable) can be adjusted. In the short run, fixed factors, such as plant and equipment, cannot be fully modified or adjusted. The long run is the period in which all factors employed by the firm, including capital, can be changed.
TECHNOLOGICAL CHANGEMost of the increases in output come from technological change, which improves productivity and raises living standards. We distinguished process innovation, which occurs when a new engineering knowledge improves production techniques for existing products, from product innovation, whereby new or improved products are introduced in the market place.
PRODUCTIVITY AND THE AGGREGATE PRODUCTION FUNCTIONOne of the most important measures of economic performance is productivity. Productivity is a concept measuring the ration of total output to a weighted average of inputs. Two important variants are labor productivity, which calculates the amount of output per unit of labor, and total factor productivity, which measures output per unit of total inputs (typically of capital and labor). Productivity grows because of economies of scale and because of technological change. Economies of scale and mass production have been important elements of productivity growth over the last century. The aggregate production functions relate total output to the qty of inputs and to total productivity.
There are a few important results from the economist regarding the aggregate production functions: a) Total factor productivity has been increasing throughout the 20th century because of technological progress and higher levels of worker educational skills. b) The capital stock has been growing faster than the number of worker-hours c) The rate of return on capital might have been expected to encounter diminishing return because each capital unit now has less labor to cooperate with it. d) Over the 20th century, labor productivity grew at an average rate of slightly more than 2% per year.
BUSINESS ORGANIZATIONS
THE NATURE OF THE FIRM
Business firms are specialized organizations devoted to managing the process of production. Among their important functions are exploiting economies of mass production, raising funds and organizing factors of production.
BIG, SMALL AND INFINITESIMAL BUSINESS The majority of businesses in America are tiny units owned by a single person – the individual proprietorship. Others are partnerships, owned by two or perhaps two hundred partners. The largest businesses tend to be corporations. Tiny businesses predominate in numbers. But in sales and assets, in political and economic power, and in size of payroll and employment, the few hundred largest corporations dominate the economy.
The individual proprietorship, also called “mom and pop” stores, are small stores that might do a few hundred dollars of business per day and barely provide a minimum wage for the owners’ efforts. The average lifetime of this type of businesses is one year.
The partnerships account for only a small fraction of total economic activity. The reason is that partnerships pose certain disadvantages that make them impractical for large business. The major disadvantage is unlimited liability (general partners are liable w/o limit for all debts contracted). Partnerships are simply too risky for most situations.
A corporation is a form of business organizations chartered in one of the 50 states or abroad and owned by a number of individual stockholders. The corporation has a separate legal identity. The corporation enjoys the right of limited liability, whereby each owner’s investment and financial exposure is strictly limited to a specific amount.
The central features of a modern corporation are the following… a) The ownership of a corporation is determined by the ownership of the company’s common stock b) In principle, the shareholders control the company they own. They collect dividends in proportion to the fraction of shares they own. In practice, shareholders of giant corp exercise virtually no control. c) The corporation’s managers and directors have the legal power to made decisions for the corporation. The shareholders own the corporation, but the managers run it
Some of the advantages of corporations are: a) Simply way to engage in business. A corp is a legal person that can conduct business b) Corp are hardly little democracies, so their managers can make decisions quickly c) Corporate stockholders enjoy limited liability
One major disadvantage of corporations is that government levies an extra tax on corporate profits. The large corporation is treated differently in that some of its income is doubly taxed – first as a corporate profits and then as individual income or dividends. Efficient production often requires large-scale enterprises, which needed billions of dollars of invested capital. Corporations, with limited liability and a convenient management structure, can attract large supplies of private capital, produce a variety of related products and pool investor risks.
COSTS
Everywhere that production goes, costs follow close behind like a shadow. Profitable businesses are acutely aware of this simple fact as they determine their production strategies, since every dollar of unnecessary costs reduces the firm’s profits by that same dollar.
ECONOMIC ANALYSIS OF COSTSTOTAL COST: FIXED AND VARIABLE Fixed cost, sometimes called “overhead”, represents the total dollar expense that is paid out even when no output is produced. They are unaffected by any variation in the quantity of output. Some examples are: rent, payments for equipment, interest on debts, etc. Variable cost represents expenses that vary with the level of output – such as raw materials, wages, and fuel – and includes all costs that are not fixed. By definition VC (variable cost) begins at zero when q(quantity) is zero. Total cost represents the lowest total dollar expense needed to produce each level of output q. TC rises as q rises. TC = FC + VC
DEFINITION OF MARGINAL COSTMarginal cost is one of the most important concepts in all economics. Marginal Cost (MC) denotes the extra additional cost of producing 1 extra unit of output. Say a firm is producing 1000 CDs for $10,000. If the TC of producing 1001 CDs is $10,006, then the marginal cost of production is $6 for the 1001st CD. Empirical studies have found that for the most activities in the short run, marginal cost curves are U-shaped. This U-shaped curve falls in the initial phase, reaches a minimum point, and finally begins to rise.
AVERAGE COSTLike marginal cost, average cost (AC) is a concept widely used in business. It is the total cost divided by the total number of units produced. AC = TC / q. By comparing AC with selling price, businesses can determine whether or not they are making profit. Just as we separated total cost into fixed and variable costs, we can also break average cost into fixed and variable components. Average fixed cost (AFC) if defined as FC / q. Since total fixed cost is a constant, dividing it by an increasing output gives a steadily falling average fixed cost curve. Average variable cost (AVC) equals variable cost divided by output, or AVC= VC / q. AVC curves first fall and the rises. There are some rules that are important to remember: 1. When Marginal Cost (MC) is below average cost (AC), it is pulling AC down. 2. When MC is above AC, it is pulling AC up. 3. When MC just equals AC, AC is neither rising nor falling and is at its minimum level. Hence, at the bottom of a U-shaped AC, MC = AC = minimum AC.
THE LINK BETWEEN PRODUCTION AND COSTSClearly the cost of inputs like labor and land are important factors influencing cost. But the cost curve for a firm also depends very closely on the firm’s production function. To see this, note that if technological improvements allow the firm to produce the same output with fewer inputs, the firm’s cost will fall, and the cost curve will shift down. The production function (plus factor prices) will tell us which is the least costly combination of inputs the firm can select that can yield that output. In the short run, when factors such as capital are fixed, variable factors tend to show an initial phase of increasing marginal product followed by diminishing marginal product. The corresponding cost curves show an initial phase of declining marginal costs, followed by increasing MC after diminishing returns have set in. The short run is the period of time that is long enough to adjust variable inputs, such as materials and production labor, but too short to allow all inputs to be changed. In the long run, all inputs can be adjusted. Hence in the long run, all costs are variable and none are fixed.
CHOICE OF INPUTS BY THE FIRMIn our analysis, we will rely on the fundamental assumption that firms minimize their cost of production. This cost minimization assumption simply states that the firm should strive to produce its output at the lowest possible cost and thereby have the maximum amount of revenue left over for profits or for other objectives. Least-cost rule is to produce a given level of output at least cost, a firm should buy inputs until it has equalized the marginal product per dollar spent on each input. This implies that: Marginal product of “L” / Price of “L”. A corollary of the least-cost rule is the substitution rule. Substitution rule: If the price of one factor falls while all other factor prices remain the same, firms will profit by substituting the now-cheaper factor for other factors until the marginal products per dollar are equal to all inputs.
ECONOMIC COSTS AND BUSINESS ACCOUNTING
THE INCOME STATEMENT, OR STATEMENT OF PROFIT AND LOSS Net Income (profit on the income statement) = total revenue – total expenses. This definition gives the famous “bottom line” of profits that firms want to maximize. Depreciation measures the annual cost of a capital input that a company actually owns itself. There are a number of different formulas for calculating each year’s depreciation, but each follows two major principles: a) the total amount of depreciation over the asset’s lifetime must equal the capital good’s historical cost or purchase price; b) the depreciation is taken in annual accounting charges over the asset’s accounting lifetime, which is usually related to the actual economic lifetime of the asset.
THE BALANCE SHEETThe balance sheet is a picture of financial conditions on a given date. This statement records what an entity is worth at a given point of time. On one side of the balance sheet are the assets (valuable properties or rights owned by the firm). On the other side are two items, the liabilities (money or obligations owned by the firm) and net worth (or net value, equal to total assets minus total liabilities). The income statement measures the flows into and out of the firm, while the balance sheet measures the stock of assets and liabilities at the end of an accounting year.
OPPORTUNITY COSTSThe opportunity costs of a decision include all its consequences, whether they reflect monetary transactions or not. Decisions have opportunity costs because choosing one thing in a world of scarcity means giving up something else. The opportunity cost is the value of the most valuable good or service forgone. Economic costs include, in addition to explicit money outlays, those opportunity costs incurred because resources can be used in alternative ways.
SUPPLY
PERFECTLY COMPETITIVE MARKETS
This chapter on industrial organization analyzes the behavior of perfectly competitive markets; these are idealized markets in which all firms and consumers are too small to affect the price.
SUPPLY BEHAVIOR OF THE COMPETITIVE FIRM
BEHAVIOR OF A COMPETITIVE FIRM
In analyzing the supply behavior of perfectly competitive firms, we make two observations. First, we will assume that our competitive firm maximizes profits. Second, we observe that perfect competition is a world of atomistic firms who are price-takers. Profit maximization requires the firm to manage its internal operation efficiently and to make sound decisions in the market place. Because profits involve both costs and revenues, the firm must have a good grasp of its cost structure.
Perfect competition is the world of price-takers. Important to remember: a) Under perfect competition, there are many small firms, each producing an identical product and each too small (compare to the market) to affect the price. b) The perfect competitor faces a completely horizontal demand curve c) The extra revenue gained from each extra unit sold is therefore the market price.
Rule for a firm’s supply under perfect competition: A firm will maximize profits when it produces at that level where marginal cost equals price: MC = P (table of page 149) The zero profit point is where the production level at which the firm makes zero profit, price equals average costs, so revenues just covers cost. A profit-maximizing firm will set its output at that level where marginal cost equals price. Diagrammatically, this means that a firm’s marginal cost curve is also its supply curve.
The critical low market price at which revenues just equal variable costs or where losses are equal to fixed costs is called the shutdown point. Shutdown Rule: When the price falls below average variable costs, the firm will maximize profits (minimize its losses) by shutting down. The analysis of shutdown conditions leads to the surprising conclusion that profit-maximizing firms may in the short run continue to operate even though they are loosing money. This condition will hold particularly for firms that are heavily indebted and therefore have high fixed costs.
SUPPLY BEHAVIOR IN COMPETITIVE INDUSTRIES
SUMMING ALL FIRMS’ SUPPLY CURVES TO GET MARKET SUPPLY
The total quantity brought to market at a given price will be the sum of the individual quantities that all firms supply at that price; therefore the market supply curve for a good is obtained by adding horizontally the supply curves of all the individual producers of that good.
SHORT-RUN AND LON RUNG EQUILIBRIUMIn the short run, demand shifts produce greater price adjustments and smaller quantity adjustments than they do in the long run. We can understand this observation by distinguishing two time periods for market equilibrium that correspond to different cost categories: a) Short run equilibrium, when any change in output must use the same fixed amount of capital b) Long run equilibrium, when capital and all other factors are variable and there is a free entry and exit of firms from the industry.
In the long run firms will produce only when price is at or above the zero-profit condition where price equals average cost. Zero-profit long run equilibrium: In a competitive industry populated by identical firms with free entry and exit, the long run equilibrium condition is that price equals marginal cost equals the minimum long-run average cost of each identical firm. P = MC = minimum long run AC = zero-profit price. This is the long run zero-economic profit condition.
SPECIAL CASES OR COMPETITIVE MARKETS
GENERAL RULES Demand Rule: (a) Generally, an increase in demand for a commodity will raise the price of the commodity. (b) For most commodities, an increase in demand will also increase the quantity demanded. A decrease in demand will have the opposite effects Supply Rule: An increase in supply of a commodity will generally lower the price and increase the quantity bought and sold. A decrease in supply has the opposite effects.
Some goods or productive factors are completely fixed in amount, regardless of price. When the qty supplied is constant at every price, the payment for the use of such factor of production is called rent or pure economic rent.
Quantity corollaries of the supply curve: a) An increased supply will decrease P most when demand is inelastic b) An increased supply will increase Q least when demand is inelastic
EFFICIENCY AND EQUITY OF COMPETITIVE MARKET
EVALUATING THE MARKET MECHANISM In analyzing an economy, we are centrally concerned with the concept of allocative efficiency or efficiency. Allocative efficiency (or efficiency) occurs when no possible reorganization or production can make anyone better off without making someone else worse off. Under conditions of allocative efficiency; one person’s satisfaction or utility can be increased only by lowering someone else’s utility.
One of the most profound results in all economics is that allocation of resources by perfectly competitive markets is efficient. Economic surplus is the sum of the consumer surplus, which is the area between the demand curve and the price line. The producer surplus is the area between the price line and the supply curve. Efficiency implies that economic surplus is maximized, where economic surplus equals consumer surplus + producer surplus.
Efficiency comes because: a) P = MU b) P = MC c) Therefore MU = MC. Thus the marginal social cost of producing a good under perfect competition just equals its marginal utility valuation in terms of goods or leisure forgone. It is exactly this condition which guarantees that a competitive equilibrium is efficient
The perfectly competitive market is a device for synthesizing a) the willingness of consumer possession dollar votes to pay for goods with b) the marginal costs of those goods as represented by firms’ supply. Under certain conditions, competition guarantees efficiency, in which no consumer’s utility can be raised w/o lowering another consumer’s utility.
Examples
1.1) Explain how the cool head might provide the essential positive economic analysis to implement the normative value judgments of the warm heart. Do you agree with Marshall’s view of the role of the teacher? Do you accept his challenge?
Being the first economist to establish Economics as a separate discipline and field of study, A. Marshall has been considered the father of partial equilibrium analysis . Focusing on the study of individual markets in isolation, his modes of analysis provided the basis for the studies of microeconomics. A. Marshall approached economics with moral considerations setting the purpose of his studies.
As Marshall saw it, a cool head will allow you to use your studies and instruments to measure, plan and organize the economy but your heart must guide you toward having the results be for the general good, “ensuring a prosperous and just society”. His role of the teacher was noble and well intentioned.
There are two basic approaches to improving people’s lives; one way that feels good is to take the direct “warm heart” approach. For example; if you want “more food for everyone”, then focus on the hungry and give them some food. This is the typical “warm hearted” method of solving society’s ills. Using value judgments, this is the typical “normative” approach that results in more government hand outs, and the creation of such things as a “welfare state”. The alternative approach, one that is often considered the “cool heads”, or “positive” approach, is to take a more scientific approach and to first focus on solving the underlying economic ills of society. For example, you might focus on improving nations GDP or productivity as a means of improving everyone’s lives (note: “a rising tide lifts all boats”). In this indirect way, the people in a society are all better off. Economists are sometimes seen as “cool” or calculating, but the opposite is actually true. It is only by maintaining cool heads at the service of warm hearts that all of society can be improved.
Yes, we do accept the challenge.
1.7) Some scientists believe that we are rapidly depleting our natural resources. Assume that there are only two inputs (labor and natural resources) producing two goods (concerts and gasoline) with no improvement in society’s technology over time. Show what would happen to the PPF over time as natural resources are exhausted. How would invention and technological improvement modify your answer? On the basis of this example, explain why it is said that “economic growth is a race between depletion and invention”.
If we represent PPF (Product-Production-Frontier) for this case in the following graph:
The curves in blue represent the PPF curves and their intrinsic tradeoffs between the production of gasoline and concerts.
Each curve represents the PPF at a different moment. Given that no innovation or improvement is done, the resources depletion results necessarily in a decrease of inputs. In consequence, the PPF curve shifts to the left (inward), representing a decreasing overall capacity of production. This effect or shift tendency is shown through the red arrows.
The depletion of “resources” would affect the quantity of gasoline more rapidly than the quantity of concerts consumed. There will be a slightly faster decrease in gasoline over time, with concerts only dropping off slightly.
On the other hand, improvements or innovation could increase the overall capacity of production, which would be reflected in an outward shift of the PPF curve, as expressed with the dashed green arrow.
Therefore, when it’s said that “economic growth is a race between depletion and invention”, we’re expressing in words the “couple of forces” represented by the red arrows and the green dashed arrows in the above figure. As the world’s demand of resources increases at a rapid rate, there is the need to innovate, invent, and improve production in order to shift the PPF outward and not allow for the natural inward tendency.
One way to explain this is by looking at oil as an example. As the commodity is depleted, the price of that commodity will rise. As the price rises there will be more incentive to innovate and come up with more clever ways of getting that commodity (deep see drilling, for example). There will always be an incentive to innovate as the price of a commodity rises (as it nears depletion). Taking the oil example a little farther (closer to actual depletion), there will be increased incentive to replace the internal combustion engine for alternative (hydrogen fuel cells?) technology.
2.1) What determines the composition of national output? In some cases, we say that there is consumer sovereignty, meaning that consumers decide how to spend their incomes on the basis of their taste and market prices. In other cases, decisions are made by political choices of legislatures. Consider the following examples: transportation, education, police, energy efficiency of appliances, health-care coverage, television advertising. For each describe whether the allocation is by consumer sovereignty or by political decision. Would you change the method of allocation for any of these goods?
Most national economies are mixed economies; they make their internal national market making decisions based on powers and forces of supply and demand and they have areas which are regulated or supervised by the government. Whether government intervenes in a particular area depends on whether the government believes it needs to step in to improve market inefficiencies or promote equality government supervision was necessary to prevent an uneven distribution of the commodity, if the market would be inefficient in providing the public goods or this area of the market was key in promoting economic stability for the nation. Considering the following examples, there would be a varied degree of government intervention.
• Transportation: Transportation is a category that has some aspects of political decision making, and some aspects of consumer sovereignty. With respects to roads, governments typically decide which roads are built where. In some rare circumstances there are privately funded road projects, but they are less common. In the railroad industry, there is a mixture of public as well as private decision making. Deregulation has led to the private competition in the airline industry. Also, there is private competition in the sea / shipping industry (containers). Although private enterprise could find providing public transportation lucrative, there would be a part of the population that would likely be underserved by consumer sovereignty decision making in this area. People would need to be mobilized to attend work, school, etc. regardless and/or in spite of their income. In general, national output allocation in the “Transportation” sector is primarily determined by political decision. On a personal level, we feel that the allocation in the USA is fairly good, and we would not make any significant changes to the system.
• Education: Education is an elemental factor in a nation’s progress. It allows for more educated labor forces and consumers that attract and create higher paying industries. A private education system will probably improve the overall quality of schools, as schools compete for students (customers). However, there will be many left out who cannot afford to attend private school. Therefore, it is necessary for government to provide education in order for it to be accessible to everyone. This is a normative economic decision (one based on value judgments) that is typically determined at the ballot box. Currently, we have an educational system offering both public and private educations. We believe that the government should intervene to allow greater opportunities for underprivileged students who demonstrate great potential but are not challenged or motivated by poor performing schools. Allocation by political decision
• Police: Police provide safety to the nation. They should not follow the interest of an individual or set individuals whose main concern is to have a lucrative enterprise. The allocation of security personnel for the common people cannot be provided based on a consumer’s preference or decision of purchase. However, there is a market of enterprises, homes, and individuals who demand greater security than that provided by local government. Allocation is by political decision. We do not believe the method of allocation requires change.
• Energy Efficiency of Appliances: If the market is an environmental and energy conscious market, then appliance manufacturers will produce energy efficient appliances. Private enterprise will sooner or later supply products to meet this demand. However, government may also step in and create incentives to stimulate production of energy efficient appliances. Allocation by consumer sovereignty. We do not believe the method of allocation requires change.
• Health-Care Coverage: In many societies, the right to health care is considered a social and universal right regardless of one’s economic welfare. In the USA, however, health care decisions are made both by government and individuals. It is a mixed systemn. On one hand, health care providers compete for businesses and individuals. On the other, the government provides alternatives for citizens who can not afford private health care but these still prove to be inaccessible to some. In general, we believe that health is a universal right; therefore, we believe government should do more to provide universal health care.
• Television Advertising: This area is very much controlled by private enterprise being able to demand and pay for advertising space and air time. Whoever is willing and able to pay for the spot, will have time to promote to consumers their products and services. However, government intervention would be important here to provide control in what the public is viewing and in order to avoid activities that will bring more harm than good to the public. In other words, kids see commercials for sweets and processed foods but market’s supply and demand mechanism does not make it profitable for farmers to advertise their healthy products. Political decisions need to regulate content of television advertising for good of the general population.
2.3) This chapter discusses many “market failures”, areas in which the invisible hand guides the economy poorly, and describes the role of government. Is it possible that there are, as well, “government failures,” government attempts to curb market failures that are worse that the original market failures? Think of some examples of government failures. Give some examples in which government failures are so bad that it is better to live with the market failures that to try to correct them.
Government failures: The most classical example we can think of is the nationalization of Railways carried out in 1948 by the Argentinean president then, J. D. Perón. in the name of “National Sovereignty”.
The railways as a public service lost. As it’s said, “everyone’s business is no one business”, then a sense of accountability was lost in the internal management by the new –and inexpert- administrators, and this was reflected in the level of service and maintenance of the fleet.
On the other side, the new owner –the Argentinean government- failed to make the necessary investment during the following decades in order to expand the coverage of railways and make this public service more efficient.
By the time of “Ferrocarriles Argentinos” privatization in the 90’s –ironically under a peronist government- found a company with severe inefficiency problems reflected in fleet obsolescence, bad state of railroads, and a generalized low perception of the quality of service.
Nevertheless, there are several good examples of decades of good state administration of railways in Europe. Besides, the new private companies that administered the new privatized railways in Argentina in the 90’s, had heterogeneous results: while one of them did a very good job in renewing the fleet and investing in infrastructure achieving a much more efficient a higher quality service, this was not the case of other of the companies.
3.3) Explain why the price in competitive markets settles down at the equilibrium intersection of supply and demand. Explain what happens if the market price starts our too high or too low.
If we consider a purely competitive market a product price will be defined solely by the transactions between sellers and buyers. When the quantity demanded of the product equals the quantity supplied, there is an equilibrium also called market-clearing price. This equilibrium is defined by the intersection between the demand and supply curves, at which point, suppliers are producing the exact quantity the market is demanding at the price the market believes is right.
In the case where the market price of a good or service starts out too high, consumers will not purchase that good or service resulting in a surplus of goods offered. Suppliers will compete to get rid of their inventory naturally forcing the price of that goods or service downward until the price reaches a point accepted by consumers.
Conversely, if the market price starts out too low, than there will be a greater quantity demanded than that being offered. Suppliers will raise production to meet excess demand and as the market will tolerate a price raise, suppliers will naturally increase their price of goods to increase returns. Quantity supplied and the price of the good or service will increase until it reaches equilibrium point.
3.7) Examine the graph for the price of gasoline in Fig. 3-1, page 46. Then, using a supply-demand diagram, illustrate the impact of each of the following on price and quantity demanded:
a. Improvements in transportation lower the costs of importing oil into the United States in the 1960s.
A change in technology, specifically affecting transportation means, affects the supply of oil within the US. The supply curve shifts to the right and there is abundance in supply compare to previous years and the supply. There is a lower price of oil since there is a larger supply.
b. After the 1973 war, oil producers cut oil production sharply.
If oil production was cut, the result is scarcity of the commodities in the market. This will raise prices for the oil that is available and for whoever is willing to pay the price to purchase it. Graphically the supply curve shifts to the left and price goes up again to a new equilibrium compared to the 1960s
c. After 1980, smaller automobiles get more miles per gallon.
Technology affects supply and demand. As automobiles become more efficient, operation becomes more affordable and demand will rise. Initially, more mpg would mean less gas needed to run your car and thus, less need to consume gas; the supply curve would shift to the left, resulting in a new equilibrium at a lower price. However, now it is more affordable to own a small car and buy the gas to run it. The demand for a complementary good of gas (small cars) would increase as well as the need for gas. The demand schedule would shift to the right resulting in a new price that still could be lower than the original before the change in technology.
d. A record-breaking cold winter in 1995-1996 unexpectedly raises the demand for heating oil.
This price will rise because SUPPLY will sift to the LEFT. Heating oil is not the same thing as gasoline. It is a substitute of supply. On the supply side, heating oil is made from the same raw materials as gasoline. In normal situations, the supply of heating oil is stockpiled during the summer, and then distributed during the winter. In the case of an extremely cold winter, there may be fear of a depletion of inventories, or fears that distribution may become interrupted due to frozen rivers and lakes. This combination of actual depletion of inventories, plus extra fear on the behalf of the distributors can result in extra orders being sent to the oil suppliers. In this case, the raw material can be used to make heating oil instead of gasoline. This is the classic “substitution of supply”. The result is that the Supply curve for gasoline will shift to the left as oil is sent to make heating oil instead.
e. A global economic recovery in 1999-2000 leads to a sharp upturn in oil prices.
A global recovery signifies a higher demand for gas in industry and transportation. Higher demand, means higher prices. Demand schedule shifts to the right. Furthermore, oil demand is very price inelastic. Therefore, economic recovery demanding greater oil will not be greatly affected by an increase in oil prices.
4.4) Consider a competitive market for apartments. What would be the effect on the equilibrium output and price after the following changes (other things held equal)? In each case, explain your answer using supply and demand.
a. A rise in the income of consumers.
If consumers find themselves with more money to spend, they will want bigger and better apartments, and will be willing to pay for them (Moises likes this one). Apartment prices will rise reflected by an outward shift of the demand curve and a higher equilibrium point with supply.
b. A $10 per month tax on apartment rentals.
Although a $10 a month tax will probably not create that much of an effect on the apartment market, generally any tax has a negative effect on demand as consumers do not want to pay more for a good or service, in this case an apartment. Therefore, there will be an inward shift (left) of the demand curve resulting in a lower quantity demanded for apartments and a lower equilibrium price with the apartment supply.
There is a good chance that most of the price increase will go to the consumer because the demand will be more price inelastic than the supply. This is because people need apartments in the short term, and the price increase is not significant enough to make them change their buying habits.
c. A government edict saying apartments cannot rent for more than $200 per month.
If the government places a price ceiling of $200, under the market equilibrium, there will be a shortage of supply. Suppliers will not be motivated to rent apartments if they can not charge what the market is willing to pay (an amount greater than the government ceiling rate of $200/month). On the other hand, a government price ceiling of $200/month will create a great demand for apartment rentals. Since there is great demand for apartments, there is motivation for the creation of a black market where some apartments will be rented illegally above the government price ceiling as tenants are willing to pay more.
d. A new construction technique allowing apartments to be build at half the cost.
The increase in cost efficiency will be reflected by an outward shift of the supply curve. The outward shift (right) of supply creates a new equilibrium point with the demand curve at a lower price and a greater quantity.
e. A 20% increase in the wages of construction workers.
The construction companies will try to translate this increase to the price, this will drive the supply curve slightly up, now the equilibrium point with the demand curve will be reached at a slightly higher price, lower quantities.
5.2) Each week Tom Wu buys 2 burgers at $2 each, eight cokes at $0.50 each, and 8 slices of pizza at $1 each, but he buys no hot dog at $1.50 each. What can you deduce about Tom's marginal utility for each of the four goods?
Tom receives the same satisfaction from consuming 2 burgers at $2 each, eight cokes at $0.50 each, and 8 slices of pizza at $1. Each good has the same marginal utility of the last dollar spent of any one good (hamburger) has exactly the same marginal utility of the last dollar spent on any other good (pizza). However, consuming a 3rd burger, 9th coke, or 9th slice of pizza, will produce no more utility for Tom. Therefore, he will not consume this extra item.
Regarding the $1.50 hot dog (That he doesn’t buy); it tells us that if Tom were to purchase even one Hotdog at $1.50, then he would have to cut back on something else. But he values his 8 cokes * 0.50 = $4.00, and his 8 slices of pizza * $1 = $8.00, and his 2 hamburgers * $2 = $4.00. So, with his budget of 4+4+8 = $16.00…that he does not budget any money for hotdogs because that would mean that he would have to decrease his consumption of one of those other goods.
Because he does not decrease his consumption of one of those goods, then we know that the marginal utility of the first hotdog DIVIDED BY ITS PRICE is not higher than even the last marginal utility of any of those other goods DIVIDED BY ITS PRICE.
In the end, Tom does not buy the hot dog price at $1.50 because it provides less marginal utility per dollar than does the other foods he consumes. Or, it could be that Tom is allergic to hot dogs!
5.9) An interesting application of supply and demand to addictive substances compares alternative techniques for supply restriction. For this problem, assume that the demand for addictive substances is inelastic.
a) One approach (used today for heroine and cocaine and for alcohol during Prohibition) is to reduce supply at the nation’s border. Show how this raises price and increases the total income of the suppliers in the drug industry.
Although in a free-market economy the government usually lets people decide what is best for their interests and respects their preferences, there are also cases where the government decides to overrule private decisions like in the case of demerit goods. One example of demerit goods is the consumption of addictive harmful substances as heroine, cocaine and alcohol.
Several different policies have been imposed by governments around the world to help reducing the consumption of addictive harmful substances, such as the prohibition of selling and using these substances as well as the enforcement of this prohibition with criminal sanctions. Although different countries may have different approaches to this subject (for instance the U.S. and Netherlands differ on the way consumption should be penalized), there is a general consensus that the government should intervene on this matter.
One of the policies the government may choose to issue is the reduction of supply at the nation’s border. In this case, as we will see, there is a direct effect on the price and demand curve for this product (product in this case is an addictive harmful substance).
A typical supply and demand graph for this product is shown in Figure 1, where S0 is the supply curve before the government applies any policy.
Figure 1. Supply and demand for an addictive harmful substance.
When the government decides to reduce the supply at the nation’s border, there is a shift in supply to S1, which moves the equilibrium point from E0 to E1. The effect of this shift is an increase in price and because this product is considered inelastic, it would also generate an increase in the total income (Y1 > Y0) for the suppliers of this industry. A numeric example has been included in Figure 1 for clarification purposes.
b) An alternative approach (followed today for tobacco and alcohol) is to tax the goods heavily. Using the tax apparatus developed in Chapter 4, show how this reduces the total income of the suppliers in the drug industry.
As mentioned in the previous example, governments have different ways to intervene in a free-market. One policy being used by most of the countries around the world is to levy taxes on these products, mostly commodities. This policy will be explored further in this example.
A typical supply and demand graph for this product is shown in Figure 2, where S0 is the supply curve before the government levies taxes.
Figure 2. Supply and demand for tobacco and alcohol.
When the government decides to levy taxes, there is a shift in supply to S1, which moves the equilibrium point from E0 to E1. The effect of this shift is an increase in price and, because this product is considered inelastic, it would also generate an increase in the total income (Y1 > Y0) for the suppliers of this industry.
But in reality the suppliers are “collecting” the taxes for the government and the net income (total income minus taxes) for the suppliers has decreased. A numeric example has been included in Figure 2 for clarification purposes. Although the demand is relatively price-inelastic, the supply is relatively price-elastic. In this case the tax of $1.5 is being paid by the consumer (in the amount of $1) and the supplier (in the amount of $0.5).
c) Comment on the difference between the two approaches.
The first approach has the direct intent to limit supply and affect the supply level of addictive substances within a market. The market will show a leftward shift of the supply curve (S1). Since demand for addictive substances is relatively inelastic and the demand curve has a steep slope, the new equilibrium point (E1) is at lower quantity and a higher price than the original equilibrium point (E0).
With less suppliers of the substance, those who do supply it are actually selling it a higher price than before. There is a significantly greater increase of price than a reduction in quantity once the supply of addictive substance is limited. Income earned at the original point of equilibrium (Y0=12) is lower than the income at the new equilibrium (Y1=15.75). This phenomenon would explain that, even though there can be legal and even social restrictions on selling and distributing addictive substances, it can be still looked at as a lucrative and desired business giving place to black markets or underground meetings between buyers and sellers.
In the second approach, the government levies taxes on the product and, therefore generates a net raise in the price of $1.5 (from P0 at $3, to P2 at $4.5). However, the demand of addictive substances is price inelastic causing the equilibrium to actually meet at P1 and Q1. In doing this, the demand and supply of the addictive substances reach a new equilibrium where the income at the new price and quantities is higher than the original; however the new equilibrium point does not have the new price ($4) cover the cost of the tax completely ($3+$1.5=$4.5). Demand for the item is relatively price-inelastic and the consumer will contribute in paying, imbedded in the price, $1 of the $1.5 tax. The remaining $0.5 of the tax is paid by the supplier.
The latter approach concentrates on the price regulation through taxation of the substance while the first approach limits the supply of the item. It is important to note that even though the income gained is higher at the new equilibrium and the consumer is paying for part of the imposed tax, the suppliers’ income has decreased because of the difference between Po and P1 ($1) is lower than the tax increase ($1.5).
From an economic normative standpoint, taxation of the addictive substances could be a far better approach than limiting supply entry at the borders because drug dealers do not become extremely wealthy by supplying the addictive substance. Instead of profiting drug dealers, the money would be going to the government who could use the money to fund rehab and educations centers to help addictive consumers and, thus, offset the effects of the negative externality. This is important because the actual demand for addictive substances does not drop off very much as the price increases. Without social treatment centers to help the addictive consumers, in the case of borders controls leading to less supply and higher prices, there is a tendency for the addicted consumer to turn to predatory crime in order to obtain money to buy the expensive drugs they need.
6.5) Suppose you are running the food concession at the athletic events for your college. You sell hot dogs, colas, and potato chips.
a) What are your inputs of capital, labor, and materials?
Capital: • Grilling machine for hotdogs, • Fountain drink machine, • Refrigerator, • Rack for potato chips, • Sign with store name, • Overhead menu, • Fluorescent lights, • Cash register • Concession Fees (rent)
Labor: • Cook(s) for hotdogs • Cashier(s) • Manager
Materials: • Raw hotdogs • Buns • Condiments • Colas • Water • Cups • Napkins • Holders for drinks / hotdogs • Electricity • Cleaning materials
b) If the demand for hot dogs declines, what steps could you take to reduce output in the short run? In the long run?
Short run: • Cut back on the number of cooks to a minimum of 1 • Cut back on the number of managers • Eliminate manager position all together • Reduce number of cashiers to a minimum of 1 • Order less hotdogs from suppliers • Order less buns (bread) from suppliers • Order less condiments • Order less napkins • Order less holders (trays) and Cups
Long run: • Sell extra grilling machines • Sell extra cash registers • Sub Rent part of the space to other concession (may be a t-shirt shop).
7.4) “Compulsory military service allows the government to fool itself and the people about the true cost of a big army. Compare the budget cost and the opportunity cost of a voluntary army (where army pay is high) with those of compulsory service (where pay is low). What does the concept of opportunity cost contribute to analyzing the quotation?
One of the many challenges civil society faces is the allocation of resources towards security. Commonly we ask, how many resources are we going to allocate towards security and how are we going to channel these resources.
According to some people, compulsory military service is “the ultimate intrusion of government into the private lives of individuals in democratic societies” . Although this is a political decision that in a democratic society should be made by consensus from the executive and the legislative branches, it has – as all decisions – many consequences.
Great Britain had a very interesting story regarding this matter at the beginning of World War I. A spirit of enthusiasm and patriotism led a massive number of workers to voluntarily leave their jobs in order to join the army. This hurt both the economy and an efficient mobilization of manpower. By 1917, the army had grown beyond the size of the British economy, forcing the government to empower its Department of National Service to allocate men for either fighting or production.
Let’s assume Britain’s size of the "big army" is fixed at 1,000,000 people and that they had lots of volunteers ready to join an army. Assuming that compulsory pay were $1 per hour (very low), but voluntary pay were $26 per hour (high), this would mean that compulsory pay was $1,000,000 per hour, compared to $26,000,000 per hour for voluntary army. Depending upon the time frame in consideration, the budgetary difference in cost could stretch into trillions of dollars. Apparently, the obvious choice for government would be to elect the compulsory option and “save” $25 million per hour. It is only by reviewing the external opportunity costs associated with this decision that the government might choose otherwise.
From an economical point of view we are compelled to “pierce the veil of money” and see beyond the budget cost. In order to assess the opportunity cost of a certain choice, we have to think of all or most of its consequences.
One of the opportunity costs of having a draft army is that people that might otherwise add to society may forgo the necessary training and development. Imagine what the loss to society would have been if Bill Gates were to have been drafted into the military. Would he still have created Microsoft? The loss to society as a whole would be immense if daring entrepreneurs, such as Bill Gates, had been forced into military service and had missed the creative development process.
We could think of the cost of opportunity of mandatory service in terms of: • labor force lost, in consequence: o shortage in labor supply increases wages (higher production costs) o workers’ income lost or reduced (for those drafted) due to lower military wages or nonexistent wages (as was the case in several Latin American countries in previous decades) o lesser qualified or experienced workers replacing those drafted • aggregate income loss
Thinking purely from a military point of view, having a compulsory army might actually result in a batch of lesser qualified and motivated soldiers. Today, the US is a country facing some of the difficulties depicted in the last scenario. The Army recruiters missed their goal of 80,000 volunteers by 7,000, and only to try to reach the same goal for the following year . As a result, physical and age requirements have been reduced in order to increase the pool of potential soldiers. This reduces the quality of soldiers since now a 42 year old passed peek physical condition can still join and go to basic training. In addition, signing bonuses have gone up to an average $15,000 in order to attract more applicants.
For the purpose of this analysis, we’ll consider two main scenarios: times of war and times of peace.
A war can have several huge effects on the economy of a country: while it encourages the production of certain military supplies, it can also draw resources to other activities like education and healthcare. The overall economic outcomes for a country can have such magnitude that can make the opportunity cost we’re considering insignificant.
With this in mind, and if we only consider times of peace, the previously listed opportunity costs of a voluntary army will eventually disappear, while the opportunity costs of a mandatory service still apply.
Another interesting historical case on the issue is the derogation in 1994 of the mandatory military service in Argentina triggered by a scandal that begun with the murder of a young recruit within the Army. This change converted a zero-wage mandatory duty into a low-wage voluntary service that somehow helped to palliate the unemployment problems in the poorest provinces of the country.
In summary, we consider that in times of peace the opportunity cost of a compulsory military service is much higher than the budget and opportunity costs of a voluntary service. While on the other hand, drastic situations may require governments to implement a compulsory service in order to preserve a nation’s future and well-being.
9.2) Explain why each of the following statements is false. For each, write the correct statement.
a) A monopolist maximizes profits when MC = P.
b) The higher the price elasticity, the higher is a monopolist’s price above its MC.
c) Monopolists ignore the marginal principle. The marginal principle is “the fundamental notion that people will maximize their income or profits when the marginal cost and marginal benefits of their actions are equal” . A monopolist is the single firm that dominates and industry and any type of market producer is interested in maximizing their profits, their monopolistic attributes might just give them the conditions to be able to, even more than any other perfect or imperfect competitor. Monopolists can sustain supply of an entire industry’s output with an economy of scale. They face a price inelastic demand with a cost advantage that allows them to increase their prices to obtain higher profits.
Monopolists rely on the marginal principle to achieve profit-maximizing conditions. In examining their marginal revenue (MR), the generated change in the revenue per unit, and their marginal cost (MC) they can determine the quantity at which to produce and their best profit point, where MR is equal to MC. Price must be above marginal cost to ensure profits will be maximized. The actual profit maximization is shown below in the gray area in the graph below, area that represents the difference between the point on the demand curve for the quantity where MR=MC and the quantity on the average cost (AC) curve. With the monopolists' downward sloping curve and inelastic demand slope, price will be greater than or above the marginal revenue (P> MR).
Thus, to say that monopolists ignore the marginal principle is false because that would mean that they could not base their profit-maximizing production structure on the idea by considering that the last unit the company sells brings in extra revenue just equal to its extra cost. It would be correct to state, “ Monopolists acknowledge the marginal principle”.
d) Monopolists will maximize sales. They will therefore produce more than perfect competitors and their price will lower.
Monopolists are usually large firms that dominate an industry when compared to perfect competitors that are many firms that have an equal participation and affect industry equally. In perfect competition, the producer, guided by their selfish interest to maximize their wealth, their production function and output will be based on the price the consumer to purchase it at considering their own internal cost structure and their achieved economies of scale.
In a perfect competition, companies will maximize sales in the measure that higher sales translate to higher profit. Perfect competitors are price-takers because in order to maximize their profit they need to have their total revenue (TR) minus their total costs (TC) have the largest difference as possible between the firm’s total revenue and total costs ( TP= TR – TC = (pxq)-TC ). In order to achieve this the incremental change in total revenue per unit, or marginal revenue, must be equal to the incremental change in total cost, or marginal cost. It is when marginal revenue and marginal cost are equal. However, we must bear in mind that in perfect competition, a perfect competitor can sell all he wants at the market price and the sale of extra units will never decrease in price so price and marginal revenues are identical.
Monopolists, as seen previously, will look to maximize profits and the price of their profits will not be equal to their marginal cost and marginal revenue. It will be above it. This does not necessarily mean that they will look to maximize sales, product more than perfect competitors, or have lower price. Their total output and price will be in function of where MC is equal to MR. Their prices tend to be above their cost to maximize profits which result in high prices compared to those set in perfect competition. Their out put tend to be at low efficient levels. It would be correct to say, “Monopolists may not maximize sales. They can or cannot produce more than perfect competitors and their price may not be lower.”
10.3) "Perfect price discrimination" occurs when each consumer is charged his or her maximum price for the product. When this happens, the monopolist is able to capture the entire consumer surplus. Draw a demand curve for each of six consumers and compare (a) the situation in which all consumers face a single price with (b) a market under perfect price discrimination. Explain the paradoxical result that perfect price discrimination removes the inefficiency of monopoly.
To make this example easier, we will assume constant returns to scale (MC= constant). Then we will look at 6 different cases of monopoly pricing, and analyze the consumer surplus (definition), the monopolies economic profits (in excess of normal fair economic profits of perfect competition, and also the deadweight loss (the lost economic welfare that is neither captured in the monopolies profits, nor in the consumer surplus under monopolistic pricing).
a) First we consider the situation of perfect competition. In this situation, the price set to the intersection of MC and demand, we would have a total quantity sold at Q1. To illustrate consumer surplus, we will look at 6 clients, each of whom has a different ability to pay (based on their concept of marginal utility of this product). Client #1 would be willing to pay $100; client #2 would pay $90; #3 would pay $80; #4 would pay $70; #5 would pay $60; #6 would pay $50, which just happens to be the equilibrium point under perfect competition (where MC would equal MR of perfect competition, assuming normal economic profits for the firm). With a market price of $50, then all clients will be charged this price, even though client #1 was actually willing to pay $100 for it. Therefore, client #1 enjoys a consumer surplus of $50. If you add up the entire consumer surplus, you get the area shaded in the (DEF) triangle in the diagram below. This exemplifies the total consumer surplus under perfect competition.
Next, let’s consider a situation of perfect monopoly, but where the producer charges only one set price for his product (no price differentiation yet). In this case, the monopolist producer will choose to produce at a quantity where MR = MC, which is shown graphically as point “A” below. By looking at the demand curve (DD), you will see that the monopolist will charge a price of $80. At that price level of $80, the clients #4, #5, and #6 will not elect to purchase the product. Client #1 would have a consumer surplus of $20; consumer #2 would have $10. The consumer profit as shown below in the triangle BDG. The monopolist would make their additional economic profit as shown in the yellow box (ABGF) below. But there will now be a lost economic surplus as shown by the “deadweight loss” in triangle ABE (grey triangle below). This deadweight loss results from an inefficient pricing structure of the typical monopolist. Nobody captures this potential economic profit (or consumer surplus).
b) Finally, lets consider a situation of perfect monopoly, but this time let’s assume that the monopolist was able to use “perfect price discrimination”, meaning that they were able to charge each customer exactly the amount that they were willing to pay. In this case, there would be no deadweight loss, but neither would there be any consumer surplus, because each client is paying exactly the level that they were willing to pay. In this case, the monopoly is capturing all of the available economic profits. See graph below
17.7) Make a list of industries that you feel are candidates for the title “natural monopoly”. Then review the different strategies for intervention to prevent exercise of monopoly power. What would you do about each industry on your list?
A natural monopoly is a market in which the industry’s output can be efficiently produced only by a single firm. In a natural monopoly, average and marginal costs continuously drop as output grows (downward sloping average and marginal cost curves). As a result, there cannot be perfect competition between many small firms as one large firm is much more efficient. Since production/distribution is most efficiently done by one firm, the argument is made to regulate natural monopolies in order to prevent monopoly pricing. The following graph demonstrates the ideal and practical regulation of monopolies:
Natural monopolies are regulated to prevent firms from charging high prices (Pm) with little quantity demanded (Qm) while still making huge profits. Traditional regulation consists of average cost pricing, where benefits are distributed between firm and consumers while improving economic efficiency. A regulated price shifts the price closer to marginal cost, demonstrated at (Pr) and (Qr), which is the point where average cost intersects the demand curve.
Industry examples of natural monopolies include:
Telephone Service Providers Electricity distribution Utilities (Natural gas, water, waste disposal) Energy Production Railways
We commonly find highly regulated natural monopolies in developing countries, such as Nicaragua, where the market is very sensitive to price fluctuations and where the market is not large enough to sustain several competitors. Following we will review the different possible interventions that could be taken to curb monopolistic power and pricing.
The most common form of intervention is economic regulation in the form of average cost pricing. Here prices are set according to where demand intersects with average price, rather than at the monopolistic maximum-profitability price where marginal revenues equal marginal costs. Since marginal costs are lower than average costs, setting the price equal to marginal costs (which is the ideal economic efficient point) would not make sense as it represents a loss for the firm.
An alternative to average cost pricing is performance-based regulation. In this scenario the telephone company's regulated prices would move with inflation minus a performance incentive. Here the company is motivated to improve efficiency as a cost reduction directly translates into profits. This mimics a competitive market. One downside to this approach is that an incorrect value for the efficiency improvement could either cause company to go bankrupt or earn huge monopoly profits.
A newer form of regulation is known as social regulation. This form of regulation is intended to protect the environment, the health and safety of workers and consumers. In some countries (particularly developing countries), governments allow natural monopolies to get away with harmful practices due to the lack of social regulation. Another strategy is deregulation, opening the market to competition and the free movement of firms. Here competition will increase offering while at the same time forcing prices downward.
Following we will suggest which strategies should be taken to prevent monopolistic power for the industries previously listed.
A. Telephone Service Providers
In highly sensitive markets where the government has failed to operate public telecommunication companies efficiently or even regulate the industry effectively, we believe the best solution is to deregulate the market. This will remove the burden from the government to assure what is best for consumers as natural competition will take care of this. Furthermore, it will save government resources that could be used for other social improvements such as education, healthcare, or infrastructure.
B. Electricity Distribution
Electricity distribution is another natural monopoly that should be deregulated. In Nicaragua for example, electricity distribution was privatized and sold to the company Union Fenosa from Spain. The argument for privatization was made for similar reasons listed above; the private company can improve efficiency and provide better services with newer technologies. The National Energy Institute (INDE) has maintained strict price controls on Union Fenosa while the company’s costs have increased significantly. The price INDE has imposed on Union Fenosa is a price below the company’s average cost. This has forced Union Fenosa to reduce output in order to stay afloat. As a result, there are frequent power outages that hinder the national economy. If the price of distribution was market regulated, than we could find an equilibrium of price and quantity that is most efficient.
As ideal as a competitive market would be for efficient pricing of electricity distribution, certain markets are just too small for many firms. And even if one additional firm entered the market, the two firms can eventually collaborate and form a cartel to protect each other. They would protect their assets, while placing barriers to new entrants. Therefore, we must accept that a natural monopoly is the most effective method of operating. In the case of electric distribution, we would suggest that performance based pricing that fluctuates with inflation minus an efficiency incentive would be the best way to simulate a competitive market. However, it would be essential to frequently monitor the rate of the incentive in order to prevent crippling the company or to prevent it from enjoying unprecedented gains common in monopolistic markets.
C. Utilities (Natural Gas, Water, and Waste Disposal)
Similar to electricity distribution companies, utilities are difficult to convert into a competitive market. In large established markets such as the U.S., this may feasible, however, small developing countries do not represent a large enough market that can sustain several firms. Consequently, economic regulation is necessary to prevent monopolistic pricing. We believe that performance based pricing is the best strategy to simulate competitive markets for utilities. The performance incentive will motivate companies to improve efficiency and invest in technologies.
D. Energy Production
Energy companies in the production side are commonly natural monopolies. For example, it does not make sense for two oil companies to share the same well or two nuclear power plants for one community. Social regulation in this market is needed in order to prevent natural monopolies in this industry from destroying the environment or from ignoring safety for workers and local residents. For example, oil companies in the “upstream” (production side of the industry) could be required to allocate a percentage of profits into a safety development and training fund. Or, they could be required to pay an environment tax that would be a percentage of profits.
We believe that creating incentives, rather than social regulation, is the most efficient method for getting energy production companies in natural monopolies to invest in technology, safety, and training. This can be done by providing tax breaks for companies who meet certain target levels or pass certain safety standards.
In Central America, energy production is highly inefficient and highly regulated. These countries do not have the capacity to produce the energy demanded therefore; they often find themselves purchasing energy from other countries. However, intermediary countries will block the energy transfer and force countries to purchase elsewhere at a higher price. In this scenario, we believe that the best solution is deregulation of the market along with market integration. A Central American energy grid should be created along with an energy exchange. Here, energy producers will compete for demand and energy will most efficiently be allocated. At the same time, consumers/countries will always obtain the best price available.
E. Railways
The railway industry is a natural monopoly that has been severely impacted by regulation along with strong competition from substitute services. We believe that deregulating the industry will allow rail companies to more effectively compete with the trucking industry, airline industry, and even the sea cargo industry. Rail companies already have enough pressure from competitors that there is no need to regulate its prices. The competition already forces the rail companies to maintain competitive prices while continuously seeking efficiency and innovation.
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