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both demand and supply curves, the equilibrium quantity increases whereas the equilibrium price remains unchanged, and in Figure 5.4(b), equilibrium quantity remains the same whereas price decreases due to a leftward shift in demand curve and a rightward shift in supply curve. 5.1.2 Market Equilibrium: Free Entry and Exit In the last section, the market equilibrium was studied under the assumption that there is a fixed number of firms. In this section, we will study market equilibrium when firms can enter and exit the market freely. Here, for simplicity, we assume that all the firms in the market are identical. What is the implication of the entry and exit assumption? This assumption implies that in equilibrium no firm earns supernormal profit or incurs loss by remaining in production; in other words, the equilibrium price will be equal to the minimum average cost of the firms. 2019-20 To see why it is so, suppose, at the prevailing market price, each firm is earning supernormal profit. The possibility of earning supernormal profit will attract some new firms. As new firms enter the market supply curve shifts rightward. However, demand remains unchanged. This causes market price to fall. As prices fall, supernormal profits are eventually wiped out. At this point, with all firms in the market earning normal profit, no more firms will have incentive to enter. Similarly, if the firms are earning less than normal profit at the prevailing price, some firms will exit which will lead to an increase in price, and with sufficient number of firms, the profits of each firm will increase to the level of normal profit. At this point, no more firm will want to leave since they will be earning normal profit here. Thus, with free entry and exit, each firm will always earn normal profit at the prevailing market price. Free for all Recall from the previous chapter that the firms will earn supernormal profit so long as the price is greater than the minimum average cost and at prices less than minimum average cost, they will earn less than normal profit. Therefore, at prices greater than the minimum average cost, new firms will enter, and at prices below minimum average cost, existing firms will start exiting. At the price level equal to the minimum average cost of the firms, each firm will earn normal profit so that no new firm will be attracted to enter the market. Also the existing firms will not leave the market since they are not incurring any loss by producing at this point. So, this price will prevail in the market. Therefore, free entry and exit
of the firms imply that the market price will always be equal to the minimum average cost, that is p = min AC From the above, it follows that the equilibrium price will be equal to the minimum average cost of the firms. In equilibrium, the quantity supplied will be determined by the market demand at that price so that they are equal. Graphically, this is shown in Figure 5.5 where the market will be in equilibrium at point E at which the demand curve DD intersects the p0 = min AC line such that the market price is p0 and the total quantity demanded and supplied is equal to q0. At p0 = min AC each firm supplies same amount of output, Price Determination with Free Entry and Exit. With free entry and exit in a perfectly competitive market, the equilibrium price is always equal to min AC and the equilibrium quantity is determined at the intersection of the market demand curve DD with the price line p = min AC. 81 2019-20 say q0f. Therefore, the equilibrium number of firms in the market is equal to the number of firms required to supply q0 output at p0, each in turn supplying q0f amount at that price. If we denote the equilibrium number of firms by n0, then n0 = q q 0 0 f To understand the equilibrium price and quantity determination more clearly, let us look at the following example. EXAMPLE Consider the example of a market for wheat such that the demand curve for wheat is given as follows 5.2 qD = 200 – p for 0 ≤ p ≤ 200 = 0 for p > 200 Assume that the market consists of identical farms. The supply curve of a single farm is given by s fq = 10 + p for p ≥ 20 = 0 for 0 ≤ p < 20 The free entry and exit of farms would mean that the farms will never produce below minimum average cost because otherwise they will incur loss from production in which case they will exit the market. As we know, with free entry and exit, the market will be in equilibrium at a price which equals the minimum average cost of the farms. Therefore, the equilibrium price is p0 = 20 At this price, market will supply that quantity which is equal to the market demand. Therefore, from the demand curve, we get the equilibrium quantity: q0 = 200 – 20 = 180 Also at p0 = 20, each farm supplies q0f = 10 + 20 = 30 Therefore, the equilibrium number of farms is n0 = 0 q q 0 f =
180 30 = 6 Thus, with free entry and exit, the equilibrium price, quantity and number of farms are Rs 20, 180 kg and 6 respectively. Shifts in Demand Let us examine the impact of shift in demand on equilibrium price and quantity when the firms can freely enter and exit the market. From the previous section, we know that free entry and exit of the firms would imply that under all circumstances equilibrium price will be equal to the minimum average cost of the existing firms. Under this condition, even if the market demand curve shifts in either direction, at the new equilibrium, the market will supply the desired quantity at the same price. In Figure 5.6, DD0 is the market demand curve which tells us how much quantity will be demanded by the consumers at different prices and p0 denotes 82 2019-20 the price which is equal to the minimum average cost of the firms. The initial equilibrium is at point E where the demand curve DD0 cuts the p0 = minAC line and the total quantity demanded and supplied is q0. The equilibrium number of firms is n0 in this situation. Now suppose the demand curve shifts to the right for some reason. At p0 there will be excess demand for the commodity. Some dissatisfied consumers will be willing to pay higher price for the commodity, so the price tends to rise. This gives rise to a possibility of earning supernormal profit which will attract new firms to the market. The entry of these new firms will eventually wipe out the supernormal profit and the price will again reach p0. Now higher quantity will be supplied at the same price. From the panel (a), we can see that the new demand curve DD1 intersects the p0 = minAC line at point F such that the new equilibrium will be (p0, q1) where q1 is greater than q0. The new equilibrium number of firms n1 is greater than n0 because of the entry of new firms. Similarly, for a leftward shift of the demand curve to DD2, there will be 83 Shifts in Demand. Initially, the demand curve was DD0, the equilibrium quantity and price were q0 and p0 respectively. With rightward shift of the demand curve to DD1, as shown in panel (a), the equilibrium quantity increases and with leftward shift of the demand curve to DD2, as shown in panel (b), the equilibrium quantity decreases. In both the cases, the equilibrium price remains unchanged at p0. excess supply at the price p0. In
response to this excess supply, some firms, which will be unable to sell their desired quantity at p0, will wish to lower their price. The price tends to decrease which will lead to the exit of some of the existing firms and the price will again reach p0. Therefore, in the new equilibrium, less quantity will be supplied which will be equal to the reduced demand at that price. This is shown in panel (b) where due to the shift of demand curve from DD0 to DD2, quantity demanded and supplied will decrease to q2 whereas the price will remain unchanged at p0. Here, the equilibrium number of firms, n2 is less than n0 due to the exit of some existing firms. Thus, due to a shift in demand rightwards (leftwards), the equilibrium quantity and number of firms will increase (decrease) whereas the equilibrium price will remain unchanged. Here, we should note that with free entry and exit, shift in demand has a larger effect on quantity than it does with the fixed number of firms. But unlike with fixed number of firms, here, we do not have any effect on equilibrium price at all. 2019-20 5.2 APPLICATIONS In this section, we try to understand how the supply-demand analysis can be applied. In particular, we look at two examples of government intervention in the form of price control. Often, it becomes necessary for the government to regulate the prices of certain goods and services when their prices are either too high or too low in comparison to the desired levels. We will analyse these issues within the framework of perfect competition to look at what impact these regulations have on the market for these goods. 5.2.1 Price Ceiling It is not very uncommon to come across instances where government fixes a maximum allowable price for certain goods. The government-imposed upper limit on the price of a good or service is called price ceiling. Price ceiling is generally imposed on necessary items like wheat, rice, kerosene, sugar and it is fixed below the market-determined price since at the market-determined price some section of the population will not be able to afford these goods. Let us examine the effects of price ceiling on market equilibrium through the example of market for wheat. Price Catcher 84 Figure 5.7 shows the market supply curve SS and the market demand curve DD for wheat. at The equilibrium price and quantity of wheat are p* and q* respectively. When the government imposes price ceiling cp which is lower than the equilibrium price level, there
will be an excess demand for wheat in the market at that price. The consumers demand qc kilograms of wheat whereas the firms supply cq'kilograms. Effect of Price Ceiling in Wheat Market. The equilibrium price and quantity are p* and q* respectively. Imposition of price ceiling at pc gives rise to excess demand in the wheat market. Hence, though the intention of the government was to help the consumers, it could end up creating shortage of wheat. How is the quantity of wheat (q'c) then distributed among the consumers? One way of doing this is to distribute it to everyone, through a system of rationing. Ration coupons are issued to the consumers so that no individual can buy more than a certain amount of wheat and this stipulated amount of wheat is sold through ration shops which are also called fair price shops. 2019-20 In general, price ceiling accompanied by rationing of the goods may have the following adverse consequences on the consumers: (a) Each consumer has to stand in long queues to buy the good from ration shops. (b) Since all consumers will not be satisfied by the quantity of the goods that they get from the fair price shop, some of them will be willing to pay higher price for it. This may result in the creation of black market. 5.2.2 Price Floor For certain goods and services, fall in price below a particular level is not desirable and hence the government sets floors or minimum prices for these goods and services. The governmentimposed lower limit on the price that may be charged for a particular good or service is called price floor. Most well-known examples of imposition of price floor are agricultural price support programmes and the minimum wage legislation. Price pf p* SS DD O qf q* q'f Quantity Fig. 5.8 Effect of Price Floor on the Market for Goods. The market equilibrium is at (p, q). Imposition of price floor at pf gives rise to an excess supply. Through an agricultural price support programme, the government imposes a lower limit on the purchase price for some of the agricultural goods and the floor is normally set at a level higher than the market-determined price for these goods. Similarly, through the minimum wage legislation, the government ensures that the wage rate of the labourers does not fall below a particular level and here again the minimum wage rate is set above the equilibrium wage rate. Figure 5.8 shows the market supply and the market demand curve for a commodity on which price floor is imposed. The market
equilibrium here would occur at price p* and quantity q*. But when the government imposes a floor higher than the equilibrium price at pf, the market demand is qf whereas the firms want to supply q ′ f, thereby leading to an excess supply in the market equal to qf q ′ f. In the case of agricultural support, to prevent price from falling because of excess supply, government needs to buy the surplus at the predetermined price. 85 • • In a perfectly competitive market, equilibrium occurs where market demand equals market supply. The equilibrium price and quantity are determined at the intersection of the market demand and market supply curves when there is fixed number of firms. • Each firm employs labour upto the point where the marginal revenue product of labour equals the wage rate. • With supply curve remaining unchanged when demand curve shifts rightward (leftward), the equilibrium quantity increases (decreases) and equilibrium price increases (decreases) with fixed number of firms. 2019-20 • With demand curve remaining unchanged when supply curve shifts rightward (leftward), the equilibrium quantity increases (decreases) and equilibrium price decreases (increases) with fixed number of firms. • When both demand and supply curves shift in the same direction, the effect on equilibrium quantity can be unambiguously determined whereas the effect on equilibrium price depends on the magnitude of the shifts. • When demand and supply curves shift in opposite directions, the effect on equilibrium price can be unambiguously determined whereas the effect on equilibrium quantity depends on the magnitude of the shifts. In a perfectly competitive market with identical firms if the firms can enter and exit the market freely, the equilibrium price is always equal to minimum average cost of the firms. • • • With free entry and exit, the shift in demand has no impact on equilibrium price but changes the equilibrium quantity and number of firms in the same direction as the change in demand. In comparison to a market with fixed number of firms, the impact of a shift in demand curve on equilibrium quantity is more pronounced in a market with free entry and exit. Imposition of price ceiling below the equilibrium price leads to an excess demand. Imposition of price floor above the equilibrium price leads to an excess supply. • • s s s Equilibrium Excess demand Excess supply Marginal revenue product of labour Value of marginal product of labour Price ceiling, Price floor KKKKK 86. Explain market equilibrium. 2. When do we say there is excess demand for a commodity in the market? 3. When do we say there is excess
supply for a commodity in the market? 4. What will happen if the price prevailing in the market is (i) above the equilibrium price? (ii) below the equilibrium price? 5. Explain how price is determined in a perfectly competitive market with fixed number of firms. 6. Suppose the price at which equilibrium is attained in exercise 5 is above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it? 7. At what level of price do the firms in a perfectly competitive market supply when free entry and exit is allowed in the market? How is equilibrium quantity determined in such a market? 8. How is the equilibrium number of firms determined in a market where entry and exit is permitted? 9. How are equilibrium price and quantity affected when income of the consumers (a) increase? (b) decrease? 10. Using supply and demand curves, show how an increase in the price of shoes affects the price of a pair of socks and the number of pairs of socks bought and sold. 2019-20 11. How will a change in price of coffee affect the equilibrium price of tea? Explain the effect on equilibrium quantity also through a diagram. 12. How do the equilibrium price and quantity of a commodity change when price of input used in its production changes? 13. If the price of a substitute(Y) of good X increases, what impact does it have on the equilibrium price and quantity of good X? 14. Compare the effect of shift in demand curve on the equilibrium when the number of firms in the market is fixed with the situation when entry-exit is permitted. 15. Explain through a diagram the effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity. 16. How are the equilibrium price and quantity affected when (a) both demand and supply curves shift in the same direction? (b) demand and supply curves shift in opposite directions? 17. In what respect do the supply and demand curves in the labour market differ from those in the goods market? 18. How is the optimal amount of labour determined in a perfectly competitive market? 19. How is the wage rate determined in a perfectly competitive labour market? 20. Can you think of any commodity on which price ceiling is imposed in India? What may be the consequence of price-ceiling? 21. A shift in demand curve has a larger effect on price and smaller effect on quantity when the number of firms is fixed compared to the
situation when free entry and exit is permitted. Explain. 22. Suppose the demand and supply curve of commodity X in a perfectly competitive market are given by: qD = 700 – p qS = 500 + 3p for p ≥ 15 = 0 for 0 ≤ p < 15 Assume that the market consists of identical firms. Identify the reason behind the market supply of commodity X being zero at any price less than Rs 15. What will be the equilibrium price for this commodity? At equilibrium, what quantity of X will be produced? 23. Considering the same demand curve as in exercise 22, now let us allow for free entry and exit of the firms producing commodity X. Also assume the market consists of identical firms producing commodity X. Let the supply curve of a single firm be explained as qS f = 8 + 3p for p ≥ 20 = 0 for 0 ≤ p < 20 (a) What is the significance of p = 20? (b) At what price will the market for X be in equilibrium? State the reason for your answer. (c) Calculate the equilibrium quantity and number of firms. 24. Suppose the demand and supply curves of salt are given by: qD = 1,000 – p qS = 700 + 2p (a) Find the equilibrium price and quantity. (b) Now suppose that the price of an input used to produce salt has increased so that the new supply curve is qS = 400 + 2p How does the equilibrium price and quantity change? Does the change conform to your expectation? (c) Suppose the government has imposed a tax of Rs 3 per unit of sale of salt. How does it affect the equilibrium price and quantity? 25. Suppose the market determined rent for apartments is too high for common people to afford. If the government comes forward to help those seeking apartments on rent by imposing control on rent, what impact will it have on the market for apartments? 87 2019-20 Chapter 6 Non-competitive Marketsetsetsetsets Non-competitive Mark Non-competitive Mark Non-competitive Mark Non-competitive Mark We recall that perfect competition is a market structure where both consumers and firms are price takers. The behaviour of the firm in such circumstances was described in the Chapter 4. We discussed that the perfect competition market structure is approximated by a market satisfying the following conditions: (i) there exist a very large number of firms and consumers of the commodity, such that the output sold by each firm is negligibly small compared to the total output of all the firms
combined, and similarly, the amount purchased by each consumer is extremely small in comparison to the quantity purchased by all consumers together; (ii) firms are free to start producing the commodity or to stop production; i.e., entry and exit is free (iii) the output produced by each firm in the industry is indistinguishable from the others and the output of any other industry cannot substitute this output; and (iv) consumers and firms have perfect knowledge of the output, inputs and their prices. In this chapter, we shall discuss situations where one or more of these conditions are not satisfied. If assumption (ii) is dropped, and it becomes difficult for firms to enter a market, then a market may not have many firms. In the extreme case a market may have only one firm. Such a market, where there is one firm and many buyers is called a monopoly. A market that has a small number of large firms is called an oligopoly. Notice that dropping assumption (ii) leads to dropping assumption (i) as well. Similarly, dropping the assumption that goods produced by a firm are indistinguishable from those of other firms (assumption iii) implies that goods produced by firms are close substitutes, but not perfect substitutes for each other. Such markets, where assumptions (i) and (ii) may hold, but (iii) does not hold are called markets with monopolistic competition. This chapter examines the market structures of monopoly, monopolistic competition and oligopoly. 6.1 SIMPLE MONOPOLY IN THE COMMODITY MARKET A market structure in which there is a single seller is called monopoly. The conditions hidden in this single line definition, however, need to be explicitly stated. A monopoly market structure requires that there is a single producer of a particular commodity; no other commodity works as a substitute for this commodity; and 2019-20 for this situation to persist over time, sufficient restrictions are required to be in place to prevent any other firm from entering the market and to start selling the commodity. In order to examine the difference in the equilibrium resulting from a monopoly in the commodity market as compared to other market structures, we also need to assume that all other markets remain perfectly competitive. In particular, we need (i) All the consumers are price takers; and (ii) that the markets of the inputs used in the production of this commodity are perfectly competitive both from the supply and demand side. ‘I’ ‘M’ Perfect Competition If all the above conditions are satisfied, then we define the situation as
one of monopoly in a single commodity market. Competitive Behaviour versus Competitive Structure A perfectly competitive market has been defined as one where an individual firm is unable to influence the price at which the product is sold in the market. Since price remains the same for any level of output of the individual firm, such a firm is able to sell any quantity that it wishes to sell at the given market price. It, therefore, does not need to compete with other firms to obtain a market for its produce. This is clearly the opposite of the meaning of what is commonly understood by competition or competitive behaviour. We see that Coke and Pepsi compete with each other in a variety of ways to achieve a higher level of sales or a greater share of the market. Conversely, we do not find individual farmers competing among themselves to sell a larger amount of crop. This is because both Coke and Pepsi possess the power to influence the market price of soft drinks, while the individual farmer does not. Thus, competitive behaviour and competitive market structure are, in general, inversely related; the more competitive the market structure, less competitive is the behaviour of the firms. On the other hand, the less competitive the market structure, the more competitive is the behaviour of firms towards each other. In a monopoly there is no other firm to compete with. 6.1.1 Market Demand Curve is the Average Revenue Curve The market demand curve in Figure 6.1 shows the quantities that consumers as a whole are willing to purchase at different prices. If the market price is at p0, consumers are willing to purchase the quantity q0. On the other hand, if the market price is at the lower level p1, consumers are willing to buy a higher quantity q1. That is, price in the market affects the quantity demanded by the consumers. This is also expressed by saying that the quantity purchased by the consumers is a decreasing function of the price. For the monopoly firm, the above argument expresses itself from the reverse direction. The monopoly firm’s decision to sell a larger quantity is possible only at a lower price. Conversely, if the monopoly firm brings a smaller quantity of the commodity into the market for sale it will be able to sell at a higher price. Thus, for the monopoly firm, the price depends on the quantity of the commodity sold. The same is also expressed by stating 89 2019-20 that price is a decreasing function of the quantity sold. Thus, for the monopoly firm, the market demand curve expresses the price that consumers are willing to pay for different quantities
supplied. This idea is reflected in the statement that the monopoly firm faces the market demand curve, which is downward sloping. Price D p0 p1 D q1 q0 O Output Fig. 6.1 The above idea can be viewed from another angle. Since the firm is assumed to have perfect knowledge of the market demand curve, the monopoly firm can decide the price at which it wishes to sell its commodity, and therefore, determines the quantity to be sold. For instance, examining Figure 6.1 again, since the monopoly firm is aware of the shape of the curve DD, if it wishes to sell the commodity at the price p0, it can do so by producing and selling quantity q0, since at the price p0, consumers are willing to purchase the quantity q0. On the other hand, if it wants to sell q1, it will only be able to do so at the price p1. Market Demand Curve. Shows the quantities that consumers as a whole are willing to purchase at different prices. The contrast with the firm in a perfectly competitive market structure should be clear. In that case, the firm could bring into the market as much quantity of the commodity as it wished and could sell it at the same price. Since this does not happen for a monopoly firm, the amount received by the firm through the sale of the commodity has to be examined again. 90 We do this exercise through a schedule, a graph, and using a simple equation of a straight line demand curve. As an example, let the demand function be given by the equation q = 20 – 2p, where q is the quantity sold and p is the price in rupees. The equation can be written in terms of p as p = 10 – 0.5q Substituting different values of q from 0 to 13 gives us the prices from 10 to 3.5. These are shown in the q and p columns of Table 6.1. These numbers are depicted in a graph in Figure 6.2 with prices on the vertical axis and quantities on the horizontal axis. The prices that are available for different quantities of the commodity are shown by the solid straight line D. The total revenue (TR) received by the firm from the sale of the commodity equals the product of the price and the quantity sold. In Table 6.1: Prices and Revenue q p TR AR MR 0 8 – 9.5 9 10 9.5 9.5 18 9 8.5 25.5 8.5 8 32 7.5 37.
5 7.5 7 42 6.5 45.5 6.5 6 48 5.5 49.5 5.5 50 10 5 11 4.5 49.5 4.5 12 4 13 3.5 45.5 3.5 48 5 6 4 7 – 9.5 8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5 0.5 -0.5 -1.5 -2.5 2019-20 the the case of the monopoly firm, the total revenue is not a straight line. Its shape depends on the shape of curve. Mathematically, TR is represented as a function of the quantity sold. Hence, in our example TR = p × q demand = (10 – 0.5q) × q = 10q – 0.5q2 This is not the equation of a straight line. It is a quadratic equation in which the squared term has a negative cofficient. Such an equation represents an inverted vertical parabola. TR, AR, MR O Fig. 6.2 TR 10 D = AR Output MR Total, Average and Marginal Revenue Curves: The total revenue, average revenue and the marginal revenue curves are depicted here. In Table 6.1, the TR column represents the product of the p and q columns. It can be noticed that as the quantity increases, TR increases to Rs 50 when output becomes 10 units, and after this level of output, total revenue starts declining. The same is visible in Figure 6.2. The revenue received by the firm per unit of commodity sold is called the Average Revenue (AR). Mathematically, AR = TR/q. In Table 6.1, the AR column provides values obtained by dividing TR values by q values. It can be seen that the AR values turn out to be the same as the values in the p column. This is only to be expected Since TR = p × q, substituting this into the AR equation AR = TR q AR = q ) ( p × q = p As seen earlier, the p values represent the market demand curve as shown in Figure 6.2. The AR curve will therefore lie exactly on the market demand curve. This is expressed by the demand curve is the average revenue curve for the monopoly firm. Graphically, the value of AR can be found from the TR curve for any level of quantity sold through a simple construction given in Figure 6.3. When quantity is 6 units, draw a vertical
line passing through the value 6 on the horizontal axis. This line will Relation between Average Revenue and Total Revenue Curves. The average revenue at any level of output is given by the slope of the line joining the origin and the point on the total revenue curve corresponding to the output level under consideration. 91 2019-20 cut the TR curve at the point marked ‘a’ at a height equal to 42. Draw a straight line joining the origin O and point ‘a’. The slope of this ray from the origin to a point on the TR provides the value of AR. The slope of this ray is equal to 7. Therefore, AR has the value 7. The same can be verified from Table 6.1. 6.1.2 Total, Average and Marginal Revenues A more careful glance at Table 6.1 reveals that TR does not increase by the same amount for every unit increase in quantity. Sale of the first unit leads to a change in TR from Rs 0 when quantity is of 0 unit to Rs 9.50 when quantity is 1 unit, i.e., a rise of Rs 9.50. As the quantity increases further, the rise in TR is smaller. For example, for the 5th unit of the commodity, the rise in TR is Rs 5.50 (Rs 37.50 for 5 units minus Rs 32 for 4 units). As mentioned earlier, after 10 units of output, TR starts declining. This implies that bringing more than 10 units for sale leads to a level of TR less than Rs 50. Thus, the rise in TR due to the 12th unit is: 48 – 49.50 = –1.5, ie a fall of Rs 1.50. This change in TR due to the sale of an additional unit is termed Marginal Revenue (MR). In Table 6.1, this is depicted in the last column. Observe that the MR at any quantity is the difference between the TR at that quantity and the TR at the previous quantity. For example, when q = 3, MR = (25.5 – 18) = 7.5 TR, MR In the last paragraph, it was shown that TR increases more slowly as quantity sold increases and falls after quantity reaches 10 units. The same can be viewed through the MR values which fall as q increases. After the quantity reaches 10 units, MR has negative values. In Figure 6.2, MR is depicted by the dotted line. c L2 b d TR L1 a O 10 Output
MR Fig. 6.4 Relation between Marginal Revenue and Total Revenue Curves. The marginal revenue at any level of output is given by the slope of the total revenue curve at that level of output. Graphically, the values of the MR curve are given by the slope of the TR curve. The slope of any smooth curve is defined as the slope of the tangent to the curve at that point. This is depicted in Figure 6.4. At point ‘a’ on the TR curve, the value of MR is given by the slope of the line L1, and at point ‘b’ by the line L2. It can be seen that both lines have positive slope, but the line L2 is flatter than line L1, ie its slope is lesser. When 10 units of the commodity are sold, the tangent to the TR is horizontal, ie its slope is zero.1 The value of the MR for the same quantity is zero. At point ‘d’ on the TR curve, where the tangent is negatively sloped, the MR takes a negative value. We can now conclude that when total revenue is rising, marginal revenue is positive, and when total revenue shows a fall, marginal revenue is negative. Another relation can be seen between the AR and the MR curves. Figure 1Question: Why is the MR not equal to zero at q=10 in table 6.1? This is because we are measuring MR ‘discretely’, i.e, by jumping from 9 units to 10 units. If you recalculate the TR for values of q closer to 10 e.g., 9.5, 9.75 or 9.9, the TR will get closer to 50, Eg: at q=9.9, TR will be 49.995. 92 2019-20 AR, MR O Fig. 6.5 (a) AR, MR AR Output O MR AR Output MR (b) Relation between Average Revenue and Marginal Revenue curves. If the AR curve is steeper, then the MR curve is far below the AR curve. 6.2 shows that the MR curve lies below the AR curve. The same can be seen in Table 6.1 where the values of MR at any level of output are lower than the corresponding values of AR. We can conclude that if the AR curve (ie the demand curve) is falling steeply, the MR curve is far below the AR curve. On the other hand, if
the AR curve is less steep, the vertical distance between the AR and MR curves is smaller. Figure 6.5(a) shows a flatter AR curve while Figure 6.5(b) shows a steeper AR curve. For the same units of the commodity, the difference between AR and MR in panel (a) is smaller than the difference in panel (b). 6.1.3 Marginal Revenue and Price Elasticity of Demand The MR values also have a relation with the price elasticity of demand. The detailed relation is not derived here. It is sufficient to notice only one aspect– price elasticity of demand is more than 1 when the MR has a positive value, and becomes less than the unity when MR has a negative value. This can be seen in Table 6.2, which uses the same data presented in Table 6.1. As the quantity of the commodity increases, MR value becomes smaller and the value of the price elasticity of demand also becomes smaller. Recall that the demand curve is called elastic at a point where price elasticity is greater than unity, inelastic at a point where the price elasticity is less than unity and unitary elastic when price elasticity is equal to 1. Table 6.2 shows that when quantity is less than 10 units, MR is positive and the demand curve is elastic and when quantity is of more than 10 units, the demand curve is inelastic. At the quantity level of 10 units, the demand curve is unitary elastic. Table 6.2: MR and Price Elasticity Elasticity MR 10 11 12 13 10 9.5 9 8.5 8 7.5 7 6.5 6 5.5 5 4.5 4 3.5 9.5 8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5 0.5 -0.5 -1.5 -2.5 19 9 5.67 4 3 2.33 1.86 1.5 1.22 1 0.82 0.67 0.54 6.1.4 Short Run Equilibrium of the Monopoly Firm As in the case of perfect competition, we continue to regard the monopoly firm as one which maximises profit. In this section, we analyse this profit maximising 93 2019-20 behaviour to determine the quantity produced by a monopoly firm and price at which it is sold. We shall assume that a firm does not maintain stocks of the quantity produced and that the entire quantity produced
is put up for sale. The Simple Case of Zero Cost a TR, AR, MR, Price Suppose there exists a village situated sufficiently far away from other villages. In this village, there is exactly one well from which water is available. All residents are completely dependent for their water requirements on this well. The well is owned by one person who is able to prevent others from drawing water from it except through purchase of water. The person who purchases the water has to draw the water out of the well. The well owner is thus a monopolist firm which bears zero cost in producing the good. We shall analyse this simple case of a monopolist bearing zero costs to determine the amount of water sold and the price at which it is sold. Short Run Equilibrium of the Monopolist with Zero Costs. The monopolist’s profit is maximised at that level of output for which the total revenue is the maximum. Fig. 6.6 Output AR = D 5 O MR TR 10 94 Figure 6.6 depicts the same TR, AR and MR curves, as in Figure 6.2. The profit received by the firm equals the revenue received by the firm minus the cost incurred, that is, Profit = TR – TC. Since in this case TC is zero, profit is maximum when TR is maximum. This, as we have seen earlier, occurs when output is of 10 units. This is also the level when MR equals zero. The amount of profit is given by the length of the vertical line segment from ‘a’ to the horizontal axis. The price at which this output will be sold is the price that the consumers as a whole are willing to pay. This is given by the market demand curve D. At output level of 10 units, the price is Rs 5. Since the market demand curve is the AR curve for the monopolist firm, Rs 5 is the average revenue received by the firm. The total revenue is given by the product of AR and the quantity sold, ie Rs 5 × 10 units = Rs 50. This is depicted by the area of the shaded rectangle. Comparison with Perfect Competition We compare the above outcome with what it would be under perfectly competitive market structure. Let us assume that there is an infinite number of such wells. Suppose a well-owner decides to charge Rs.5/bucket of water. Who will buy from him? Remember that there are many, many well-owners. Any other wellowner can attract all the buyers willing to buy for Rs. 5/bucket,
by offering to sell to them at a lower price, say, Rs. 4/bucket.. Some other well-owner can offer to sell at a still lower price, and the story will repeat itself. In fact, competition among well-owners will drive the price down to zero. At this price 20 buckets of water will be sold. Through this comparison, we can see that a perfectly competitive equilibrium results in a larger quantity being sold at a lower price. We can now proceed to the general case involving positive costs of production. 2019-20 Introducing Positive Costs Analysing using Total curves a A TC, TR1 In Chapter 3, we have discussed the concept of cost and the shape of the total cost curve having been depicted as shown by TC in Figure 6.7. The TR curve is also drawn in the same diagram. The profit received by the firm equals the total revenue minus the total cost. In the figure, we can see that if quantity q1 is produced, the total revenue is TR1 and total cost is TC1. The difference, TR1 – TC1, is the profit received. The same is depicted by the length of the line segment AB, i.e., the vertical distance between the TR and TC curves at q1 level of output. It should be clear that this vertical distance changes for diferent levels of output. When output level is less than q2, the TC curve lies above the TR curve, i.e., TC is greater than TR, and therefore profit is negative and the firm makes losses. Equilibrium of the Monopolist in terms of the Total Curves. The monopolist’s profit is maximised at the level of output for which the vertical distance between the TR and TC is a maximum and TR is above the TC. q3 Output Fig. 6.7 Profit TC1 TR O q2 q1 q0 B The same situation exists for output levels greater than q3. Hence, the firm can make positive profits only at output levels between q2 and q3, where TR curve lies above the TC curve. The monopoly firm will choose that level of output which maximises its profit. This would be the level of output for which the vertical distance between the TR and TC is maximum and TR is above the TC, i.e., TR – TC is maximum. This occurs at the level of output q0. If the difference TR – TC is calculated and drawn as a graph, it will look as in the curve marked ‘Pro
fit’ in Figure 6.7. It should be noticed that the Profit curve has its maximum value at the level of output q0. The price at which this output is sold is the price consumers are willing to pay for this q0 quantity of the commodity. So the monopoly firm will charge the price corresponding to the quantity level q0 on the demand curve. Using Average and Marginal curves The analysis shown above can also be conducted using Average and Marginal Revenue and Average and Marginal Cost. Though a bit more complex, this method is able to exhibit the process in greater light. In Figure 6.8, the Average Cost (AC), Average Variable Cost (AVC) and Marginal Cost (MC) curves are drawn along with the Demand (Average Revenue) Curve and Marginal Revenue crve. It may be seen that at quantity level below q0, the level of MR is higher than the level of MC. This means that the increase in total revenue from selling an extra unit of the commodity is greater than the increase in total cost for producing the additional unit. This implies that an additional unit of output 95 2019-20 f a d AC MC b pC c Price would create additional profits since Change in profit = Change in TR – Change in TC. Therefore, if the firm is producing a level of output less than q0, it would desire to increase its output since that would add to its profits. As long as the MR curve lies above the MC curve, the reasoning provided above would apply and thus the firm would increase its output. This process comes to a halt when the firm reaches an output level of q0 since at this level MR equals MC and increasing output provides no increase in profits. Equilibrium of the Monopolist in terms of the Average and the Marginal Curve. The monopolist’s profit is maximised at that level of output for which the MR = MC and the MC is rising. On the other hand, if the firm was producing a level of output which is greater than q0, MC is greater than MR. This means that the lowering of total cost by reducing one unit of output is greater than the loss in total revenue due to this reduction. It is therefore advisable for the firm to reduce output. This argument would hold good as long as the MC curve lies above the MR curve, and the firm would keep reducing its output. Once output level reaches q0, the values of MC and MR become equal and the firm stops reducing its output. Fig. 6.8
Output D = AR q0 qC MR O e 96 At qo the firm will make maximum profits. It has no incentive to change from qo. This level is called the equilibrium level of output. Since this equilibrium level of output corresponds to the point where the MR equals MC, this equality is called the equilibrium condition for the output produced by a monopoly firm. At this equilibrium level of output q0, the average cost is given by the point ‘d’ where the vertical line from q0 cuts the AC curve. The average cost is thus given by the height dq0. Since total cost equals the product of AC and the quantity produced being q0, the same is given by the area of the rectangle Oq0dc. As shown earlier, once the quantity of output produced is determined, the price at which it is sold is given by the amount that the consumers are willing to pay, as expressed through the market demand curve. Thus, the price is given by the point ‘a’ where the vertical line through q0 meets the market demand curve D. This provides price given by the height aq0. Since the price received by the firm is the revenue per unit of output, it is the Average Revenue for the firm. The total revenue being the product of AR and the level of output q0, can be shown as the area of the rectangle Oq0ab. It can be seen from the diagram that the area of the rectangle Oq0ab is larger than the area of the rectangle Oq0dc, i.e., TR is greater than TC. The difference is the area of the rectangle cdab. Thus, Profit = TR – TC which can be represented by this area cdab. 2019-20 Comparison with Perfect Competition again We compare the monopoly firm’s equilibrium quantity and price with that of the perfectly competitive firm. Recall that the perfectly competitive firm was a price taker. Given the market price, the firm in a perfectly competitive market structure believed that it could not alter the price by producing more of the output or less of it. Suppose that the firm, whose equilibrium we were considering above, believed that it was a perfectly competitive firm. Then, given its level of output at q0, price of the commodity at aq0 = Ob, it would expect the price to remain fixed at Ob, and therefore, every additional unit of output could be sold at that price. Since the cost of producing an additional unit, given by the MC, stands at
eq0 which is less than aq0, the firm would expect a gain in profit by increasing the output. This would continue as long as the price remained higher than the MC. At the point ‘f ’ in Figure 6.8, where the MC curve cuts the demand curve, price received by the firm becomes equal to the MC. Hence, it would no longer be considered beneficial by this perfectly competitive firm to increase output. It is for this reason that Price = Marginal Cost that is considered the equilibrium condition for the perfectly competitive firm. The diagram shows that at this level of output, the quantity produced qc is greater than q0. Also, the price paid by the consumers is lower at pc. From this we conclude that the perfectly competitive market provides a production and sale of a larger quantity of the commodity compared to a monopoly firm. Further the price of the commodity under perfect competition is lower compared to monopoly. The profit earned by the perfectly competitive firm is also smaller. In the Long Run We saw in Chapter 5 that with free entry and exit, perfectly competitive firms obtain zero profits. That was due to the fact that if profits earned by firms were positive, more firms would enter the market and the increase in output would bring the price down, thereby decreasing the earnings of the existing firms. Similarly, if firms were facing losses, some firms would close down and the reduction in output would raise prices and increase the earnings of the remaining firms. The same is not the case with monopoly firms. Since other firms are prevented from entering the market, the profits earned by monopoly firms do not go away in the long run. Some Critical Views We have seen how a monopoly will typically charge higher prices than a competitive firm. In this sense, monopolies are often considered exploitative. However, varying views have been expressed by economists concerning the question of monopoly. First, it can be argued that monopoly of the kind described above cannot exist in the real world. This is because all commodities are, in a sense, substitutes for each other. This in turn is because of the fact that all the firms producing commodities, in the final analysis, compete to obtain the income in the hands of consumers. Another argument is that even a firm in a pure monopoly situation is never without competition. This is because the economy is never stationary. New commodities using new technologies are always coming up, which are close substitutes for the commodity produced by the monopoly firm. Hence, the monopoly firm always has competition in the long run. Even in the short run, the
threat of competition is always present and the monopoly firm is unable to behave in the manner we have described above. 97 2019-20 Still another view argues that the existence of monopolies may be beneficial to society. Since monopoly firms earn large profits, they possess sufficient funds to take up research and development work, something which the small perfectly competitive firm is unable to do. By doing such research, monopoly firms are able to produce better quality goods, or goods at lower cost, or both. While it is true that monopolies make supernormal profits, they may benefit consumers by lowering costs. 6.2 OTHER NON-PERFECTLY COMPETITIVE MARKETS 6.2.1 Monopolistic Competition We now consider a market structure where the number of firms is large, there is free entry and exit of firms, but the goods produced by them are not homogeneous. Such a market structure is called monopolistic competition. This kind of a structure is more commonly visible. There is a very large number of biscuit producing firms, for example. But many of the biscuits being produced are associated with some brand name and are distinguishable from one another by these brand names and packaging and are slightly different in taste. The consumer develops a taste for a particular brand of biscuit over time, or becomes loyal to a particular brand for some reason, and is, therefore, not immediately willing to substitute it for another biscuit. However, if the price difference becomes large, the consumer would be willing to choose a biscuit of another brand. A consumers’ preference for a brand will often vary in depth, so the change in price required for the consumer to change her brand may vary. Therefore, if price of a particular brand is lowered, some consumers will shift to consuming that brand. Lowering of the price further will lead to more consumers shifting to the brand with the lower price. Hence, the demand curve faced by the firm is not horizontal (perfectly elastic) as is the case with perfect competition. The demand curve faced by the firm is also not the market demand curve, as in the case with monopoly. In the case of monopolistic competition, the firm expects increases in demand if it lowers the price. Recall that the demand curve of a firm is also its AR curve. This firm, therefore has downward sloping AR curve. The marginal revenue is less than the average revenue, and also downward sloping. The firm increases its output whenever the marginal revenue is greater than the marginal cost. What does this firm’s equilibrium
look like? The monopolistic competitive firm is also a profit maximizer. So it will increase production as long as the addition to its total revenue is greater than the addition to its total costs. In other words, this firm (like the perfectly competitive firm as well as the monopoly) will choose to produce the quantity that equates its marginal revenue to its marginal cost. How does this quantity compare with that of the perfectly competitive firm? Recall that the MR for a perfectly competitive firm is equal to its AR. So the perfectly competitive firm, in an identical situation, would equate its AR to MC. So a firm under monopolistic competition will produce less than the perfectly competitive firm. Given lower output, the price of the commodity becomes higher than the price under perfect competition. The situation described above is one that exists in the short run. But the market structure of monopolistic competition allows for new firms to enter the market. If the firms in the industry are receiving supernormal profit in the short run, this will attract new firms. As new firms enter, some customers shift from existing firms to these new firms. So existing firms find that their demand curve 98 2019-20 has shifted leftward, and the price that they receive falls. This causes profits to fall. The process continues till super-normal profits are wiped out, and firms are making only normal profits. Conversely, if firms in the industry are facing losses in the short run, some firms would stop producing (exit from the market). The demand curve for existing firms would shift rightward. This would lead to a higher price, and profit. Entry or exit would halt once supernormal profits become zero and this would serve as the long run equilibrium. 6.2.2 How do Firms behave in Oligopoly? If the market of a particular commodity consists of more than one seller but the number of sellers is few, the market structure is termed oligopoly. The special case of oligopoly where there are exactly two sellers is termed duopoly. In analysing this market structure, we assume that the product sold by the two firms is homogeneous and there is no substitute for the product, produced by any other firm. Given that there are a few firms, each firm is relatively large when compared to the size of the market. As a result each firm is in a position to affect the total supply in the market, and thus influence the market price. For example, if the two firms in a duopoly are equal in size, and one of them decides to double its output,
the total supply in the market will increase substantially, causing the price to fall. This fall in price affects the profits of all firms in the industry. Other firms will respond to such a move in order to protect their own profits, by taking fresh decisions regarding how much to produce. Therefore the level of output in the industry, the level of prices, as well as the profits, are outcomes of how firms are interacting with each other. At one extreme, firms could decide to ‘collude’ with each other to maximize collective profits. In this case, the firms form a ‘cartel’ that acts as a monopoly. The quantity supplied collectively by the industry and the price charged are the same as a single monopolist would have done. At the other extreme, firms could decide to compete with each other. For example, a firm may lower its price a little below the other firms, in order to attract away their customers. Obviously, the other firms would retaliate by doing the same. So the market price keeps falling as long as firms keep undercutting each others’ prices. If the process continues to its logical conclusion, the price will have fallen till the marginal cost. (No firm will supply at a lower price than the marginal cost). Recall that this is the same as the perfectly competitive price. In practice, cooperation of the kind that is needed to ensure a monopoly outcome is often difficult to achieve in the real world. On the other hand, firms are likely to realize that competing fiercely by continuously under-cutting prices is harmful to their own profits. So, the oligopolistic equilibrium is likely to lie somewhere between the two extremes of monopoly and perfect competition • The market structure called monopoly exists where there is exactly one seller in any market. • A commodity market has a monopoly structure, if there is one seller of the commodity, the commodity has no substitute, and entry into the industry by another firm is prevented. The market price of the commodity depends on the amount supplied by the monopoly firm. The market demand curve is the average revenue curve for the monopoly firm. • 99 2019-20 • The shape of the total revenue curve depends on the shape of the average revenue curve. In the case of a negatively sloping straight line demand curve, the total revenue curve is an inverted vertical parabola. • Average revenue for any quantity level can be measured by the slope of the line from the origin to the relevant point on the total revenue curve. • Marginal revenue for any quantity level can be measured by the slope
of the • • • • tangent at the relevant point on the total revenue curve. The average revenue is a declining curve if and only if the value of the marginal revenue is lesser than the average revenue. The steeper is the negatively sloped demand curve, the further below is the marginal revenue curve. The demand curve is elastic when marginal revenue has a positive value, and inelastic when the marginal revenue has a negative value. If the monopoly firm has zero costs or only has fixed cost, the quantity supplied in equilibrium is given by the point where marginal revenue is zero. In contrast, perfect competition would supply an equilibrium quantity given by the point where average revenue is zero. • Equilibrium of a monopoly firm is defined as the point where MR = MC and MC is rising. This point provides the equilibrium quantity produced. The equilibrium price is provided by the demand curve given the equilibrium quantity. Positive short run profit to a monopoly firm continue in the long run. • • Monopolistic competition in a commodity market arises due to the commodity • being non-homogenous. In monopolistic competition, the short run equilibrium results in quantity produced being lesser and prices being higher compared to perfect competition. This situation persists in the long run, but long run profits are zero. • Oligopoly in a commodity market occurs when there are a small number of firms producing a homogenous commodity. s Monopoly Monopolistic Competition Oligopoly KKKKK. What would be the shape of the demand curve so that the total revenue curve is (a) a positively sloped straight line passing through the origin? (b) a horizontal line? 2. From the schedule provided below calculate the total revenue, demand curve and the price elasticity of demand: Quantity Marginal Revenue 1 10 5 3. What is the value of the MR when the demand curve is elastic? 100 2019-20 4. A monopoly firm has a total fixed cost of Rs 100 and has the following demand schedule: Quantity Price 1 100 2 90 3 80 4 70 5 60 6 50 7 40 8 30 9 20 10 10 Find the short run equilibrium quantity, price and total profit. What would be the equilibrium in the long run? In case the total cost was Rs 1000, describe the equilibrium in the short run and in the long run. 5. If the monopolist firm of Exercise 3, was a public sector firm. The government set a rule for its manager to accept the goverment fixed price as given (i.e. to be a price taker
and therefore behave as a firm in a perfectly competitive market), and the government decide to set the price so that demand and supply in the market are equal. What would be the equilibrium price, quantity and profit in this case? 6. Comment on the shape of the MR curve in case the TR curve is a (i) positively sloped straight line, (ii) horizontal straight line. 7. The market demand curve for a commodity and the total cost for a monopoly firm producing the commodity is given by the schedules below. Use the information to calculate the following: Quantity Price Quantity Total Cost 0 52 0 10 1 44 1 60 2 37 2 90 3 31 4 26 5 22 6 19 7 16 8 13 3 4 5 6 7 8 100 102 105 109 115 125 (a) The MR and MC schedules (b) The quantites for which the MR and MC are equal (c) The equilibrium quantity of output and the equilibrium price of the commodity (d) The total revenue, total cost and total profit in equilibrium. 8. Will the monopolist firm continue to produce in the short run if a loss is incurred at the best short run level of output? 9. Explain why the demand curve facing a firm under monopolistic competition is negatively sloped. 10. What is the reason for the long run equilibrium of a firm in monopolistic competition to be associated with zero profit? 11. List the three different ways in which oligopoly firms may behave. 12. If duopoly behaviour is one that is described by Cournot, the market demand curve is given by the equation q = 200 – 4p, and both the firms have zero costs, find the quantity supplied by each firm in equilibrium and the equilibrium market price. 13. What is meant by prices being rigid? How can oligopoly behaviour lead to such an outcome? 101 2019-20                             Average cost Total cost per unit of output. Average fixed cost Total fixed cost per unit of output. Average product Output per unit of the variable input. Average revenue Total revenue per unit of output. Average variable cost Total variable cost per unit of output
. Break-even point is the point on the supply curve at which a firm earns normal profit. Budget line consists of all bundles which cost exactly equal to the consumer’s income. Budget set is the collection of all bundles that the consumer can buy with her income at the prevailing market prices. Constant returns to scale is a property of production function that holds when a proportional increase in all inputs results in an increase in output by the same proportion. Cost function For every level of output, it shows the minimum cost for the firm. Decreasing returns to scale is a property of production function that holds when a proportional increase in all inputs results in an increase in output by less than the proportion. Demand curve is a graphical representation of the demand function. It gives the quantity demanded by the consumer at each price. Demand function A consumer’s demand function for a good gives the amount of the good that the consumer chooses at different levels of its price when the other things remain unchanged. Duopoly is a market with just two firms. Equilibrium is a situation where the plans of all consumers and firms in the market match. Excess demand If at a price market, demand exceeds market supply, it is said that excess demand exists in the market at that price. Excess supply If at a price market, supply is greater than market demand, it is said that there is excess supply in the market at that price. Firm’s supply curve shows the levels of output that a profitmaximising firm will choose to produce at different values of the market price. Fixed input An input which cannot be varied in the short run is called a fixed input. 2019-20 Income effect The change in the optimal quantity of a good when the purchasing power changes consequent upon a change in the price of the good is called the income effect. Increasing returns to scale is a property of production function that holds when a proportional increase in all inputs results in an increase in output by more than the proportion. Indifference curve is the locus of all points among which the consumer is indifferent. Inferior good A good for which the demand decreases with increase in the income of the consumer is called an inferior good. Isoquant is the set of all possible combinations of the two inputs that yield the same maximum possible level of output. Law of demand If a consumer’s demand for a good moves in the same direction as the consumer’s income, the consumer’s demand for that good must be inversely related to the price of the good
. Law of diminishing marginal product If we keep increasing the employment of an input with other inputs fixed then eventually a point will be reached after which the marginal product of that input will start falling. Law of variable proportions The marginal product of a factor input initially rises with its employment level when the level of employment of the input is low. But after reaching a certain level of employment, it starts falling. Long run refers to a time period in which all factors of production can be varied. Marginal cost Change in total cost per unit of change in output. Marginal product Change in output per unit of change in the input when all other inputs are held constant. Marginal revenue Change in total revenue per unit change in sale of output. Marginal revenue product(MRP) of a factor Marginal Revenue times Marginal Product of the factor. Market supply curve shows the output levels that firms in the market produce in aggregate corresponding to different values of the market price. Monopolistic competition is a market structure where there exit a very large number of sellers selling differentiated but substitutable products. Monopoly A market structure in which there is a single seller and there are sufficient restrictions to prevent any other seller from entering the market. Monotonic preferences A consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared to the other bundle. Normal good A good for which the demand increases with increase in the income of the consumer is called a normal good. Normal profit The profit level that is just enough to cover the explicit costs and opportunity costs of the firm is called the normal profit. Oligopoly A market consisting of more than one (but few) sellers is called a oligopoly. Opportunity cost of some activity is the gain foregone from the second best activity. Perfect competition A market environment wherein (i) all firms in the market produce the same good and (ii) buyers and sellers are price-takers. Price ceiling The government-imposed upper limit on the price of a good or service is called price ceiling. Price elasticity of demand for a good is defined as the percentage change in demand for the good divided by the percentage change in its price. 2019-20          Price elasticity of supply is the percentage change in quantity supplied due to
a one per cent change in the market price of the good. Price floor The government-imposed lower limit on the price that may be charged for a particular good or service is called price floor. Price line is a horizontal straight line that shows the relationship between market price and a firm’s output level. Production function shows the maximum quantity of output that can be produced by using different combinations of the inputs. Profit is the difference between a firm’s total revenue and its total cost of production. Short run refers to a time period in which some factors of production cannot be varied. Shut down point In the short run, it is the minimum point of AVC curve and in the long run, it is the minimum point of LRAC curve. Substitution effect The change in the optimal quantity of a good when its price changes and the consumer’s income is adjusted so that she can just buy the bundle that she was buying before the price change is called the substitution effect. Super-normal profit Profit that a firm earns over and above the normal profit is called the super-normal profit. Total cost is the sum of total fixed cost and total variable cost. Total fixed cost The cost that a firm incurs to employ fixed inputs is called the total fixed cost. Total physical product Same as the total product. Total product If we vary a single input keeping all other inputs constant, then for different levels of employment of that input we get different levels of output from the production function. This relationship between the variable input and output is referred to as total product. Total return Same as the total product. Total revenue is equal to the market price of the good multiplied by the quantity of the good sold by a firm. Total revenue curve shows the relationship between firm’s total revenue and firm’s output level. Total variable cost The cost that a firm incurs to employ variable inputs is called the total variable cost. Value of marginal product (VMP) of a factor Price times Marginal Product of the factor. Variable input An input the amount of which can be varied. 2019-20                            �
�� the change in total revenue (marginal revenue) is positive then demand is price elastic, if the change in total revenue is negative the demand is price inelastic. If the marginal revenue is exactly zero then demand is unit elastic. 5. The following determinants of the price elasticity of demand will determine how responsive the quantity demanded is to changes in price. These determinants are: a. substitutability 31 b. proportion of income c. luxuries versus necessities d. time 6. Price Elasticity of Supply is determined by the following time frames. The more time a producer has to adjust output the more elastic is supply. a. market period b. short run c. long run 7. Cross elasticity of demand measures the responsiveness of the quantity demanded of one product to changes in the price of another product. For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi. 8. Income elasticity of demand measures the responsiveness of the quantity demanded of a commodity to changes in consumers' incomes. 9. Interest rate sensitivity. 32 6. Consumer Behavior Lecture Notes 1. Individual demand curves can be constructed from observing consumer purchasing behaviors as we change price. a. This is called REVEALED PREFERENCE b. Market demand curves are constructed by aggregating individual demand curves for specific commodities. 2. Individual preferences can be modeled using a model called indifference curve - budget constraint and from this model we can derive an individual demand curve. a. The budget constraint shows the consumer's ability to purchase goods. The consumer is assumed to spend their resources on only beer and pizza. If all resources are spent on beer then the intercept on the beer axis is the amount of beer the consumer can purchase; on the other hand, if all resources are spent on pizza then the intercept on that axis is the amount of pizza that can be had. 33 If the price of pizza doubles then the new budget constraint becomes the dashed line. The slope of the budget constraint is the negative of the relative prices of beer and pizza. b. The indifference curve shows the consumer's preferences: 1. There are three assumptions that underpin the indifference curve, these are: 1) Indifference curves are everyplace thick 2) Indifference curves do not intersect one another 3) Indifference curves are strictly convex to the origin The dashed line (2) shows a higher level of total satisfaction than does the solid line (1). Along each indifference curve is the mix of beer and pizza that gives the consumer equal total utility.
Consumer equilibrium is where the highest indifference curve they can reach is exactly tangent to their budget constraint. Therefore if the price of pizza increases we can identify the price from the slope of the budget constraint and the quantities purchased from the values along the pizza axis and derive and individual demand curve for pizza: 34 When the price of pizza doubled the budget constraint rotated from the solid line to the dotted line and instead of the highest indifference curve being curve 1, the best the consumer can do is the indifference curve labeled 2. Deriving the individual demand curve is relatively simple. The price of pizza (with respect to beer) is given by the (-1) times slope of the budget constraint. The lower price with the solid line budget constraint results in the level the higher level of pizza being purchased (labeled 1for the indifference curve - not the units of pizza). When the price increased the quantity demanded of pizza fell to the levels associated with budget constraint 2. Notice that Q2 and P2 are associated with indifference curve 2 and budget constraint 2, and that Q1 and P1 result from indifference curve 1 and budget constraint 1. The above model shows this individual consumer's demand for pizza. 35 3. Income and substitution effects combine to cause the demand curve to slope downwards. a. the income effect results from the price of a commodity going down permitting consumers to spend less on that commodity, hence the same as having more resources. b. As a price increases, the consumer will purchase less of that commodity and buy more of a substitute, this is the substitution effect. c. The combination of the income and substitution effects is that an individual (hence a market) demand curve will generally slope downward. d. Giffin's Paradox is the fact that some commodities may have an upward sloping demand curve. This happens because the income effect results in less of a quantity demanded for a product the lower the price. 1. There is also the snob appeal possibility where the higher the price the more desired the commodity is - Joy Perfume advertised itself as the world's most expensive. 3. Utility maximizing rule - consumers will balance the utility they receive against the cost of each commodity to arrive at the level of each commodity they should consume to maximize their total utility. a. algebraic restatement - MUa/Pa = MUb/Pb =... = Mu z / P z = 1 36 7. Costs of Production Lecture Notes 1. Explicit are accounting costs, however, Implicit Costs are the opportunity costs of business decisions
. a. normal profit includes an opportunity cost - the profit that could have been made in the next best alternative allocation of productive resources. 3. In other words, there is a difference between economic and accounting cost; accountants are unconcerned with opportunity costs. 2. Time Periods are defined by the types of costs observed. These time periods differ from industry to industry. a. market period - everything is fixed b. short run - there are both fixed and variable costs c. long run - everything is variable 3. Prelude to Production Costs in Short Run - include both fixed and variable costs: a. the law of diminishing returns is the fact that as you add variable factors of production to a fixed factor at some point, the increases in total output become smaller. b. total product is the total units of production obtained from the productive resources employed. 37 c. average product is total product divided by the number of units of the variable factor employed d. marginal product is the change in total product associated with a change in units of a variable factor 1. graphical presentation: The top graph shows total product (total output). As total product reaches its maximum marginal product becomes zero and then negative as total product declines. When marginal product reaches its maximum, the total product curve becomes flatter. As marginal product is above average product in the bottom diagram, average product is increasing. When marginal product is below average product, then average product is decreasing. The ranges of marginal returns are identified on the above graphs. 38 4. Short-run costs: a. total costs = VC + FC b. variable costs are those items that can be varied in the short-run, i.e., labor c. fixed costs are those items that cannot be varied in the short-run, i.e., plant and equipment The fixed cost curve is a horizontal line because they do not vary with quantity of output. Variable cost has a positive slope because it vary with output. Notice that the total cost curve has the same shape as the variable cost curve, but is above the variable cost curve by a distance equal to the amount of the fixed cost. d. average total costs = TC/Q e. average variable cost = VC/Q f. average fixed cost = FC/Q g. marginal cost = ÎTC/ÎQ; where Î stands for change in. 39 1. The following diagram presents the average costs and marginal cost curve in graphical form. Notice that the average fixed cost approaches zero as quantity increases. Average total cost is the
summation of the average fixed and average variable cost curves. The marginal cost curve intersects both the average total cost and average variable cost curves at their respective minimums. The following graph relates average and marginal product to average variable and marginal cost. Notice that at the maximum point on the average product curve, marginal cost reaches a minimum. Where marginal cost equals average variable cost, the marginal product curve intersects the average product curve. 40 5. Long Run Average Total Cost Curve a. Is often called an envelope curve because it is the minimum points of all possible short-run average total cost curves (allowing technology and fixed cost to vary). 6. Economies of Scale are benefits obtained from a company becoming large and Diseconomies of Scale are additional costs inflicted because a firm has become too large. a. The causes of economies of scale are: 1. labor specialization 2. managerial specialization 3. more efficient capital 4. ability to profitably use by-products b. Diseconomies of scale are due to the fact that management loses control of the firm beyond some size. 41 c. Constant returns to scale are large ranges of operations where the firm's size matters little. d. Minimum efficient scale is the smallest size of operations where the firm can minimize its long-run average costs. e. Natural monopoly is a market situation where per unit costs are minimized by having only one firm serve the market -- i.e., electric companies. 42 8. Pure Competition Lecture Notes 1. There are several models of market structure, these include: a. pure competition (atomized competition, price taker, freedom of entry & exit, no nonprice competition, standardized product) b. pure monopoly (one seller, price giver, entry & exit blocked, unique product, nonprice competition) c. monopolistic competition (large number of independent sellers, pricing policies, entry difficult, nonprice competition, product differentiation) d. oligopoly (very few number of sellers, often collude, often price leadership, entry difficult, nonprice competition, product differentiation) 1. all assume perfect knowledge 2. Assumptions of Pure Competition: a. large number of agents b. standardized product c. no non-price competition d. freedom of entry & exit 43 e. price taker 3. Revenue with a price taking firm: a. average revenue and marginal revenue are equal for the purely competitive firm because price does not change with quantity. b. total revenue is P x Q which is the total area under the demand curve (up
to where MR = MC) for the purely competitive firm. 4. The profit-maximizing rule is that a firm will maximize profits where Marginal Cost is equal to Marginal Revenue. a. MC = MR b. Where MC = MR; revenue is at its maximum and costs are at their minimum. 5. Model of the purely competitive industry: The purely competitive industry is the supply and demand diagram presented in chapter 4. 44 6. Firm in Perfect Competition a. perfectly elastic demand curve b. Because the firm is a price taker, meaning that it charges the same price across all quantities of output, marginal revenue is always equal to price, and average revenue will always be equal to price. Therefore the demand curve intersects the price axis and is horizontal (perfectly elastic). c. Establishing price in the industry and the firm: 45 d. The price is established by the interaction of supply and demand in the industry (Pe) and the quantity exchanged in the industry is the summation of all of the quantities sold by the firms in the industry. e. Economic profit for the competitive firm is shown by the rectangle labeled AEconomic Profit@ in the following diagram: f. The firm produces at where MC = MR, this establishes Qe. At the point where MC = MR the average total cost (ATC) is below the demand curve (AR) and therefore costs are less than revenue, and an economic profit is made. The reason for this is that the opportunity cost of the next best allocation of the firm's productive resources is already added into the firm's ATC. 1. However, the firm cannot continue to operate at an economic profit because those profits are a signal to other firms to enter the market (free entry). As firms enter the market, the industry supply curve shifts to the right reducing price and thereby eliminating economic profits. Because of the atomized competition assumption, the number of firms that must enter the market to increase industry supply must be substantial. g. A normal profit for the competitive firm is shown in the following diagram: 46 1. The case where a firm is making a normal profit is illustrated above. Where MC = MR is where the firm produces, and at that point ATC is exactly tangent to the demand curve. Because the ATC includes the profits from the next best alternative allocation of resources this firm is making a normal profit. h. economic loss for a firm in pure competition: i. The case of an economic loss is illustrated above. The firm produces where MC
= MR, however, at that level of production the ATC is above the demand curve, in other words, costs exceed revenues and the firm is making a loss. 47 j. shut-down case 1. The firm will continue to operate in the case presented in (d.) above because the firm can cover all of its variable costs and have something left to pay on its fixed costs - this is loss minimization. However, in the case above you can see that the AVC is above the demand curve at where MC=MR, therefore the firm cannot even cover its variable costs and will shut down to minimize its losses. 7. Pure Competition and Efficiency a. Allocative efficiency criteria are satisfied by the competitive model. Because P = MC, in every market in the economy there is no over- or under- allocation of resources in this economy. b. Technical or Productive efficiency criteria are also satisfied by the competitive model because price is equal to the minimum Average Total Cost. c. This, however, does not mean a purely competitive world is utopia. There are several problems including which are typically associated with a purely competitive market: 1. Market failures and externalities. 48 2. Income distribution may lack fairness. 3. There may be a limited range of consumer choice. 4. Many natural monopolies are in evidence in the real world. 49 9. Pure Monopoly Lecture Notes 1. Assumptions of Monopoly Model a. single seller b. no close substitutes c. price giver d. blocked entry e. non-price competition 2. The Firm is the Industry and therefore faces a downward sloping demand curve, which is also the average revenue curve.. a. If the firm wants to sell more it must lower its price therefore marginal revenue is also downward sloping, but has twice the slope of the demand curve. 50 1. The point where the marginal revenue curve intersects the quantity axis is of significance; this point is where total revenue is maximized. Further, the point on the demand curve associated with where MR = Q is unit price elastic demand; to the left along the demand curve is the elastic range, and to the right is the inelastic range. 3. There is no supply curve in an industry which is a monopoly. a. The monopoly decides how much to produce using the profit maximizing rule; or where MC= MR 4. Monopolized Market a. Economic Profit: b. Because entry is blocked into this industry the economic profits shown above can be maintained in the long
run. The monopolist produces where MC = MR, but the price charged is all the market will bear, that is, where the demand curve is above the intersection of MC = MR. 51 c. Economic losses 1. This monopolist is making an economic loss. The ATC is above the demand curve (AR) at where MC = MR (the loss is the labeled rectangle). However, because AVC is below the demand curve at where MC = MR the firm will not shut down so as to minimize its losses. 5. Economic Effects of Monopoly: a. prices, output & resource allocations are not consistent with allocative and maybe not technical efficiency criteria. With allocative efficiency consider the following graph: 52 1. The above graph shows the profit maximizing monopolist, Pm is the price in the monopoly and Qm is the quantity exchanged in this market. However, where MC = D is where a perfectly competitive industry produces and this is associated with Pc and Qc. The monopolist therefore produces less and charges more than a purely competitive industry. b. A monopolist can also segment a market and engage in price discrimination. Price discrimination is where you charge a different price to different customers depending on their price elasticity of demand. Because the consumer has no alternative source of supply price discrimination can be effective. c. Sometimes a monopolist is in the best interests of society (besides the natural monopoly situation). Often a company must expend substantial resources on research and development. If these types of firms where forced to permit free use of their technological developments (hence no monopoly power) then the incentive to develop new technology and products would be eliminated. 6. Regulated Monopoly - Because there are natural monopoly market situations it is in the public interest to permit monopolies, but they are generally regulated. Examples of regulated monopolies are electric utilities, cable TV companies, and telephone companies (local). a. A monopoly regulated at social optimum P = D = MC 53 1. This firm is being regulated at the social optimum, in other words, what the industry would produce if it were a purely competitive industry. The price it is required to charge is also the competitive solution. However, notice the ATC is below the demand curve at the social optimum which means this firm is making an economic profit. It is also possible with this solution that the firm could be making an economic loss (if ATC is above demand) or even shut down (if AVC is above demand). b. A monopolist regulated at the fair
return P = D = AC 1. The fair rate of return enforces a normal profit because the firm must price its output and produce where ATC is equal to demand. This eliminates economic profits and the risk of loss or of even putting the monopolist out of business. c. The dilemma of regulation is knowing where to regulate, at the social optimal or at the fair return. In reality regulated monopolies are permitted to earn a rate of return only on invested capital and all other costs are simply passed on to the consumer. 1. Rate regulation using, invested capital as the rate base, causes an incentive for firms to over-capitalize and not be sensitive to variable costs. This is called the Averch-Johnson Effect. d. X-efficiency is where the firm's costs are more than the minimum possible costs for producing the output. Electric companies over-capitalize and use excess capital to avoid labor and fuel expenditures (which are generally 54 much cheaper than the additional capital) - nuclear generating plants are a good example of this. 9. Sherman Antitrust Act B monopolize or restraint trade or conspire to monopolize a market. a. Interstate Commerce b. Criminal Provisions 1. Felony c. Civil Provisions 1. Private civil suit, not criminal 2. Treble damages 55 10. Resource Markets Lecture Notes 1. Resource Market Complications: a. Resource markets are often heavily regulated, particularly capital and labor markets. b. Because labor (human beings as a factor of production) and private property are involved in resource markets there tends to be more controversy concerning these markets. 2. The demand for all productive resources is a derived demand. By derived demand it is meant that it is the output of the resource and not the resource itself for which there is a demand. a. marginal product is MP = ÎTP/ÎL where L is units of labor, (or K for capital, etc. b. marginal revenue product is MRP = ÎTR/ÎL 3. Demand Curve: 56 a. Because the demand for a productive resource is a derived demand, the demand schedule for that productive resource is simply the MRP schedule of that resource. 4. Determinants of Resource Demand: a. productivity b. quality of resource c. technology 5. Determinants of Resource Price Elasticity: a. rate of decline of MRP b. ease of resource substitutability c. elasticity of product demand d. K/L ratios 6. Marginal resource
cost is the amount that the addition of one more unit of a productive resource adds to total resource costs. a. MRC = ÎTRC/ÎL 7. The profit maximizing employment of resources is where MRP = MRC, where MRC is the supply curve of the resource in a purely competitive resource market. 57 a. resource market equilibrium 8. Least Cost Combination of all productive resources is determined by hiring resources where the ratio of MRP to MRC is equal to one for all resources. a. MRPlabor/MRClabor = MRPcapital/MRCcapital =... = MRPland/MRCland = 1 b. The quantities of the resource to the left (right) of the equilibrium point is under-utilization (over-utilization) where MRP / MRC > 1 (MRP / MRC < 1) 9. Marginal Productivity Theory of Income Distribution a. inequality under this theory arises because of differences in the productivity of different resources and the value of the product it produces. b. One serious flaw in the theory is that of imperfect competition in the product and resource markets. 58 1. monopsony is one buyer of a resource (or product) and causes factor payments below the competitive equilibrium. 2. monopoly power can also cause some goods and services to be over-valued. 59 11. Wage Determination Lecture Notes 1. Nominal versus Real Wages: a. Nominal wages (W) are money wages, unadjusted for the cost of living. b. Real wages (W/P) are money wages adjusted for the cost of living (P) in other words, what you can buy. 2. Earnings and Productivity a. In theory an employee should be paid what she earns for the company, MRP, however, this theory has serious flaws in practice. b. Market imperfections, i.e., monopsony results in the earnings of workers being paid to other factors of production. c. Problems with measuring MRP, because of engineering complications of technology. 3. Supply and Demand for Labor: a. competitive labor market 60 1. The supply and demand curves for the industry are summations of the individual firms' respective demand and supply curves. Notice that the firm faces a perfectly elastic supply of labor curve, while the supply curve for the industry is upward sloping just like we observed in the product markets. b. monopsony labor market (one buyer of labor) 61 1. Notice
that MRC breaks out to the right of the supply curve and is much steeper; this is due to the pricing policy the monopolist can employ. Also the wage and employment levels in the monopsony are much lower than in a competitive labor market. 4. Control of Monopsony: a. minimum wages has been one approach to the control of monopsony. 1. minimum wages under competition 2. The minimum wage acts the same as an effective price floor in that it creates a surplus of labor -- unemployment. The distance between Qd and Qe is the number of workers who lost jobs, and the distance between Qe and Qs is the number of workers attracted to this market that cannot find employment. 3. Minimum wage opponents argue that the minimum wage does two things that are bad for the economy (and these arguments are based on the competitive model) b. The working poor can very easily become the unemployed poor if the competitive model's predictions are correct. c. Again, the government interferes with the freedom of management to operate its firm -- thereby reducing economic freedom and increasing costs of doing business. 62 1. minimum wages in a monopsony 2. In a monopsony the wage increases with the establishment of a minimum wage, but if the employer is rationale so too does the employment level. 3. If the monopsony model is accurate then the conservative argument does not hold water. Recent research results seem to suggest the monopsony predictions are correct. 5. Unions have also be an effective response to monopsony: a. craft union (exclusive union): 1. AFL Affiliated, organizes one skill class of employees (i.e., IBEW) 63 2. Craft unions can control the supply of labor somewhat because of the fact that they represent primarily skilled employees and have control of the apprentice programs and the standards for achieving journeyman status. b. industrial union 1. CIO affiliate, organizes all skill classes within a firm (i.e., UAW) 2. The industrial union establishes the minimum acceptable wage, below which they will strike rather than work. This approach depends upon solidarity among the work force to make the threat 64 of a strike effective. c. There is a flaw in this analysis. Perfectly competitive labor markets are used to illustrate the effects of two different types of unions. If labor markets were competitive and there were not market imperfections unions would likely not be an economic priority for workers. However, unions are necessary in imperfectly competitive labor markets
. 1. The pure craft and pure industrial union virtually no longer exist. The AFL and CIO merged in the mid-1950s and the distinction between the two types of unions had all but disappeared by this time -- the exception is some of the building trades unions. 6. Bilateral Monopoly is where there is a monopsonist that is organized by a union that attempts to offset the monopsony power with monopoly power. a. The bilateral monopoly model is rather complex. The employer (monopsonist) will equate MRC with demand and attempt to pay a wage associated with that point on the supply curve. The monopolist (union) will equate MRP' with supply and attempt extract a wage associated with that point on the demand curve. The situation shown in this graph shows that the competitive wage is just about halfway between what the union and employer would impose. The wage and employment levels established in this type of situation is a function of the relative bargaining power of the employer and union, therefore this model is indeterminant. 65 b. The indeterminant nature of this model is why industrial relations developed as a separate field from economics (in large measure). c. Industrial relations in the United States has been a function of the legal environment as much as market forces. 7. Private sector labor history is a sorted affair, with distinct periods. a. The first years (until 1932) the law in the U.S. was extremely anti-worker and anti-union, Injunctions, anti-trust prosecution etc. b. 1932-1935 was the Norris-LaGuardia Act and Railway Labor Act period, and the government was neutral towards workers and unions. c. 1935-47 Government was pro-union, pro-worker B the Wagner Act period. d. 1947-1982 The Taft-Hartley Act period less pro-union, more balanced. e. The post-PATCO; post-Requinst activitist court 1982 on, anti-union, anti- worker B almost back to the pre-1932 period 8. Public Sector industrial relations more problematic. a. Civil Service Reform Act of 1974 governs Federal Employees 1. Homeland Security Act contains negation of bargaining rights for tens of thousands of Federal Employees b. State employees covered by state statutes; most states have protective legislation 1. States without protective legislation are typically southern and 66 rather poor B Indiana has no protective legislation 9. Market Wage Differentials arise from several sources: a. Geographic immobility b. Discrimination c
. Differences in productivity 1. Ability 2. Difference in price of final product 10. Human Capital refers to the various aspects of a person that makes them productive. Gary Becker=s book in the 1950s Human Capital earned him the Nobel Prize, but also brought greater attention to skills and knowledge as a determinant of income. a. Abilities, personality, and other personal characteristics are a portion of human capital -- many of these items are genetic, environmental, or a matter of experience. b. Education, training, and the acquisition of skills are human capital that is either developed or obtained. 1. In general it is hard to separate the sources of human capital; however, most is probably acquired. 2. In general, the higher the levels of human capital, the more productive an employee. 67 12. Epilogue to Principles of Economics Lecture Notes 1. Changing World - Economically a. Outsourcing B sending work out of the firm for cost cutting reasons B generally to save labor costs. 1. Consumer incomes and production costs 2. Say=s Law B accounting identity B cost of product is factor incomes b. Economics and Ethics 1. Fas – ethics 2. Boni Mores - public opinion or morals 3. Lex - law a. Law becomes dominate, but law is a constraint on the pursuit of self-interest (same as ethics and morals) b. Self-interest - rationality c. Internationalization 1. Comparative advantage is the basis for trade among nations as well as people. 68 a. Natural resources b. Technological innovation c. Human capital 2. Language and cultural diversity important to individual and societal success a. The middle east and different value systems and perceptions 2. American interests and foreign policy a. Anti-American perspectives abroad b. Reliance on foreign sources of energy c. Perception of imperialism versus American generosity 1. Peace Corps 2. Marshall Plan 3. Globalization and domestic changes a. Increasingly the U.S. is a service economy 1. Goods producing comparative advantage being lost 2. Multi-national corporations b. De-industrialization 69 1. Lower incomes 2. More rapid changes 4. Parting words a. Principles of microeconomics is a scientific framework for decision- making. 1. Mother discipline of the business disciplines a. Marketing, finance, production management b. Useful in career, brings rational standards to decision-making. 70 READING ASSIGNMENTS INTRODUCTION TO MICROECONOMICS E201 71 CHAPTER 1 Introduction to Economics This is an introductory course
in economics. As with most introductory courses there are certain foundations that must be laid before the structure of the discipline may be meaningfully examined. This chapter and the following two chapters will lay those foundations -- the rudimentary definitions, and basic concepts upon which the following ideas will be built are discussed. Further, there is a general discussion of the methods used by economists in their analyses. Specifically, this chapter will focus on specific definitions, policy, and objective thinking. A discussion of the role of assumptions in model building will also be offered as a basis for understanding the economic models that will be built in the following chapters. Definitions Economics is a social science. In other words, it is a systematic examination of human behavior, based on the scientific method, and reliant upon rigorous analysis of that behavior. Economics is the mother discipline from which most of the business disciplines arose. Most people have a vague idea of what the word economics means, but precise definitions generally require some academic exposure to the subject. Economics is the study of the ALLOCATION of SCARCE resources to meet UNLIMITED human wants. In other words, economics is the study of human behavior as it pertains to material well-being. The key words in this definition are in all capital letters. Because there are a finite number of resources available, the fact that human want exceed that (are unlimited) then the resources are scare relative to the want for them. Because there are fewer resources than wants there must be allocation mechanism of some sort – markets, government, law of the jungle, etc. Robert Heilbroner describes economics as the "Worldly Philosophy." A "Worldly Philosophy" is concerned with matters of how our material or worldly well-being is best served. In fact, economics is the organized examination of how, why and for what purposes people conduct their day-to-day activities, particularly as it relates to the accumulation of wealth, earning an income, spending their resources, and other matters concerning material well-being. This worldly philosophy has been used to explain most rational human behavior. (Irrational behavior being the domain of specialties in sociology, psychology, history, and anthropology.) Underlying all of economics is the 72 base assumption that people act in their own perceived best interest (at least most of the time and in the aggregate). Without the assumption of rational behavior, economics would be incapable of explaining the preponderance of observed economic activity. As limiting as this assumption may seem, it appears to be an accurate description of reality. In 17
76 Adam Smith penned An Inquiry into the Nature and Causes of the Wealth of Nations. With its publication, capitalism was born, from the ashes of the mercantilist system that preceded it. Smith described an economic system of cottage industries and relatively unfettered pursuit of self-interest, and how that unfettered pursuit of self-interest could result in a system that distributed its limited resources in an efficient fashion. Adam Smith’s view of self-interest and exchange An Inquiry in the Nature and Cause of the Wealth of Nations, Adam Smith, New York: Knopf Publishing, 1910, p. 14.... In almost every other race of animals each individual, when it is grown to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show then that it is for their own advantage to do for him what he requires of them. Whoever offer to another a bargain of any kind, proposes to do this. Give which I want, and you shall have this, which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good office which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.... Adam Smith, Wealth of Nations. New York: Alfred A. Knopf, 1991, p. 13. Experimental economics, using rats in mazes, suggests that rats will act in their own best interest (incidentally, Kahneman won a Noble Prize for this sort of research – it is serious business, not just fun and games like it sounds). Rats, it was discovered, prefer root beer to water. The result is that rats will pay a greater price (longer mazes and electric shocks) to obtain root beer than they will to obtain water. Therefore it appears to be a reasonable assumption that humans are no less rational – as Adam Smith postulates in his view of how we might best obtain our dinner. Most
academic disciplines have evolved over the years to become collections of 73 closely associated scholarly endeavors of a specialized nature. Economics is no exception. An examination of one of the scholarly journals published by the American Economics Association, The Journal of Economic Literature, reveals a classification scheme for the professional literature in economics. Several dozen specialties are identified in that classification scheme, everything from national income accounting, to labor economics, to international economics. In other words, the realm of economics has expanded over the centuries that it is nearly impossible for anyone to be an expert in all aspects of the discipline, so each economist generally specializes in some narrow portion of the discipline. The decline of the generalist is a function of the explosion of knowledge in most disciplines. In general, economics is bifurcated by the focus of the analysis – that is, there are two bundles of issues that are examined by economists. These bundles of issues are considered together, by the level of the activity upon which the analysis is focused. Economics is generally classified into two general categories of inquiry, these two categories are: (1) microeconomics and (2) macroeconomics. Microeconomics is concerned with decision-making by individual economic agents such as firms and consumers. In other words, microeconomics is concerned with the behavior of individuals or groups organized into firms, industries, unions, and other identifiable agents. The focus of microeconomics is on decisionmaking, and hence markets. Microeconomics is the subject matter of this course (E201). Macroeconomics is concerned with the aggregate performance of the entire economic system. That is, the performance of the U.S. economy or, in a more modern sense, the global economy. The issues of unemployment, inflation, economic development and growth, the balance of trade, and business cycles are the topics that occupy most of the attention of students of macroeconomics. These matters are the topics to be examined the course that follows this one (E202). Methods in Economics Economists seek to understand the behavior of people and economic systems using scientific methods. These scientific endeavors can be classified into two categories of activities, these are: (1) economic theory and (2) empirical economics. Theoretical and empirical economics are very much related activities, even though distinguished here for simplicity of presentation. Economic theory relies upon principles to analyze behavior of economic agents. These theories are typically rigorous, mathematical representations of human behavior with respect to the production or distribution of goods and services in 74 microeconomics – and the aggregate economy in macro
economics. A good theory is one that accurately predicts future human behavior and can be supported with evidence. Nobel Prize Winners in Economic Science 1969 J. Tinbergen (Netherlands); R. Frisch (Norway) 1970 P.A. Samuelson (USA - Indiana) 1971 S. Kuznets (USA, Soviet Union) 1972 J. R. Hicks (United Kingdom); K. J. Arrow (USA) 1973 W. Leontief (USA) 1974 F. A. Hayek (Austria, USA); K. G. Myrdal (Sweden) 1975 T. Koopmans (USA); L. Kantorovich (Soviet Union) 1976 M. Friedman (USA) 1977 B. Ohlin (Sweden); J. Meade (United Kingdom) 1978 H. A. Simon (USA) 1979 T. W. Schultz (USA); A. Lewis (United Kingdom) 1980 L. R. Klein (USA) 1981 J. Tobin (USA) 1982 G. J. Stigler (USA) 1983 G. Debreu (USA) 1984 R. Stone (United Kingdom) 1985 F. Modigliani (Italy, USA) 1986 J. Buchanan (USA) 1987 R. M. Solow (USA) 1988 M. Allais (France) 1989 T. Haavelmo (Norway) 1990 H. Markowitz (USA); M. Miller (USA); W. Sharpe (USA 1991 R. H. Coase (United Kingdom, USA) 1992 G. S. Becker (USA) 1993 R. W. Fogel (USA); D. C. North (USA) 1994 R. Selten (Germany); J. C. Harsanyi (USA); J. F. Nash (USA) 1995 R. E. Lucas (USA) 1996 J. A. Mirrlees (United Kingdom); William Vickery (Canada, USA) 1997 R. C. Merton (USA); M. S. Scholes (USA) 1998 A. Sen (India, United Kingdom) 1999 R. A. Mundell (USA) 2000 J. J. Heckman (USA); D. L. McFadden (USA) 2001 G. A. Akerlof (USA); A. M. Spence (USA); J. E. Stiglitz (USA - Indiana) 2002 D. Kahneman (USA, Isreal); V. L. Smith (USA) Economic theory tends to
be a very abstract area of the discipline. Mathematical modeling was introduced into the discipline early in the eighteenth century by such scholars as Mill and Ricardo. In the middle of the twentieth century, an economist, Paul 75 Samuelson, from M.I.T., published his book, Mathematical Foundations of Economic Analysis, and from the that point forward, economic theory was to become heavily mathematical – gone were the days of the institutionalists from the mainstream of economic theory. (Incidentally Paul Samuelson won the Nobel Prize for Foundations, and he is a Hoosier, Stiglitz is also from Indiana, and both are from Gary, Indiana). The above table presents a list of those who have won Nobel Prizes in Economic Science. Notice that the overwhelming majority of these persons are Americans – two of whom are from Indiana, and several are from the University of Chicago. It is also interesting to note that one must be living to receive the Nobel Prize; so many famous economists who met their end before receiving the prize will not be listed. Further, it is also interesting to note that the Nobel Prize in Economic Sciences is the newest of the prizes, beginning with Tinbergen’s award in 1969. Empirical economics relies upon facts to present a description of economic activity. Empirical economics is used to test and refine theoretical economics, based on tests of economic theory. The area referred to as econometrics is the arena in economics in which empirical tests of economic theory occurs. The area is founded in mathematical statistics and is critical to our ability to test the veracity of economic theories. Theory concerning human behavior is generally constructed using one of two forms of logic – inductive logic or deductive logic. Most of the social studies, i.e., sociology, psychology and anthropology typically rely on inductive logic to create theory. Inductive logic creates principles from observation. In other words, the scientist will observe evidence and attempt to create a principle or a theory based on any consistencies that may be observed in the evidence. Economics relies primarily on deductive logic to create theory. Deductive logic involves formulating and testing hypotheses. In other words, the theory is created, and then data is applied in a statistical test to see if the theory can be rejected. Often the theory that will be tested comes form inductive logic or sometimes informed guess-work. The development of rigorous models expressed as equations typically lend themselves to rigorous statistical methods to determine whether the models are consistent with evidence from reality. The tests
of hypotheses can only serve to reject or fail to reject a hypothesis. Therefore, empirical methods are focused on rejecting hypotheses and those that fail to be rejected over large numbers of tests generally attain the status of principle. However, examples of both types of logic can be found in each of the social sciences and in most of the business disciplines. In each of the social sciences it is common to find that the basic theory is developed using inductive logic. With increasing 76 regularity standard statistical methods are being employed across all of the social sciences and business disciplines to test the validity and the predictability of theories developed using these logical constructs. The usefulness of economics depends on how accurate economic theory predicts human behavior. In other words, a good theory is one that is an accurate description of reality. Economics provides an objective mode of analysis, with rigorous models that permit the discounting of the substantial bias that is usually present with discussions of economic issues. The internal consistency brought to economic theory by mathematical models of economic behavior provides for this consistency. However, no model is any better than the assumptions that underpin that model. If the assumptions are unrealistic, so too will be the models' predictions. The objective mode of analysis is an attempt to make a social study more scientific. That is, a systematic analysis of rational human behavior. “Rational” is a necessary component of this attempt. It is the rationality that makes behavior predictable, and what most economists don’t like to admit is without this underlying premise, economics quickly falls into a quagmire of irreproducible results and disjointed theories. The purpose of economic theory is to describe behavior, but behavior is described using models. Models are abstractions from reality - the best model is the one that best describes reality and is the simplest (the simplest requirement is called Occam's Razor). Economic models of human behavior are built upon assumptions; or simplifications that allow rigorous analysis of real world events, without irrelevant complications. Often (as will be pointed-out in this course) the assumptions underlying a model are not accurate descriptions of reality. When the model's assumptions are inaccurate then the model will provide results that are consistently wrong (known as bias). One assumption frequently used in economics is ceteris paribus which means all other things equal (notice that economists, like lawyers and doctors will use Latin for simple ideas). This assumption is used to eliminate all sources of variation in the model except those sources under examination (not very realistic!). 77 Economic Goals, Policy, and Reality Most people and organizations
do, at least, rudimentary planning, the purpose of planning is the establishment of an organized effort to accomplish some economic goals. Planning to finish your education is an economic goal. Goals are, in a sense, an idea of what should be (what we would like to accomplish). However, goals must be realistic and within our means to accomplish, if they are to be effective guides to action. This brings another classification scheme to bear on economic thought. Economics can be again classified into positive and normative economics. Positive economics is concerned with what is; and normative economics is concerned with what should be. Economic goals are examples of normative economics. Evidence concerning economic performance or achievement of goals falls within the domain of positive economics. The normative versus positive economics arguments begs the question of whether economics is truly a value free science. In fact, economics contains numerous value judgments. Rational behavior assumes that people will always behave in their own self-interest. Self-interest is therefore presented as a positive element of behavior. In fact, it is a value judgment. Self-interest is probably descriptive of the majority of Americans’ behaviors over the majority of time, however, each of us can think of instances where self-less behavior is observed, and is frequently encouraged. Efficiency is a measurable concept, and is taken as a desirable outcome. However, efficiency is not always desirable. Equity or fairness is also something prized by most people. The efficiency criterion in economics is not always consistent with equity; in fact, these two ideas are often in conflict. Economics also generally assumes that more is preferred to less by all consumers and firms. However, there are disposal problems, distributional effects, and other problems where more may not be such a good thing. Obesity is a result of more, but a bad result. Pollution, poverty, and crime may also be examined as more begetting problems. Most nations have established broad social goals that involve economic issues. The types of goals a society adopts depends very much on the stage of economic development, system of government, and societal norms. Most societies will adopt one or more of the following goals: (1) economic efficiency, (2) economic growth, (3) economic freedom, 78 (4) economic security, (5) an equitable distribution of income, (6) full employment, (7) price level stability, and (8) a reasonable balance of trade. Each goal (listed above) has obvious merit. However, goals are little more than value statements in this broad context. For example, it is
easy for the very wealthy to cite as their primary goal, economic freedom, but it is doubtful that anybody living in poverty is going to get very excited about economic freedom; but equitable distributions of income, full employment and economic security will probably find rather wide support among the poor. Notice, if you will, goals will also differ within a society, based on socio-political views of the individuals that comprise that society. Economics can hardly be separated from politics because the establishment of national goals occurs through the political arena. Government policies, regulations, law, and public opinion will all effect goals and how goals are interpreted and whether they have been achieved. A word of warning, eCONomics can be, and has often been used, to further particular political agendas. The assumptions underlying a model used to analyze a particular set of circumstances will often reflect the political agenda of the economist doing the analysis. An example liberals are fond of is, Ronald Reagan argued that government deficits were inexcusable, and that the way to reduce the deficit was to lower peoples' taxes -- thereby spurring economic growth, therefore more income that could be taxed at a lower rate and yet produce more revenue. Mr. Reagan is often accused, by his detractors, of having a specific political agenda that was well-hidden in this analysis. His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric to make his tax cuts for rich acceptable to most of the voters. (Who really knows?) Conservatives are fonder of criticizing the Clinton administration’s assertions that the way to reduce the deficit was to spend money where it was likely to be respent, and hence grow the economy and the result was more tax revenues, hence eliminate the deficit. Most political commentators, both left and right, have mastered the use of assumptions and high sounding goals to advance a specific agenda. This adds to the lack of objectivity that seems to increasingly dominate discourse on economic problems. On the other hand, goals can be public spirited and accomplish a substantial amount of good. President Lincoln was convinced that the working classes should have access to higher education. The Morrell Act was passed 1861 and created Land Grant institutions for educating the working masses (Purdue, Michigan State, Iowa State, and 79 Kansas State (the first land grant school) are all examples of these types of schools). By educating the working class, it was believed that several economic goals could be achieved, including growth, a more equitable distribution of income, economic security and freedom. In other words, economic goals that are
complementary are consistent and can often be accomplished together. Therefore, conflict need not be the centerpiece of establishing economic goals. Because any society's resources are limited there must be decisions about which goals should be most actively pursued. The process by which such decisions are made is called prioritizing. Prioritizing is the rank ordering of goals, from the most important to the least important. Prioritizing of goals also involve value judgments, concerning which goals are the most important. In the public policy arena prioritizing of economic goals is the subject of politics. Policy Policy can be generally classified into two categories, public and private policy. The formulation of public and private policy is the creation of guidelines, regulations, or law designed to effect the accomplishment of specific economic (or other) goals. Public policy is how economic goals are pursued. Therefore, to understand goals one needs to understand something of the process of formulating policy. Business students will have an in depth treatment of policy making in Administrative Policy (J401) and the School of Public and Environmental Affairs requires a similar course in some of its degree programs. For students in other programs the brief treatment here will suffice for present purposes. The steps in formulating policy are: 1. stating goals - must be measurable with specific stated objective to be accomplished. 2. options - identify the various actions that will accomplish the stated goals & select one, and 3. evaluation - gather and analyze evidence to determine whether policy was effective in accomplishing goal, if not reexamine options and select option most likely to be effective. 80 Both the public and private policy formulation process is a dynamic one. Economic goals change with public opinion and with achievement. Step 1 involves the value statement of setting goals. Step 2 involves selecting the appropriate model and the options associated with that model to accomplish the specified goal. The final step involves gathering evidence and the appropriate analysis to determine whether the policy needs revision. The process of formulating policy is therefore a loop, and requires continuous monitoring and revising. The major difference between public policy and private policy is that private policy is not subject to democratic processes. The Board of Directors or management of a company will decide what goals are to be accomplished and what policy options are best used to do so. Often private policy is made behind closed-doors without public accountability, even though there are often public costs imposed. The strength of public policy is created in the open, with public debate, and often has the force of law (and not just company rules and regulations). Objective Thinking Most people bring many misconceptions
and biases to economics. After all, economics deals with people's material well-being – a very serious matter to most. Because of political beliefs and other value system components rational, objective thinking concerning various economic issues fail. Rational and objective thought requires approaching a subject with an open-mind and a willingness to accept what ever answer the evidence suggests is correct. In turn, such objectivity requires the shedding of the most basic preconceptions and biases -- not an easy assignment. What conclusions an individual draws from an objective analysis using economic principles, are not necessarily cast in stone. The appropriate decision based on economic principles may be inconsistent with other values. The respective evaluation of the economic and "other values" (i.e., ethics) may result in a conflict. If an inconsistency between economics and ethics is discovered in a particular application, a rational person will normally select the option that is the least costly (i.e., the majority view their integrity as priceless). An individual with a low value for ethics or morals may find that a criminal act, such as theft, as involving minimal costs. In other words, economics does not provide all of the answers; it provides only those answers capable of being analyzed within the framework of the discipline. There are several common pitfalls to objective thinking in economics. Among the most common of these pitfalls, which affect economic thought, are: (1) the fallacy of composition, and (2) post hoc, ergo prompter hoc. Each of these will be reviewed, in turn in the following paragraphs. The fallacy of composition is the mistaken belief that what is true for the 81 individual must be true for the group. An individual or small group of individuals may exhibit behavior that is not common to an entire population. For example, if one individual in this class is a I.U. fan then everyone in this class must be an I.U. fan is an obvious fallacy of composition. Statistical inference can be drawn from a sample of individuals, but only within confidence intervals that provide information concerning the likelihood of making an erroneous conclusion (E270, Introduction to Statistics provides a more in depth discussion of confidence intervals and inference). Post hoc, ergo prompter hoc means after this, hence because of this, and is a fallacy in reasoning. Simply because one event follows another does not necessarily imply there is a causal relation. One event can follow another and be completely unrelated, this is simple coincidence. One event can follow another, but there may be something other than direct causal relation that accounts for the timing of the two
events. For example, during the thirteenth century people noticed that the black plague occurred in a location when the population of cats increased. Unfortunately, some concluded that the plague was caused by cats so they killed the cats. In fact, the plague was carried by fleas on rats. When the rat population increased, cats were attracted to the area because of the food supply. The rat populations increased, and so did the population of fleas that carried the disease. This increase in the rat population also happened to attract cats, but cats did not cause the plague, if left alone they may have gotten rid of the real carriers (the rats, therefore the fleas). Perhaps it is interesting to note that in any scientific endeavor there is a basic truth. Simple answers to complex problems are appealing, abundant, and often wrong. This twist on Occam’s razor is true. Too often the desire to have a simple solution will blind individuals, and public opinion to the more complex and often more harsh realities. One must take great care to assure that this simple trap does not befall one in their search for truth, because not all truth is simple. Policy is fraught with danger. Failure to anticipated the consequences of certain aspects of policy may cause results that were neither intended nor anticipated by the policy-makers; this is referred to as the law of unintended consequences. The following box presents an excellent historical example of the law of unintended consequences. 82 Law of Unitended Consequences “The Legend of Pig Iron” (David A. Dilts, Indiana Policy Review, Vol. 1, No. 5, pp. 28-29.) Many a cliché seems to center on pork. The head of the household is supposed to " put bacon on the table," "pork barrels," and politicians are frequently accused of being in too close a proximity. It only seems fitting that one more story concerning pork should be brought to your attention. During World War II, farmers in the corn belt argued that regulation of the price of pork had no effect on the war effort, and that they should be permitted to sell their commodities without government interference. The farmers brought political pressure to bear on the Congress and our representatives to deregulate the price of pork. The end result was to shut down the steel mills in Gary. Shut down our steel mills? How could this be? Since it is not intuitively obvious how this happened, I'll explain. In 1942, there had been a change in management in the Philippines. And, as luck would
have it, we didn't have good trade relations with the new management -- the Japanese. Therefore we did not have access to Manila fibre, necessary in making everything from rope to battleships. We had not yet developed synthetic fibre and therefore has to rely on the fibre previously available. That fibre was hemp. Now hemp grows in the same places, under the same climatic conditions as does corn. Corn is what hogs eat. And because corn was not being grown in the Midwest, the farmers sought alternative feed for the increased number of hogs they were raising. (Remember, increased price results in a larger quantity supplied.) Oats, wheat and barley were available from the Great Plains region. The problem was shipping it to where the hogs were raised in the Corn Belt of the Lower Midwest. In their search for transportation, the farmers found that railroads were regulated and reserved for military and heavy industry; trucks needed gasoline and rubber, both in short-supply; and airplanes were being built almost exclusively for military purposes. This left the farmers without a ready source of domestic transportation for the needed grain. But they eventually found a source of shipping that was neither regulated nor controlled, because it was international in nature -- the iron-ore barges on the Great Lakes. They bid up the price and the barges started hauling oats to the pigs and stopped hauling ore to the Gary steel mills. And there you have it: Without the requisite iron ore the steel mills could not produce; they were actually shut down for a period as a direct result of deregulating the price of pork. 83 Statistical Methods in Economics The use of statistical methods in empirical economics can result in errors in inference. Most of the statistical methods used in econometrics (statistical examination of economic data) rely on correlation. Correlation is the statistical association of two or more variables. This statistical association means that the two variables move predictably with or against each other. To infer that there is a causal relation between two variables that are correlated is an error. For example, a graduate student once found that Pete Rose's batting average was highly correlated with movement in GNP during several baseball seasons. This spurious correlation cannot reasonably be considered path-breaking economic research. On the other hand, we can test for causation (where one variable actually causes another). Granger causality states that the thing that causes another must occur first, that the explainer must add to the correlation, and must be sensible. As with most statistical methods Granger causality models permit testing for
the purpose of rejecting that a causal relation does not exist, it cannot be used to prove causality exists. These types of statistical methods are rather sophisticated and are generally examined in upper division or graduate courses in statistics. As is true with economics, statistics are simply a tool for analyzing evidence. Statistical models are also based on assumptions, and too often, statistical methods are used for purposes for which they were not intended. Caution is required in accepting statistical evidence. One must be satisfied that the data is properly gathered, and appropriate methods were applied before accepting statistical evidence. Statistics do not lie, but sometimes statisticians do! Objectivity and Rationality Objective thinking in economics also includes rational behavior. The underlying assumptions with each of the concepts examined in this course assumes that people will act in their perceived best interest. Acting in one's best interests is how rationality is defined. The only way this can be done, logically and rigorously, is with the use of marginal analysis. This economic perspective involves weighing the costs against the benefits of each additional action. In other words, if benefits of an additional action will be greater than the costs, it is rational to do that thing, otherwise it is not. Too often people permit the costs already paid to influence their decision-making, and hence they are lead astray by not focusing on the margin. The problem with rationality is perception. Often what people believe is in their own self-interest may not be. (Remember the Pig Iron example). Education and the gathering of information helps to make perceptions more accurate views of reality. In 84 other words, the more we can eliminate our biases and faulty perceptions, the more likely we are to act in our own interest. However, there are costs associated with information gathering and with education, therefore rationality may be costly. KEY CONCEPTS Economics Microeconomics Macroeconomics Economic Theory v. Empirical Economics Inductive v. Deductive Logic Usefulness of Economics Occam’s Razor Rationality Assumptions in Economics Ceteris Paribus Simplification for rigor’s sake Positive v. Normative Economics Economic Goals Policy Formulation Objective Thinking Fallacy of Composition Post hoc, ergo propter hoc fallacy Causation v. Correlation Granger Causality Tests Cost-Benefit Perspective 85 Food for Thought: STUDY GUIDE Most people have their own opinions about things. How might opinions be of value? Explain. Compare and contrast deductive logic with inductive logic. What evidence can statistical analysis provide? Critically evaluate this
evidence and explain the role of empirical economics in developing economic theory. Sample Questions: Multiple Choice: Which of the following is not an economic goal? A. Price Stability B. Full Employment C. Economic Security D. All of the above are economic goals If we provide school lunches for children from households with incomes below the poverty level, and finance the school lunch program with an increase in taxes on incomes in excess of $100,000, these actions are likely to: A. Promote stability but reduce growth B. Promote equality but reduce freedom C. Promote efficiency but reduce equality D. Promote efficiency but reduce security True/ False: Non-economists are no less or more likely to be biased about economics than they are about physics or chemistry. {FALSE} Assumptions are used to simplify the real world so that it may be rigorously analyzed. {TRUE} 86 CHAPTER 2 Economic Problems The purpose of this chapter is to introduce you to several basic economic principles that will be useful in understanding the costs, markets, and the materials to follow in subsequent chapters. This chapter will examine scarcity, factors of production, economic efficiency, opportunity costs, and economic systems. In this chapter the first economic model will also be developed, the production possibilities frontier (or curve). The Economizing Problem Economics is concerned with decision-making. An economic decision is one that allocates resources, time, money, or something else of use or value. The fundamental question in economics is called the economizing problem. The economizing problem follows directly from the definition of economics offered in Chapter 1. The economizing problem involves the allocation of resources among competing wants. The economizing problem exists because there is scarcity. Scarcity arises because of two facts; (1) there are unlimited human wants, but (2) there are limited resources available to meet those wants. In other words, scarcity exists because we do not have sufficient resources to produce everything we want. Perhaps at some date in the future, a utopian world may be obtained where everyone's desires can be fully satisfied -- most economists probably hope that will not happen in their lifetimes because of their own self-interest. Economists do not differentiate between wants and needs in examining scarcity. Unfortunately, the want of a millionaire for a new Porsche is not differentiated from the need of a starving child for food in the aggregate. However, in a realistic sense, social welfare and the implications of needs versus wants are partially addressed later in this chapter in the discussions offered for allocative efficiency and economic
systems. The concept of scarcity is embedded in virtually every analysis found in economics. Because there is scarcity there is always the question of how resources are allocated and the effects of allocations on various economic agents. Each decision allocating resources to one use or economic agent is also, by necessity, a decision not to allocate resources to an alternative use. To fully understand the idea of scarcity, each of its components must be mastered. The following section of this chapter examines resources. The next sections will examine economic efficiency, opportunity costs and allocations, before proceeding 87 to the production possibilities model and economic systems. Productivity is the key Head to Head (Lester Thurow, New York: William Morrow and Company, Inc., 1992, p. 273.) If the "British disease" is adversarial labor-management relations, the "American disease" is the belief that low wages solve all problems. When under competitive pressure, American firms first go the low-wage nonunion parts of America and then on to succession of countries with ever-lower wages. But the strategy seldom works. For a brief time lower wages lead to higher profits, but eventually other with even lower wages enter the business (low wages are easy to copy), prices fall, and the higher profits generated by lower wages vanish. The search for the holy grail of high profitability lies elsewhere -- in a relentless upscale drive in technology to ever-higher levels of productivity -- and wages. Since rapid productivity growth is a moving target and therefore hard to copy, high long-run profits can be sustained. But to get the necessary human talent to employ new technologies, large skill investments have to be made. High wages have to be paid, but paradoxically high wages also leave firms with no choice but to go upscale in technology. High wages and high profits are not antithetical -- they go together. Resources and factor payments The resources used to produce economic goods and services (also called commodities) are called factors of production. These resources are the physical assets needed to produce commodities. The way that these resources are combined to produce is called technology. For example, a man with a shovel digging a ditch is one technology from which ditches can be obtained. Another technology that can produce the same commodity as a man with a shovel is a backhoe and an operator -- the former is more labor intensive, and the latter is more capital intensive. Land is a factor of production. Land includes space, natural resources, and what is commonly thought of as land. A building lot, farm land, or a parking space is
what people normally think of when they think of land. However, iron ore, water resources, oil, and other natural resources obtained from land are also one dimension of this factor of production. Another, perhaps equally important dimension, is space. The location of a building site for a business is an important consideration. For example, a retail establishment may succeed or fail because of location, therefore location is another important aspect of the resource called land. The factor payment that accrues to land for producing is rent. 88 Capital includes the physical assets (i.e., plant and equipment) used in the production of commodities. Often accountants refer to capital as money balances that are earmarked for the purchase of plant or equipment. The accounting view of capital is not the physical asset envisioned by economists (in reality the difference is one of a future claim (the accountant's view) and a present stock of capital (the economist's view) and is not trivial). Capital receives interest for its contributions to production. There is one important variation on capital. Economists also called the skills, abilities, and knowledge of human beings as human capital. Human capital is a characteristic of labor. Human capital can be acquired (i.e., education) or may be something inherent in a specific individual (i.e., size, beauty, etc.). This subject will be examined in more depth in Chapters 10 and 11. Labor includes the broad range of services (and their characteristics) exerted in the production process. Labor is a rather unique factor of production because it cannot be separated from the human being who provides it. Human beings also play other roles in the economic system, such as consumer that complicates the analysis of labor as a productive factor. The amount of human capital possessed by labor varies widely from the totally unskilled to highly trained professionals and highly skilled journeymen. Labor also includes hired management, and the lowest paid janitor. Labor is paid wages for its contribution to the production of commodities. Entrepreneur (risk taker) is the economic agent who creates the enterprise. Entrepreneurial talent not only assumes the risk of starting a business, but is generally responsible for innovations in products and production processes. The vibrancy of the U.S. economy is, in large measure, due to a wealth of entrepreneurial talent. This factor of production receives profits for its contribution to output. To obtain the maximum amount of output from the available productive resources an economic system should have full employment. Full employment is the utilization of all resources that is consistent with normal job search
and maintenance of productive capacity. Full employment includes the natural rate of unemployment, which economists estimate to be between four and six percent (unemployment due to job search and normal structural changes in the economy). Empirical evidence suggests that about 80% capacity utilization is consistent with the natural rate of unemployment. When the economy is operating at rates consistent with the natural rate of unemployment it is producing the potential total output. However, full production, 100% capacity utilization involves greater than full employment and cannot be maintained for a prolonged period without labor and capital breaking-down. Underemployment has been a persistent problem in most developed economies. Underemployment results from the utilization of a resource that is less than what is consistent with full employment. There are two ways that underemployment manifests itself. First, individuals can be employed full time, but not making use of the human 89 capital they possess. For example, in many European countries it is not uncommon for an M.D. to be employed as a practical nurse. The second way that underemployment is typically observed is when someone is involuntarily a part-time employee rather than employed full-time in an appropriate position. Economic Efficiency Economic efficiency consists of three components; these are: (1) allocative efficiency, (2) technical or productive efficiency, and (3) full employment. For an economy to be economically efficient all three conditions must be fulfilled. Allocative efficiency is concerned with how resources are allocated. In a perfectly competitive economy, without institutional impediments, monopoly power, or cartels the markets will allocate resources in an allocatively efficient manner. Allocative efficiency is measured using a concept known as Pareto Optimality (or Superiority in an imperfect world). Pareto Optimality is that allocation where no person could be made betteroff without inflicting harm on another. A Pareto Optimal allocation of resources can exist, theoretically, only in the case of a purely competitive economy (which has never existed in reality). What is of practical significance is a Pareto Superior allocation of resources. A Pareto Superior allocation is that allocation where the benefit received by one person is more than the harm inflicted on another. [cost - benefit approach] Technical or productive efficiency is a somewhat easier concept. Technical efficiency is defined as the minimization of cost for a given level of output or (alternatively) for a given level of cost you maximize output. In other words, for an economic system to be efficient, each firm in each industry
must be technically efficient. Again, a technically efficient operation is difficult to find in the real world. However, most profit-maximizing firms (as well as government agencies and non-profit organizations) will at least have technical efficiency as one of its operational goals. For an economic system to be economically efficient then full employment is also required. Due primarily to the business cycles, no economic system can consistently achieve full employment. The U.S. economy typically has one (during recoveries) to four percent (during recessions) unemployment above that associated with the natural rate of unemployment. We will return to this topic in the discussions of market structures in Chapters 8 and 9. 90 Allocative Efficiency The Economics of Welfare, fourth edition (A. C. Pigou, London: Macmillan Publishing Company, 1932, p. 89.)... Any transference of income from a relatively rich man to a relatively poor man of similar temperament, since it enables more intense wants to be satisfied at the expense of less intense wants must increase the aggregate sum of satisfaction. The old "law of diminishing utility" thus leads securely to the proposition: Any cause which increases the absolute share of real income in the hands of the poor, provided that it does not lead to a contraction in the size of the national dividend from any point of view, will, in general, increase economic welfare. Pigou states the basic proposition of Pareto Superiority in the real world; an application of income re-distribution. The “transference of income from a relatively rich man to a relatively poor man of similar temperament” making one less poor, and the other less rich, results in an application of the principle of diminishing marginal utility and, hence, allocative efficiency. In other words, the cost-benefit approach on the margin. We take the last dollar from those with less value for that dollar and add that to those more desperate for an additional dollar of income. Not only is this allocatively efficient, but there are those who would argue that this is also fair. Economic Cost Economic cost consists of two distinct types of costs: (1) explicit (accounting) costs, and (2) opportunity (implicit) costs. Explicit costs are direct expenditures in the production process. These are the items of cost with which accountants are concerned. An opportunity cost is the next best alternative that must be foregone as a result of a particular decision. Rather than a direct expenditure, an opportunity cost is the implicit loss of an alternative because
of a decision. For example, reading this chapter is costly, you have implicitly decided not to watch T.V. or spend time doing something else by deciding to read this chapter. Every choice is costly; that is, there is an opportunity cost. Economic costs are dealt with in greater detail in Chapter 7. 91 Production Possibilities The production possibilities frontier (or curve) is a simple model that can be used to illustrate what a very simple economic system can produce under some restrictive assumptions. The production possibilities model is used to illustrate the concepts of opportunity cost, productive factors and their scarcity, economic efficiency (unemployment etc.) and the economic choices an economy must make with respect to what will be produced. There are four assumptions necessary to represent the production possibilities in a simple economic system. The assumption which underpin the production possibilities curve model are: (1) the economy is economically efficient, (2) there are a fixed number of productive resources, (3) the technology available to this economy is fixed, and (4) in this economy we are going to produce only two commodities. With these four assumption we can represent all the combinations of two commodities that can be produced given the technology and resources available are efficiently used. Consider the following diagram: Beer Pizza Along the vertical axis we measure the number of units of beer we can produce and along the horizontal axis we measure the number of units of pizza we can produce. Where the solid line intersects the beer axis shows the amount of beer we can produce 92 if all of our resources are allocated to beer production. Where the solid line intersects the pizza axis indicates the amount of pizza we can produce if all of our resources are allocated to pizza production. Along the solid line between the beer axis and the pizza axis are the intermediate solutions where we have both beer and pizza being produced. The reason the line is curved, rather than straight, is that the resources used to produce beer are not perfectly useful in producing pizza and vice versa. The dashed line represents a second production possibilities curve that is possible with additional resources or an advancement in available technology. Increasing Opportunity Costs is illustrated in the above production possibilities curve. Notice as we obtain more pizza (move to the right along the pizza axis) we have to give up large amounts of beer (downward move along beer axis). In other words, the slope of the production possibilities curve is the marginal opportunity cost of the production of one additional unit of one commodity, in terms of the other commodity. Inefficiency, unemployment, and underemployment are illustrated by
a point inside the production possibilities curve, as shown above. A point consistent with inefficiency, unemployment, or underemployment is identified by the symbol to the inside of the curve. Economic growth can also be illustrated with a production possibilities curve. The dashed line in the above model shows a shift to the right of the curve. The only way this can happen is for there to be more resources or better technology and this is called economic growth. It is also possible that the curve could shift to the left (back toward the origin -- the intersection of the beer axis with the pizza axis), this could result from being forced to use less efficient technology (pollution controls) or the loss of resources (racism or sexism). Economic Systems Production and the allocation of resources occur within economic systems. Economic systems rarely exist in a pure form and the pure forms are assumed simply for ease of illustration. The following classification of systems is based on the dominant characteristics of those systems. Pure capitalism is characterized by private ownership of productive capacity, very limited government, and motivated by self-interest. Laissez faire means that government keeps their hands-off and markets perform the allocative functions within the economy. This type of system has the benefit of producing allocative efficiency if there is no monopoly power, but this type of system tends towards heavy market concentration left unregulated. There are substantial costs associated with pure capitalism. These costs include significant loses of freedom, poverty, income inequity 93 and several social ills associated with the lack of protections afforded by stronger government. What is perhaps the saving grace, is that pure capitalism does not exist in the course of economic history. Pure capitalism exists only in the tortured minds of economists, and pages of the Wealth of Nations. In the following box, Thorstein Veblen discusses his view of capitalism and the “struggle” associated with the pursuit of self-interest in a system marked with private interests. The Struggle The Theory of the Leisure Class, Thorstein Veblen, New York: Penguin Books, 1899, pp. 24-25. Wherever the institution of private property is found, even in a slightly developed form, the economic process bears the character of a struggle between men for the possession of goods. It has been customary in economic theory, and especially among those economists who adhere with least faltering to the body of modernised classical doctrines, to construe this struggle for wealth as being substantially a struggle for subsistence. Such is, no doubt, its character in large part during the earlier
and less efficient phases of industry. Such is also its character in all cases where the “niggardliness of nature” is so strict as to afford but a scanty livelihood to the community in return for strenuous and unremitting application to the business of getting the means of subsistence. But in all progressing communities an advance is presently made beyond this early stage of technological development. Industrial efficiency is presently carried to such a pitch as to afford something appreciably more than a bare livelihood to those engaged in the industrial process. It has not been unusual for economic theory to speak of the further struggle for wealth on this new industrial basis as a competition for an increase in the physical comforts of life, – primarily for an increase of the physical comforts which the consumption of goods affords. In command economies the government makes the allocative decisions. These decisions are backed with the force of law (and sometimes martial force). Political freedom is the antitheses of a command economy. Even though political and economic freedom could result in a reasonable allocation, but rarely will command economies be associated with democratic forms of government. Examples, of these types of systems abound, Nazi Germany, Chile, the former Soviet Union are but a few examples. Traditional economies base allocations on social mores or ethics or other non- market, non-legislative bases. For example, Iran is an Islamic Republic and the allocation of resources is heavily influenced by religious precepts. The purest forms of traditional economies are typically observed in tribal societies. In the South Pacific and certain South American Indian tribes, the allocation of resources is determined by 94 traditions, only some of which are based in their religion. Many of these traditions developed because of economic constraints. For example, the tradition that some native tribes in the Arctic had of putting their elderly out of the community to starve or freeze may seem barbaric, but because of the difficulty in obtaining the basic requirements of life, those that could not contribute, could not be supported. Hence a tradition that arose from economic constraints. Socialism generally focuses on maximizing individual welfare for all persons based on perceived needs, not necessarily on contributions. Socialist systems are generally concerned more with perceived equity rather than efficiency. The basic idea here is that when there is assurance of economic security then society in general is better-off. Sweden, Denmark, Norway and Iceland have systems that have large elements of socialism. Each of these three countries have been reasonably successful in maintaining relatively high levels of productivity and standards of living. Communism is a system where everyone shares equally in the output of
society (according to their needs), at least theoretically. Generally, there is no private holdings of productive resources, and government is a trustee until such time as what is called "Socialist Man" fully develops (where the individual is more concerned with aggregate welfare than individual gain). The former Soviet Union was not a communist society as perceived by Karl Marx in Das Kapital. However, examples of communist societies exist on small community levels. Both New Harmony, Indiana and Amana, Iowa were utopian communist systems that were probably more in keeping with Marxist ideals, but without the political implications and in very limited scope. Division of Labor – and possibly society Class Warfare, Noam Chomsky, Monroe, Maine: Common Courage Press, 1996, pp.19-20.... People read snippets of Adam Smith, the few phrases they teach in school. Everyone reads the first paragraph of The Wealth of Nations where he talks about how wonderful the division of labor is. But not many people get to the point hundreds of pages later, where he says that division of labor will destroy human beings and turn them into creatures as stupid and ignorant as it is possible for a human being to be. And therefore in any civilized society the government is going to have to take some measures to prevent division of labor from proceeding to its limits. 95 Virtually all economic systems are mixed systems. A mixed system is one that contains elements of more than one of the above pure systems. The U.S. economy is a mixed system, with significant amounts of capitalism, command, and socialism. The U.S. economy also has some very limited amounts of communism and tradition that have helped shape our system. Much of the political controversies concerning the budget deficit, social security, and the environment focuses on the what the appropriate mix of systems should exist in our economic system. Most developed economies are mixed systems. As a society grows and becomes more complex, simple pure examples of economic systems are incapable of handling the demands placed on them. Complexity generally requires elements of command, socialism and capitalism to properly allocate resources and produce commodities. This is no more evident in the troubles being experienced in the former Soviet Union and in China. As these economies attempt to modernize and develop, the policy makers have discovered the utility of market systems for many economic decisions. Estranged Worker The Economic & Philosophic Manuscripts of 1844, Karl Marx, New York: International Publishers, 1964, p. 107-8. The worker become all the poorer the more wealth he produces, the more his
production increases in power and size. The worker becomes an even cheaper commodity the more commodities he creates. With the increasing value of the world of things proceeds in direct proportion the devaluation of the world of men. Labor produces not only commodities: it produces itself and the worker as a commodity – and this in the same general proportion in which it produces commodities. This fact expresses merely that the object which labor produces – labor’s product – confronts it as something alien, as a power independent of the producer. The product of labor is labor which has been embodied in an object, which has become material: it is the objectification of labor. Labor’s realization is its objectification. In the sphere of political economy this realization of labor appears as loss of realization for the workers; objectification as loss of the object and bondage to it; appropriation as estrangement, as alienation. Developed economies are generally high income economies, because the production processes tend be capital intensive, and focused on high value-added products. An economy that has a per capita GDP of $8000 or more is a high income economy. Less developed economies fall into two categories, middle income $8000 to $800, and low income economies or those below $800. Low income economies are concentrated in South Asia, and Africa South of the Sahara. Middle income economies are in the Middle East, Eastern Europe and Latin America. The majority of the world’s 96 population, over half, live in low income economies. Perhaps the greatest economic issue facing the current generation is what can be done to bring the low income economies into meaningful participation in the global economy. The poverty of the low income economies is a serious matter without any other issue. AIDS, malaria, and a host of other health problems are associated with the poverty in these nations. Perhaps more importantly, with rising incomes in these parts of the world come several benefits globally. As income rise in low income countries, cheap labor is no longer a cause for outsourcing from the high income, industrialized parts of the world. Further, as income rise, so too does the demand for goods and services. The often used cliché “a rise tide makes all boats float higher” is exactly the case in these nations emergence into full participation in the global economy. More concerning these issues will be offered later in this book. KEY CONCEPTS Economizing problem Scarce Resources Unlimited Wants Resources and Factors Payments Land - rent Labor - wages Capital - interest Entrepreneurial Talent - profits Full Employment Undere
mployment Economic Efficiency Allocative Efficiency Technological Efficiency Full Employment Opportunity Cost Implicit vs. Explicit Costs Production Possibilities Frontier (or Curve) Growth Inefficiency Law of Increasing Opportunity Costs 97 Economic Systems Pure capitalism Command Tradition Socialism Communism Mixed Systems Developed vs. Less Developed Economies High Income Middle Income Low Income Globalization Food for Thought: STUDY GUIDE What is the economizing problem? What, precisely does scarcity have to do with this? Explain. Draw a production possibilities curve that illustrates a one-to-one trade-off between the two goods, what would cause such a production possibilities curve? Explain. Compare and contrast the various economic systems? Is a mixed system best? Explain. Differentiate between explicit and implicit costs. Is this differentiation important in economic decisions? Explain. 98 Sample Questions: Multiple Choice: Which of the following factors of production are not properly matched with their factor payments? A. Land - profits B. Labor - wages C. Capital - interest D. All are properly matched Unemployment can be illustrated with a production possibilities curve. Which of the following illustrates unemployment? A. A shift to the left of the curve B. A shift to the right of the curve C. A point on the inside of the curve D. A point on the outside of the curve Which of the following is an implicit cost of your obtaining a college education if you go to school exclusively? A. Tuition B. Books and supplies C. Income lost from a job you didn’t take D. All of the above The U.S. economy is closest to which of the following economic systems? A. Mixed B. Pure Capitalism C. Pure Command D. None of the above TRUE-FALSE A laissez faire, purely capitalistic economy will always result in economically efficient distributions of resources. {FALSE} 99 If the assumption of a fixed technology is relaxed in the production possibilities curve model, then the exact position and shape of the curve will be impossible to show using a single line. {TRUE} The former Soviet Union was an example of pure Communism and the Swedish economy an example of pure socialism. {FALSE} Opportunity cost is an example of an implicit cost. {TRUE} 100 CHAPTER 3 Interdependence and the Global Economy This chapter begins with a discussion of the interdependence of nations in the modern global economy before proceeding to a discussion of capitalist ideology. The characteristics of a market based economic system, and the motivation for international trade will then presented before offering a discussion of the role
of money in a global economic system. The final section of this chapter develops the circular flow diagram that illustrates interdependence within a global economy. Open Economic System The modern economy of most nations is no longer a closed-localized system. Virtually every nation on earth has some sort of relations with other nations. The extent to which an economic system is involved in economic relations with other countries is the degree to which that economy is open. Foreign economic relations involves the importation and exportation of goods and services. When you buy a Toyota you are having economic relations with Japan. When you work for Philips (Aero-Quip etc.) you are having economic relations with Holland (Philips is a Dutch company). Over the past three decades our reliance on foreign produced goods has become increasingly important to our standard of living. On the other hand, foreigners have become increasingly reliant on American goods. Without trade among nations then everyone would suffer the loss of goods they desire that must be imported. Foreign investment in the United States has been and continues to be an important component of our economic development. From the very beginnings of the United States European countries, i.e., France, Britain and Germany have heavily invested in the United States. In the Nineteenth Century the motivation was that the U.S. was far from the turmoil of the repeated European wars (Napoleon etc.) and investment here was protected by the expanse of the two Oceans on our east and west. As our institutions developed and became more secure, investment was attracted by the safety offered by our financial institutions and government regulations. At the same time, American industry sought to move into markets they presently served only by exportation. Controversy abounds concerning international economic relations. The outsourcing of jobs abroad has real costs for the affected households and is a source of discontent among workers who have lost their jobs to foreign competition (more concerning this will discussed in chapter 12). In many cases these job loses are simply 101 employers taking advantage of very low income populations in poor countries – with all of the social and political ills associated with economic exploitation. Over the next several decades these issues will take a more central place in political debate, and concerns over the social responsibility of business. Technology transfers are also controversial. There are currently bands on the transfer of certain technologies that have implications for national defense. However, in general, technology transfers is the exportation of ideas, knowledge and equipment that may permit less fortunate nations to more adequately participate in the global economic system. The United States is presently experiencing large
deficits in our balance of payments. The balance of payments is the net investment abroad (capital accounts) plus the net exports (current accounts) of the United States. If the balance of payments is positive, ignoring investment (capital accounts) for the moment, that means we are exporting more than we are importing. With the capital accounts that means we invest more abroad, than foreigners invest in the U.S. Together, if the balance of payment is negative, that means the net of the capital and current accounts is a negative number (i.e., we invest less abroad than foreigners invest here, and we import more than we export). Capitalist Ideology Ideology is defined by Webster’s Dictionary as: that system of mental philosophy which exclusively derives our knowledge from sensation. Webster’s also appropriately defines capitalism as: An economic system characterized by private ownership of natural resources and means of production. However, what our system is, and what ideology has grown up around the system are two different things. We have a mixed system, which includes a significant amount of market allocation mechanisms, but it is not a pure capitalist system. Further, what Adam Smith envisioned for capitalism is in many respects very much different from the more radical proponents of capitalism would have us believe is the ideal system. One should remember that a mixed system evolved for a reason, and that the ideology ought not taint the wonders of that system and the standard of living it provides. The following box is an excerpt from Adam Smith’s Wealth of Nations which clearly and unambiguously examines the idea of social welfare, with respect to the pursuit of individual welfare. Bear in mind Adam Smith was the father of capitalism as you read this excerpt. 102 Individual Self-Interest and Social Welfare An Inquiry into the Nature and Causes of the Wealth of Nations (Adam Smith, New York: Random House, Modern Library editions, 1937 [original published 1776] Book IV, Ch. 2) Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it
always the worse for society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it. Capitalist ideology is therefore what we wish to perceive it to be, rather a dispassionate observation of some characteristics of a our economic system. The characteristics of a market system are dispassionate observations about markets and their operation. Therefore capitalist ideology is different than the characteristics of a market system. The characteristics of a capitalist economy are familiar to anyone who has grown up in western industrialized countries. The elements of a capitalist ideology are: (1) freedom of enterprise, (2) self-interest, (3) competition, (4) markets and prices, and (5) a limited role for government. Freedom of enterprise, self-interest and a limited role for government are related characteristics of capitalist ideology. By limiting government participation in the economy it is thought that economic freedom to pursue one's self-interest increases – hence government participation is often called “interference.” To the extent that government limits the freedom of enterprise, there is merit to this argument. However, there are often problems associated with the pursuit of self-interest. One of the primary problems with this aspect of the ideology is it is based on the assumption that the power to limit people's self-interest comes only from government. There is also a significant amount of potential to limit economic freedom by predatory behaviors from the private sector. For example, large businesses running small ones out of business to obtain a monopoly to permit prices to increase. Again, assuming that monopoly power is not exerted over otherwise competitive markets, the competition among producers in a market economy will approximate a 103 Pareto Optimal (see Chapter 2) allocation of resources. Competition does provide for alternate sources of supply that generally increases quality and keeps prices in check. The market system is largely responsible for our high standard of living and the ability to effectively respond to changes in the global economy. Maybe the best example of the benefits that arise from a capitalist economy is the U.S. automobile industry. In the 1970s the U.S. car producers did not have effective competition, and their prices increased as the quality of U.S. built cars declined. The Japanese entered the U
.S. markets and successfully competed with the U.S. manufacturers. This caused the U.S. manufacturers to significantly increase the quality of their products and keep their prices in check. By 2004 many of the top ten vehicles in quality according to consumer reports are U.S. automobiles. Consumer Guide’s Recommended List for 2004: (http://auto.consumerguide.com/auto/new/index.cfm) lists fifteen foreign built vehicles (14 of which are Japanese name plates) and eighteen American vehicles as best buys for 2003. This is a significant benefit from competition that is fundamental to capitalism. However, capitalism has its drawbacks. Poverty, high rates of litigation, pollution, crime and several other social problems are associated with freedom and limiting government's role. There is a broad range of legitimate roles for government in a capitalist economy. As social responsibility by producers and consumers declines, the legitimate roles of government generally expand. Worse still, over the past three or four years, businesses in the U.S. have been rocked by scandals. The accounting and analyst frauds at Enron, WorldCom, Health South, and an array of brokerage firms and investment banks, have illustrated that the ethic of self-interest is hardly a reasonable basis for an economic system – without some countervailing forces. Self-interest, without government, or at least effective government regulation, may produce results that are extremely harsh for those without the resources to defend themselves. Therefore there is a strong need not only for a strong ethic of honest and forthright dealings, but also governmental regulation to proscribe the worst abuses. For the tendency of capitalism toward monopoly and market power to be held in proper balance government must have a significant role. The exact magnitude of the role of government in a free economy has always been controversial, but there is little doubt of its potential for positive outcomes. President Bush, during his first election campaign argued that he envisioned American society becoming "kinder and gentler" society. This reference was for the need for certain elements of socialism to provide limited assurance for the disabled, the elderly, and children freedom from poverty. In the years since George Bush, it seems that neither Democrats nor Republicans shared the first President Bush’s vision. Mixed economic systems are the response to the 104 drawbacks of capitalism. Not all people accept our view of the proportions of market activity that should be in evidence in a mixed economy. The Europeans and major Asian economies have far more socialism than we do. On the other hand, many of the Less
Developed Countries permit far more free enterprise than we do. Whatever the proportions, two things are certain. First, no two societies are alike in their mix of allocative mechanisms, and second the mix evolves and changes over time with the societies the system serves. Market System Characteristics The characteristics of the market system is both practically and intellectually different than capitalist ideology. The characteristics of the market system are those things upon which the operationalization of markets depend to decide what is produced and how it will be allocated. The characteristics of a typical of market system are: (1) the division of labor & specialization, (2) significant reliance on capital goods, and (3) reliance on comparative advantage. These characteristics have significant interactions and together are responsible for the competitive well-being of most market system economies. In market economies the competition among producers requires high levels of technical efficiency, which, in turn, requires labor to become specialized and focused on narrow aspects of a particular production process. By dividing tasks into small components people become better at repetitive movements and therefore their efficiency increases. As efficiency increases, cost per unit declines. 105 Division of Labor and Production An Inquiry into the Nature and Causes of the Wealth of Nations (Adam Smith, New York: G. P. Putnam and Sons, 1877 (original published 1776) Book II, Chapter V.) To take an example... from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour had rendered a distinct trade), nor acquainted with the use of machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner,
divided into about eighteen distinct operations, which in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some them consequently performed two or three distinct operations. But though they were poor, and therefore indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousands pins of middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each them have made twenty, perhaps not one pin in a day. Because of the need to compete, capital is typical used where it is less costly. Capital can be substituted for labor in many production processes and significantly reduce per unit costs of production. Comparative Advantage and Trade However, comparative advantage is somewhat more complicated. Comparative advantage is the motivation for trade among people (and nations). Terms of trade are 106 those upon which the parties may agree and depends on the relative cost advantages of trading partners and their respective bargaining power. Interdependence and Comparative Advantage An Inquiry into the Nature and Causes of the Wealth of Nations (Adam Smith, New York: Random House, Modern Library editions, 1937 [original published 1776] Book IV, Ch. 2)... It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost more to make than to buy. The taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. The farmer attempts to maler neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbors, and to purchase with a part of its produce, or what is the same thing, with the price of a part of it, whatever else they have occasion for. What is prudence to the conduct of every private family, can scarce be
folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. Consider the following illustration: Texas Cows Oranges 1000 100 Florida 100 1000 The data above show what each state could produce if all of their resources were put into each commodity. For example, if Texas put all their resources in cattle production they could produce 1000 cows but no oranges. Assuming the data give the rate at which the commodities can be substituted, if both states equally divided their resources between the two commodities, Texas can produce 500 cows and 50 oranges and Florida can produce 50 cows and 500 oranges (for a total of 550 units of each commodity produced by the two states together). If Texas produced nothing but cows it would produce 1000, and if Florida produced nothing but oranges it would produce 1000). If the countries traded on terms where one orange was worth one cow then both states would have 500 units of each commodity and obviously benefit from specialization and trade. In this example notice that oranges are relatively expensive. Trade between industries and individuals also arises from comparative 107 advantage. However, barter (direct trading of commodities) becomes increasingly difficult as an economic system becomes more complex. Barter requires a coincidence of wants, it does no good to have apples if you want oranges and the only people who have oranges hate apples. No transaction will occur under this scenario unless a third-party can be found that has a commodity that both original trading parties value and who accept both apples and oranges. Therefore, as complexity rises, so does the need for the ability to conduct business without reliance on barter, therefore the need for money. TRADE SUMMARY - U.S. Department of Commerce, International Trade Administration (billions of dollars) Year Total Exports Total Imports Balance of Trade –$378.7 $1064.2 2000 2001 998.0 1356.3 – 358.3 2002 971.7 1407.3 – 435.7 1489.2 – 501.4 2003 (est) 988.8 $1442.9 Money in an Economic System Money facilitates market activities and is necessary in complex market systems. With money people can avoid the problems associated with coincidence of wants. Among, these problems is the pricing of commodities. Prices stated in the terms of all possible trading goods makes it difficult to determine what anything costs. In barter economies
hours are spent in negotiating for even simple transactions, these hours are resources that could have been spent on other activities (therefore the hours of negotiations are the opportunity cost of a money economy). The functions of money include; (1) medium of exchange, (2) store of value, and (3) a measure of worth. Because money is acceptable as a form of payment for all commodities, barter is no longer needed. Money can be easily stored in a tin can or bank account, so commodities need not be stored and can be purchased when needed. Because money is acceptable in virtually all transactions, prices can be stated in terms of dollars or yen thereby simplifying transactions substantially. In other words, money is the grease that lubricates any complex economic system. 108 Fiat money is what is common in modern economic systems. Fiat money is money that is defined as legal tender by either a government or some organization with the authority to define legal tender. In the United States the Federal Reserve System issues Federal Reserve Notes, which serve as the legal tender for the United States. The currency used here is backed by nothing except the faith of the general public that this money will be acceptable by everyone else with whom you could have an economic transaction. President Nixon in 1971 took the United States off of the gold standard. Up to that point of time the value of the dollar was expressed in some fixed ratio to the commodity – gold. The end result was the dollar had become seriously over-valued, and something had to be done so that American exports could resume to our trading partners. When the U.S. abandoned the gold standard gold went from less than forty dollars an ounce, to over $1000 an ounce in a matter of weeks. Thus illustrating the folly of pegging one’s currency to the value of some commodity. Fiat money is not a new idea. Some European historians identify the first use of fiat money in Europe resulting from gold and silver smiths issuing their customers receipts for gold or silver left in their care. The receipts were commands over that gold and silver, and began to trade as easily as the commodity itself, to the extent that the parties to the transaction knew of the smith and the note bearer. This trade in receipts dates back to the mid-fifteenth century. Hence, in this case the value of money is based on some mutual trust between the principles to these transactions. The first recorded use of fiat money, however, dates to three hundred years earlier in Asia. Because of the shortage of gold and silver to run
the Mongol Empire, Genghis Kahn began to issue orders, in writing, that the written order was to be given deference as a specific amount of gold or silver. Genghis was known to a be nononsense sort of guy, and the violation of his decrees were clearly unhealthy acts, therefore these orders were the first fiat money recorded in history, and not backed by anything save the martial might of the Mongol Army. Perhaps, in retrospect, it is better that currency be acceptable on economic grounds, than under threat of violence from a government. Foreign Exchange International economic relations also depend, in large measure, on monetary issues. You are unlikely to accept the Turkish Lire in payment for your wages in this country, simply because you can’t easily use that money to buy anything. You want U.S. dollars in payment for your services, because you can easily spend the dollar. Countries act the same way you do. There are currencies that virtually everyone accepts as payment, and those widely accepted currencies are called hard currency. 109 The currency of the big, developed, high income economies are the hard currencies – U.S. dollar, Japanese Yen, Canadian dollar, British pound and the E.E.U.s’ Euro. Prior to the Euro, there were seven countries whose currencies were considered hard currencies. In addition to the U.S., Japan, Canada, and the United Kingdom, the French Franc, German Mark, and Italian Lire were also considered hard currencies. These seven nations are called the G-7 countries because the size and strength of their economies made them the leading economic forces on the planet, and their currencies the most accepted. The relative value of currency is called the exchange rate. For example, one U.S. dollar may buy 109 Japanese Yen but only.85 Euros. It is these currency exchange rates that, in large measure, determine net exports and foreign investment in the U.S. As the dollar gains strength, i.e., goes from 109 Yen to the dollar to 120 Yen to the dollar, then imports are cheaper. If at 110 Yen to the dollar a particular Japanese car costs $20,000 that is also 2.2 million Yen. If the dollar gains strength, and it can now purchase 125 Yen per dollar, then that 2.2 million Yen car is only $17,600. As can be readily seen the strong dollar give the American consumer an advantage in buying imports. If the dollar becomes weak then that advantage turns to disadvantage. Going back
to the example above, if the 2.2 million Yen vehicle was available at $17,600 at 125 Yen per dollar, the additional cost of $2400 would be observed if the dollar could only purchase 110 Yen. The same sort of analysis applies to American exports. With an expensive dollar it is hard to sell American goods abroad. If the Mexican Peso will buy 10 cents we may be able to sell some goods in Mexico, however if the dollar becomes stronger and Mexicans can only get 5 cents per peso, we will observe a marked decline in exports to Mexico. Currency also impacts foreign investment. If our Mexican friends invest 2 million pesos in the U.S. when the peso buys 10 cents ($200,000), and then suddenly the peso becomes worth 25 cents ($500,000) the foreign investor just made 250% on his investment simply because the U.S. dollar weakened with respect to the Mexican peso. On the other hand, if the Mexican investor bought dollars at 25 cents per peso and over a year the dollar fell to 10 cents per peso, his investment went from $500,000 to only 40% of his original investment. In other words, foreign investment becomes more attractive with strength in the host countries’ currency. A strong dollar policy means that the government will undertake policies that will increase the value of the dollar with respect to other currencies. Contractionary fiscal and monetary policies are typically associated with strong dollar policy and is properly the subject of the next course (macroeconomics). Strength a nation’s currency is typically a reflection of its strong economy and institutions. The relative supply and 110 demand for a currency will also impact the currency exchange rates. Strong dollar policies promote the importation of goods and services from abroad, and foreign investment in our domestic enterprises. On the other hand, a weak dollar policy promotes the exportation of goods and services abroad, and U.S. investment overseas. Often, the international aspects of domestic monetary and fiscal policies are less important than political consideration in the U.S. or policy consideration concerning unemployment or inflation. However, one must always remember that lobbyists and special interest groups are quick to point-out to policy makers the advantages and disadvantage of either policy for their constituents back home. The Circular Flow Diagram The circular flow diagram is used to show the interdependence that exists among sectors of the economy. The diagram illustrates that there are several collections of similar economic agents, called sectors. Households provide resources to government and business
and consume the outputs of these other sectors. The markets in which land, labor, capital, and entrepreneurial talent are sold are called resource markets. The markets in which the output of business and in some cases government is sold are called product markets. To this point, the circular flow diagram is relatively simple. However, when a foreign sector or substantial governmental sector is added it becomes more complicated. It is not unusual for a modern economy to have substantial participation in both the product and resource markets from both foreigners and governments (sometimes even foreign governments). Consider a relatively simple open-economy, trade and foreign investment occurs. The following diagram illustrates this relatively simple economic system. The interdependence in the sectors is represented by the flows in both the resource and factor markets. Resources flow from household to both the government and businesses. Private goods and services flow from the businesses to households and government, and public goods and services flow from the government to both households and businesses. The triangle representing these domestic sectors rests on a foundation called the foreign sector. Foreign households, business, and even governments (in limited ways) participate in the flows that would otherwise have been purely domestic if the economy was a closed economy. 111 _____________________________________________________________________ _____________________________________________________________________ FOREIGN SECTOR As can be easily observed the government provides public goods and services to both businesses and households and receives resources and private goods and services in return; the business sector sells commodities to households and households provide resources to businesses. This is the nature of interdependence. 112 KEY CONCEPTS Capitalist Ideology Freedom of Enterprise Self-Interest Competition Markets and Prices Limited Role for Government Market System Characteristics Division and Specialization of Labor Capital Goods Comparative Advantage Barter Coincidence of Wants Functions of Money Medium of exchange Store of Value Measure of Worth Foreign Exchange Balance of Payment Current Account Capital Account Exchange Rates Imports and Exports Foreign Investment Circular Flow Diagram Interdependence Sectors Foreign Sector 113 STUDY GUIDE Critically evaluate capitalist ideology? How does this differ from market characteristics? Explain. Explain the role of money in a modern economic system. Does this simplify or complicate matters? Explain. Develop the traditional circular flow diagram and illustrate the interdependence between the sectors. Add the government and the foreign sectors, how does this complicate matters? Explain. The following two commodities are produced by Tennessee and Kentucky: Sour Mash Whiskey Bourbon Tennessee 5,000 Kentucky 500 500 10,000 Assuming free trade and that each state wishes to consume as much of each commodity as possible,
what will each state produce? What will the terms of trade be? Explain the role of currency exchange rates in international trade. What cause these exchange rates to change? Sample Questions: Multiple Choice: 114 Which of the following is not a function of money? A. Store of value B. Measure of worth C. Medium of exchange D. All of the above are functions of money Barter is a system that historically existed since the beginnings of time. Why has barter been displaced by more modern systems? A. Coincidence of wants makes exchange complicated B. Coincidence of wants no longer exists in the world’s economy C. Gold and silver are now in plentiful supply so that money can be used D. None of the above If the dollar gains value with respect to the Euro what would we expect to observe? A. U.S. imports increase, foreign investment in the U.S. increases B. U.S. exports decrease, foreign investment in the U.S. decreases C. U.S. imports decrease, U.S. investment abroad increases D. None of the above True - False The circular flow model demonstrates that there is interdependence between the sectors but does not identify how the sectors are interdependent. {FALSE} Comparative advantage derives from having an ability to produce some commodity at a lower cost than a potential trading partner. {TRUE} The majority of the countries in the world are high income, developed countries. {FALSE} 115 CHAPTER 4 The Basics of Supply and Demand The purpose of this chapter is to develop one of the most powerful methods of analysis in the economist's tool kit. In this chapter we will develop the model of a simple market – supply and demand (the industry in pure competition – discussed further in Chapter 8). The demand schedule and supply schedule will be developed and put together to form the analysis of a market. The market presented here is the starting point for the analysis of all market structures. Markets A market is nothing more or less than the locus of exchange, it is not necessarily a place, but simply buyers and sellers coming together for transactions. Transactions occur because consumers and suppliers are able to purchase and sell at a price that is determined through the free interaction of demand and supply. Adam Smith, in the Wealth of Nations, described markets as almost mystical things. He wrote that the interaction of supply and demand "as though moved by an invisible hand" would determine the price and the quantity of a good exchanged. In fact, there is nothing
mystical about markets. If competitive, a market will always satisfy those consumers willing and able to pay the market price and provide suppliers with the opportunity to sell their wares at the market price. To understand the market, one need only understand the ideas of supply and demand and how they interact. Demand The law of demand is a principle of economics because it has been consistently observed and predicts consumers’ behavior accurately. The law of demand states that as price increases (decreases) consumers will purchase less (more) of the specific commodity, ceteris paribus. In other words, there is an inverse relationship between the quantity demanded and the price of a particular commodity. This law of demand is a general rule. Most people behave this way, they buy more the lower the price. However, everyone knows of a specific individual who may not behave as predicted by the law of demand, but remember the fallacy of composition -- because an individual or small group behaves contrary to the law of demand does not negate it. 116 The demand schedule (demand curve) reflects the law of demand. The demand curve is a downward sloping function (reflecting the inverse relationship of price to quantity demanded) and is a schedule of the quantity demanded at each and every price. Price P1 P2 Demand Q1 Q2 Quantity As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a negative relation between price and quantity, hence the negative slope of the demand schedule; as predicted by the law of demand. Consumers obtain utility (use, pleasure, jollies) from the consumption of commodities. Economists have long recognized that past some point, the consumption of additional units of a commodity bring consumers less and less utility. The change in utility derived from the consumption of one more unit of a commodity is called marginal utility. The idea that utility with the amount added to total utility will decline when additional units are consumed past some point has also the status of principle. This principle is called diminishing marginal utility. Because consumers make rational choices, that is they act in their own self interest, there are two effects that follow from their attempts to maximize their well-being when the price of a commodity changes. These two effects are called the; (1) income effect, and (2) the substitution effect. Together these effects guarantee a downward sloping demand curve. The income effect is the fact that as a person's income increases (or the price of item goes down [which effectively increases command over goods] more of
everything will be demanded. The income effect suggest that as income goes down (price increases) then less of the commodity will be purchased. 117 The substitution effect is the fact that as the price of a commodity increases, consumers will buy less of it and more of other commodities. In other words, a consumer will attempt to substitute other goods for the commodity that became more expensive. The substitution effect simply reinforces the idea of a downward sloping demand curve. The demand schedule can be expressed as a table of price and quantity data, a series of equations, or in a downward sloping graph. To this point, our discussion has focused on individuals and their behavior. Assuming that at least a significant majority of consumers are rational, it is a simple matter to obtain a market demand curve. One needs only to sum all of the quantities demanded by individuals at each price to obtain the market demand curve. Changes in the price of a commodity causes movements along the demand curve; such movements are called changes in the quantity demanded. If price decreases, then we move down and to the right along the demand curve; this is an increase in the quantity demanded. If price increases, then we move upward and to left along the demand curve, this is a decrease in the quantity demanded. Remember, (it is important) such changes are called changes in the quantity demanded because the demand curve is a schedule of the quantities demanded at each price. Movements of the demand curve itself, either to the left or right are called changes in demand. A change in demand is caused by a change in one or more of the nonprice determinants of demand. A shift to the right of the demand curve is called an increase in demand; and a shift to the left of the demand curve is called a decrease in demand. The nonprice determinants of demand are; (1) tastes and preferences of consumers, (2) the number of consumers, (3) the money incomes of consumers, (4) the prices of related goods, and (5) consumers' expectations concerning future availability or prices of the commodity. If the tastes and preferences of consumers change they will shift the demand curve. If consumers find a commodity more desirable, ceteris paribus, then an increase in demand will be observed. If consumer tastes wane for a particular product then there will be a shift to the left of the demand (a decrease in demand). An increase in the number of consumers or their money income will result in a shift to the right of the demand curve (an increase
in demand). A decrease in the number of consumers or their income will result in a shift of the demand curve toward the origin (a decrease in demand). Consumers will also react to expectations concerning future prices and availability. If consumers expect future prices to increase, their present demand curve will shift to the right; if consumers expect prices to fall then we will observe a decrease in current demand. 118 The prices of related commodities also effect the demand curve. There are two classes of related commodities of importance in determining the position of the demand curve, these are (1) substitutes, and (2) complements. A substitute is something that is alternative commodity, i.e., Pepsi is a substitute for Coca-Cola. A complement is something that is required to enjoy the commodity, i.e., gasoline and automobiles. If the price of a substitute increases, then the demand for our commodity will increase. If the price of a substitute decreases, so too will the demand for our commodity. In other words, the price of a substitute and the demand for our commodity move in the same direction. For complements, the price of the complement and the demand for our commodity move in opposite directions. If the price of a complement increases, the demand for our commodity will decrease. If the price of a complement decreases, the demand for our commodity will increase. Increase in Demand Decrease in Demand Price Price D2 D1 Quantity D2 D1 Quantity An increase in demand is shown in the first panel, notice that at each price there is a greater quantity demanded along D2 (the dotted line) than was demanded with D1 (the solid line). The second panel shows a decrease in demand, notice that there is a lower quantity demanded at each price along D2 (the dotted line) than was demanded with D1 (the solid line). 119 Changes in Quantity Demanded Price P1 P2 Demand Q1 Q2 Quantity Movement along a demand curve is called a change in the quantity demanded. Changes in quantities demanded are caused by changes in price. When price decreases from P1 to P2 the quantity demanded increases from Q1 to Q2; when price increases from P2 to P1 the quantity demanded decreases from Q2 to Q1. Supply The law of supply is that producers will supply more the higher the price of the commodity. The supply curve is an upward sloping function showing a direct relationship between prices and the quantity supplied. In other words, the supply curve has a positive slope that shows that as price increase (decreases
) so too does quantity supplied. As with the demand curve a change in the price will result in a change in the quantity supplied. An increase in price will result in an increase in the quantity supplied, and a decrease in price will result in a decrease in the quantity supplied. Again, this is because the supply curve is a schedule of the quantities supplied at each price. Changes in one or more of the nonprice determinants of supply cause the supply curve to shift. A shift to the left of the supply curve is called a decrease in supply; a shift to the right is called an increase in supply. The nonprice determinants of supply are; (1) resource prices, (2) technology, (3) taxes and subsidies, (4) prices of other goods, (5) expectations concerning future prices, and (6) the number of sellers. When resource prices increase, supply decreases (shifts left); and when 120 resource prices decrease, supply increases (shifts right). If a more cost effective technology is discovered then supply increases, increases in taxes cause the supply curve to shift left (decrease). An increase in a subsidy effects the supply curve in the same way as a cut in taxes, an increase in supply. If the price of other goods a producer can supply increases, the producer will reallocate resources away from current production (decrease in supply) and to the goods with a higher market price. For example, if the price of corn drops, a farmer will supply more beans. If producers expect future prices to increase, current supply will decline in favor of selling inventories at higher prices later. In other words, supply will decrease (a shift to the left, and exactly the opposite response will occur if producer expect future prices to be lower. If the number of suppliers increases, so too will supply, but if the number of producers declines, so too will supply. Decrease in Supply Increase in Supply Price Price S2 S1 S1 S2 Quantity Quantity A decrease in supply is shown in the first panel, notice that there is a lower quantity supplied at each price with S2 (dotted line) than with S1 (solid line). The second panel shows an increase in supply, notice that there is a larger quantity supplied at each price with S2 (dotted line) than with S1 (solid line). 121 Changes in Quantity Supplied Price Supply P1 P2 Q2 Q1 Quantity Changes in price cause changes in quantity supplied, an increase in price from
P2 to P1 causes an increase in the quantity supplied from Q2 to Q1; a decrease in price from P1 to P2 causes a decrease in the quantity supplied from Q1 to Q2. Market Equilibrium Market equilibrium occurs where supply equals demand (supply curve intersects demand curve). An equilibrium implies that there is no force that will cause further changes in price, hence quantity exchanged in the market. This is analogous to a cherry rolling down the side of a glass; the cherry falls due to gravity and rolls past the bottom because of momentum, and continues rolling back and forth past the bottom until all of its' energy is expended and it comes to rest at the bottom - this is equilibrium [a rotten cherry in the bottom of a glass]. 122 Price and Value Principles of Economics, 8th edition (Alfred Marshall, London: Macmillan Publishing Company, 1920, p. 348.)... We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens. The following graphical analysis portrays a market in equilibrium. Where the supply and demand curves intersect, equilibrium price is determined (Pe) and equilibrium quantity is determined (Qe) Price Pe Supply Demand Qe Quantity The graph of a market in equilibrium can also be expressed using a series of equations. Both the demand and supply curve can be expressed as equations. Demand Curve is Qd = 22 - P (Notice the negative sign in front the price variable, indicating a downward sloping function) 123 Supply Curve is Qs = 10 + P (Notice the positive sign in front of the price variable, indicating an upward sloping function) The equilibrium condition is Qd = Qs (For this market to obtain equilibrium, the quantity demanded must equal the quantity supplied in this market) Therefore: 22 - P = 10 + P adding P to both sides of the equation yields: 22 = 10 + 2P subtracting 10 from both sides of the equation yields: 12 = 2P or P = 6 To find the equilibrium quantity, we plug 6 (for P) into
either the supply or demand curve and get: 22 - 6 = 16 (Demand side) & 10 + 6 = 16 (Supply side) The system of equations approach to solving for equilibrium gives a specific number for price and for quantity. Unless the numbers are specified along the price axis and the quantity axis, the graph does not yield a specific number for price and quantity. However, the graph provides a visual demonstration of equilibrium which may aid learning. Changes in supply and demand in a market result in new equilibria. The following graphs demonstrate what happens in a market when there are changes in nonprice determinants of supply and demand. 124 Change in Demand Supply Price P1 P2 D2 D1 Q2 Q1 Quantity Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a decrease in demand (as demonstrated in the above graph). Such decreases are caused by a change in a nonprice determinant of demand (for example, the number of consumers in the market declined or the price of a substitute declined). With a decrease in demand there is a shift of the demand curve to the left along the supply curve, therefore both equilibrium price and quantity decline. If we move from D2 to D1 that is called an increase in demand, possibly due to an increase in the price of a substitute good or an increase in the number of consumers in the market. When demand increases both equilibrium price and quantity increase as a result. Considering the following graph, movement of the supply curve from S1 (solid line) to S2 (dashed line) is an increase in supply. Such increases are caused by a change in a nonprice determinant (for example, the number of suppliers in the market increased or the cost of capital decreased). With an increase in supply there is a shift of the supply curve to the right along the demand curve, therefore equilibrium price and quantity move in opposite directions (price decreases, quantity increases). If we move from S2 to S1 that is called an decrease in supply, possibly due to an increase in the price of a productive resource (capital) or the number of suppliers decreased. When supply decreases, equilibrium price increases and the quantity decreases as a result. That is the result of the supply curve moving up along the negatively sloped demand curve (which remains unchanged). 125 Changes in Supply S1 S2 Price P1 P2 Demand Q1 Q2 Quantity If both the demand curve and supply curve change at the same time the analysis becomes more complicated
. Consider the following graphs: Increase in Demand Decrease in Supply Decrease in Demand Increase in Supply Price D1 D2 S2 Price S1 P2 P1 P1 P2 S1 S2 D1 D2 Q Quantity Q Quantit Notice that the quantity remains the same in both graphs. Therefore, the change in the equilibrium quantity is indeterminant and its direction and size depends on the relative strength of the changes between supply and demand. In both cases, the equilibrium price changes. In the first case where demand increases, but supply decreases the equilibrium price increases. In the second panel where demand decreases and supply increases, the equilibrium price decreases. In the event that demand and supply both increase then price remains the same 126 (is indeterminant) and quantity increases, and if both decrease then price is indeterminant and quantity decreases. These results are illustrated in the following Price P Increase in Supply and in Demand Decrease in Supply and in Demand diagram s. Price P D1 D2 S2 S1 D2 D1 S2 S1 Q1 Q2 Quantity Q2 Q1 Quantity The graphs show that price remains the same (is indeterminant) but when supply and demand both increase quantity increases to Q2. When both supply and demand decrease quantity decreases to Q2. Shortages and Surpluses There is some rationale for limited government intervention in a free market economy. Perhaps the most powerful rationale for limited government arises from the effects of price controls in competitive markets. Shortages and surpluses can only result because by having some sort of price controls in the market. For example, the Former Soviet Union had a centrally planned economy and the government decided what would be produced and for what price that production would be sold. The government also was the sole employer and paid very low wages, therefore prices were also controlled at below market equilibrium levels. The result was that whenever any commodity was available in the market, there were long lines observed at any store with anything to sell, prices were low but there was nothing to buy (shortages). The popular Russian immigrant comedian, Yakov Simirnov, summed-up the plight of the working class consumer in Russia prior to break-up of the Soviet Union. He said, "In Russia we used to pretend to work, but that was alright, the government only used to pretend to pay us!" 127 Shortage is caused by an effective price ceiling (the maximum price you can charge for the product). Effective, in this sense, means that the government
can and does actively enforce the price ceiling. With the exception of the Second World War, there is little evidence that the government can effectively enforce price ceilings. Consider the following diagram that demonstrates the effect of a price ceiling in an otherwise purely competitive industry. SHORTAGE Supply Price Pe Price Ceiling Demand Qs Qe Qd Quantity For a price ceiling to be effective it must be imposed below the competitive equilibrium price. Note that the Qs is below the Qd, which means that there is an excess demand for this commodity that is not being satisfied by suppliers at this artificially low price. The distance between Qs and Qd is called a shortage. It is interesting to consider the last time that wage and price controls were attempted during the Carter administration. These short-lived price ceilings resulted in producers technically complying with the price restrictions, but they frequently changed the product. For example, warranties were no longer included in the sales price, service was extra, delivery was extra, and where possible, the product was reduced in size. For example, in the previous administration’s failed wage and price controls (Nixon) candy bars were made smaller and they put fewer M & Ms in the package and the price for these treats was not changed – effectively cutting costs, but not price, hence increasing the profit margin without raising the price of the candy. The lesson is simple, if government is going to control prices, they must be prepared to control virtually all other aspects of doing business. Surplus is caused by an effective price floor (minimum you can charge): 128 SURPLUS Price Floor Supply Price Pe Demand Qd Qe Qs Quantity For a price floor to be effective it must be above the competitive equilibrium price. Notice that at the floor price Qd is less than Qs, the distance between Qd and Qs is the amount of the surplus. Minimum wages are the best known examples of price floors and will be discussed in greater detail in Chapter 11. Implicit in these analyses is the fact that without government we could have neither shortage or surplus. In large measure, the suspicion of government is because it has the power to create these sorts of peculiar market situations. Even with the power of government to enforce law, the only way that a shortage or surplus could occur is if the price ceiling or the price floor were effective. Markets and Reality As intuitively pleasing as these analyses are, they are only models, and these models are based on assumptions that are not very good approximations of reality. In Chapter 8 the analysis
of a purely competitive market is offered. What this chapter presents is the industry in pure competition, which is based on assumptions that do not exist in reality. The assumptions are (1) perfect information about all past, and future prices, (2) no barriers to entry or exit from the market, (3) no non-price competition (advertising etc.), (4) atomized competition (so many suppliers and consumers that none can appreciably affect price or quantity), and (5) there is a standardized product (corn is corn is corn). If all of these assumptions accurately represent reality, then the firm must sell at whatever price is established in the industry. To sell at a lower price denies the firm revenue it could have otherwise earned, and to sell at a higher price would mean the firm could sell nothing. In other words, the competitive industry impose price discipline on all of the firms that together comprise that competitive industry. 129 Part of the controversy in almost any discussion of microeconomic activity is whether the results of policy can be predicted by the simple supply and demand model. Often the results of the simple supply and demand diagram are not bad rough approximations of reality – but remember that it is only a rough approximation – based on assumptions that are not very accurate depictions of reality. However, more often imperfect market models are more accurate approximations of reality – because one or more the assumptions underpinning those models more accurately reflects reality. One must be careful in applying these models, and in policy debates concerning these models. To the extent that the assumptions are not fulfilled, then the results may not be accurate. The real value of the simple supply and demand model is to provide a beginning point for coming to understand how markets really work. In most respects the simple supply and demand model is little more than the beginning point for constructing one of the more realistic market models. Pure monopoly, monopolistic competition and oligopoly are, in some important respects, refinements from the purely competitive market model. KEY CONCEPTS Market Equilibrium Law of Demand Demand schedule Utility Marginal Utility Diminishing Marginal Utility Income Effect Substitution Effect Demand Curve Determinants of Demand Tastes & Preferences Number of Consumers Money Income of Consumers Prices of Related Goods Substitutes Complements Expectations 130 Change in Demand v. Change in Quantity Demanded Price changes v. Non-price determinant changes Law of Supply Supply Schedule Supply Curve Determinants Resource prices Technology Taxes & Subsidies Prices of other goods Number of Sellers Expectations Change in Supply v
. Change in Quantity Supplied Price changes v. Non-price determinant changes Shortage and Surplus Price Floor and Price Ceiling STUDY GUIDE Food for Thought: Demonstrate what happens to a market equilibrium when: (1) demand increases, supply increases, (2) demand decreases, supply decreases, (3) demand increases, supply decreases, and (4) demand decreases, and supply increases. Do the same exercise showing only the demand curve increasing and decreasing and only the supply curve increasing or decreasing. Demonstrate the effects of a price floor: (1) above the competitive equilibrium, and (2) below the competitive equilibrium. 131 Repeat exercise 2, using a price ceiling. Using the system: Qd = Qs, where Qd = 124 - 4P and Qs = -16 + 3P What is the equilibrium price and quantity exchanged in this market? What would happen if there were a price floor of 6 imposed in this market? If 6 was a price ceiling would that change your answer? If so, how and why? Sample Questions: Multiple Choice: If a minimum wage were imposed below the competitive equilibrium what would we expect to observe in the effected labor markets? A. An excess demand for labor B. People being attracted by the higher wage cannot find jobs and some who were employed will lose their jobs, but those remaining employed will have a higher wage C. There will be unemployment created by people losing jobs, but there will be no new employees attracted to this labor market. D. Nothing will be caused by the introduction of this minimum wage If there is an increase in demand and an increase in the quantity supplied in a product market what should be observed? A. Price increases, quantity exchanged is indeterminant B. Price decreases, quantity exchanged is indeterminant C. Price decreases, quantity exchanged decreases D. Price increases, quantity exchanged increases 132 True - False If the price of Pepsi-Cola increases we should expect the demand for Coca-Cola increase, ceteris paribus. {TRUE} If consumers expect the price of computers to increase in the near future there should be an increase in the quantity demanded observed. {FALSE} 133 CHAPTER 5 Supply & Demand: Elasticities The purpose of this chapter is to extend the supply and demand analysis presented in the previous chapter. Specifically, this chapter will develop the methods employed by economists to measure consumer responsiveness to price changes -- the price elasticity of demand. Other topics examined in this chapter are the price elasticity of supply, cross
-elasticities, the income elasticity of demand and the interest elasticity of demand. Price Elasticity of Demand The price elasticity of demand is how economists measure the responsiveness of consumers to changes in prices for a commodity. In other words, as price increases (decreases), the quantity demanded by consumers will decrease (increase). The relative proportions of the changes in price and the respective quantities demanded are the responses of consumers and are referred to as the price elasticity of demand. It is this consumer responsiveness that is the subject of this chapter. Business decisions concerning prices are not always a simple matter of adding some margin to the cost of production of the commodity (cost-plus pricing). Suppliers will wish to obtain the most revenue the market will bear from the sales of their products – in other words, maximize their profits. It is therefore necessary for business to have some idea of what the market will bear, and that is where the price elasticity of demand enters the picture in business decision-making. There are three methods that are used to measure the price elasticity of demand, these are; (1) the price elasticity coefficient (midpoints formula), (2) the total revenue test, and (3) a simple examination of the demand curve. Each of these will be examined in turn, in the following paragraphs. Elasticity Coefficient The elasticity coefficient is a number calculated using price and quantity data to determine how responsive consumers are to changes in the price of a commodity. The elasticity coefficient may be calculated in two distinct ways. Point elasticity is 134 measuring responsiveness at a specific point along a demand curve. The other method is using the mid-point of the difference in the price and the mid-point in the difference of the quantity numbers. Because the midpoints formula cuts down on the confusion of which prices and quantities are to be used, it is the only coefficient we will use in this course. The price elasticity coefficient (midpoints) is calculated using the midpoints formula: Ed = Change in Qty ÷ Change in price (Q1 + Q2)/2 (P1 + P2)/2 Calculating the elasticity coefficient will yield a specific number. The value of that number provides the answer as to whether demand is price elastic or price inelastic. Elastic demand means that the consumers' quantities demanded respond (more than proportionately) to changes in price; with elastic demand the coefficient is more than one. Inelastic demand means that the consumers' quantities demanded do
not respond very much to changes in price; with inelastic demand the coefficient is less than one. Unit elastic demand means that the consumers' quantity demanded respond proportionately to change in price; with unit elastic demand the coefficient is exactly one. What this equation states is illustrated in the graph below. The midpoint between price one (P1) and price two (P2) is labeled Midpoint along the price axis and M on the quantity axis. Price P1 Midpoint P2 Demand Quantity Q1 M Q2 135 On the graph this number is the difference between Q1 and Q2 divided by the distance between the origin and the point labeled M on the quantity axis for the numerator and the difference between P1 and P2 divided the distance between the origin and the point labeled midpoint on the price axis for denominator. The ratio of the numerator to the denominator on this graph is the same number yielded by the equation. Examining the demand curve can also provide clues concerning the price elasticity of demand. A perfectly vertical demand curve indicates that the quantity demanded will be exactly the same, regardless of price. This type of demand curve is called a perfectly inelastic demand curve. A perfectly horizontal demand curve indicates that consumers will have almost any quantity demanded, but only at that price. This is called a perfectly elastic demand curve. Perfectly unit elastic demand curves are not linear, they have slopes that vary across ranges. Perfectly elastic demand Perfectly inelastic demand Price Price Demand Demand Quantity Quantity Perfectly Elastic and Perfectly Inelastic Demand Curves There is a trick to remembering inelastic and elastic demand. Notice in the above graphs that the perfectly elastic demand curve is horizontal, (add one more horizontal line at the top of the price axis and it will look like an E). The perfectly inelastic demand curve is vertical (looks like an I). If you have problems remembering the concept of inelastic or elastic demand you need only draw the curves above and observe what happens to the quantity demanded when the price changes. In the case of perfectly inelastic demand consumers will buy exactly the same quantity of a product without regard for its price. In the case of a perfectly elastic demand curve, if producers raise the price of the product, then they will sell nothing. Slope and elasticity are two different concepts. With linear demand curves, elasticity changes along the demand curve, however its slope does not. Elasticity is 136 concerned with responses in one variable to changes in the
other variable. The slope of the curve is concerned with values of the respective variables at each position along the curve (i.e., its' shape and direction). Demand Curve and Total Revenue (total revenue = P x Q) Curve Price Elastic Total Revenue t i n U Inelastic Demand Quantity Total Revenue Quantity The total revenue curve in the bottom graph is plotted by multiplying price and quantity to obtain total revenue and then plotting total revenue against quantity. In examining the above graphs, notice that as total revenue is increasing, demand is elastic. When the total revenue curve flattens-out at the top then demand becomes unit elastic, and when total revenue falls demand is inelastic. In other words, moving from left to right on the demand curve, as price and total revenue move in the opposite direction demand is price elastic, and when price and total revenue move in the same direction demand is price inelastic. The total revenue test uses the relation between the total revenue curve and the demand curve to determine the price elasticity of demand. In general, price and total revenue will move in the same direction of the demand is price inelastic (hence consumers are unresponsive in quantity purchased when price changes) and move in opposite directions if price elastic (consumers’ quantities being responsive to price changes). 137 Consider the following numerical example: _____________________________________________________________________ _____________________________________________________________________ Table 1: Total Revenue Test _____________________________________________________________________ Total Quantity _____________________________________________________________________ Price per unit Total Revenue Elasticity 12 15 16 15 12 7 >+5 >+3 >+ Elastic Elastic Elastic Inelastic Inelastic Inelastic _____________________________________________________________________ _____________________________________________________________________ Marginal revenue is the change in total revenue due to the a change in quantity demanded. The total revenue test relies on changes in total revenue (marginal revenue) to determine elasticity. If the change in total revenue (marginal revenue) is positive the demand is price elastic, if the change in total revenue is negative the demand is price inelastic. If the marginal revenue is exactly zero then demand is unit elastic. The following determinants of the price elasticity of demand will determine how responsive the quantity demanded by consumers is to changes in price. The determinants of the price elasticity of demand are; (1) substitutability of other commodities, (2) the proportion of income spent on the commodity, (3) whether the commodity is a luxury or a necessity, and (4) the amount of time that a consumer can postpone the purchase. If there are no close substitutes
then the demand for the commodity will be price inelastic, ceteris paribus. If there are substitutes then consumers can switch their purchasing habits in the case of a price increase, but if there are no substitutes then 138 consumers are more likely to buy even if price goes up. For example, if the price of Pepsi goes up, then certain consumers will buy Coke, if the price of Coke has not increased, hence the demand for Pepsi is likely to be elastic. All other things equal, the higher the proportion of income spent for the commodity more price elastic will be the demand. Most home owners are familiar with how this determinant works. The demand for single family dwellings is likely to be more elastic than the demand for apartments, because a higher proportion of your income will be spent on housing when you own your home. Commodities that are viewed as luxuries typically have price elastic demand, and commodities that are necessities have price inelastic demand. There is simply no substitute for a insulin, if you are an insulin dependent diabetic. Because insulin is a necessity for which there is no substitute, the demand will be price inelastic. Time is an important determinant of price elasticity. If a price changes, it may take consumers a certain amount of time to discover alternative lifestyles or commodities to account for the price change. For example, if the price of cars increases, a family that planned to buy a car may wait for their income or wealth to increase to make buying a new car viable alternative to continuing to drive an older vehicle. In other words, the longer the time frame for the decision to purchase the more price elastic the demand for the commodity. Price Elasticity of Supply The price elasticity of supply measures the responsiveness of suppliers to changes in price. The price elasticity of supply is determined by the following time frames; (1) market period, (2) short-run, and (3) long-run. The more time a producer has to adjust output the more elastic is supply. The time frames for producers will be discussed in more detail in Chapter 7 as they pertain to a firm's cost structure. However, it is important to understand the basic idea behind this classification of time as it relates to price elasticity. The market period is defined to be that period in which the producer can vary nothing, therefore the supply is perfectly inelastic. The long-run is the period in which the producer can vary everything, therefore the supply is perfectly elastic. The short-run is
the period in which plant and equipment cannot be varied, but most other factors' usage can be varied, therefore it depends on a producers capital - intensity as to how elastic supply is at any particular point. 139 Other Elasticities There are three other standard applications of the elasticity of demand. The cross elasticity of demand, the income elasticity of demand, and the interest rate elasticity of demand. Each of these will be examined, in turn, in the remaining paragraphs of this chapter. The cross elasticity of demand measures the responsiveness of the quantity demanded of one product to changes in the price of another product. For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi. Cross elasticity of demand gives an indication of how close a substitute or complement one commodity is for another. This concept has substantial practical value in formulating marketing strategies for most products. For example, as the price of coke increases, then consumers may purchase proportionately more Pepsi products. In such a case, the cross elasticity of demand of Pepsi to the price of coke would be termed elastic. The equation for the cross elasticity of demand described here is presented below. Ed = Change in Qty pepsi ÷ Change in price coke (Q1 Pepsi + Q2 Pepsi)/2 (P1 coke + P2 coke)/2 The income elasticity of demand measures the responsiveness of the quantity demanded of a commodity to changes in consumers' incomes. This is typically measured by replacing the price variable with income (economists use the letter Y to denote income) in the midpoints formula. Again, in business planning the responsiveness of consumers to changes in their income may be very important. Housing and automobiles, as well as, several big ticket luxury items have demand that is sensitive to changes in income. The income elasticity formula is presented below. Ed = Change in Qty ÷ Change in income (Q1 + Q2)/2 (Y1 + Y2)/2 Often interest rates will also present a limitation on a consumer’s quantity of demand for a particular commodity. As with income, often big ticket items are very sensitive to interest rates on the loans necessary to make those purchases. With the record low mortgage rates in the Spring of 2003 the quantity demanded for housing, both new and existing homes, witnessed dramatic increases. 140 The automobile companies rarely reduce prices for their vehicles, but rather, GM, Ford and Chrysler will offer incentives. Rebates, which are temporary reductions in price, and
attractive financing rates are the hooks offered to get the consumer in the showroom and into the new car. In May of 2003 all of the American producers were offering zero percent financing on all but a very few of their vehicles, and even some of the European and Japanese producers were following suite with either very low rates, or zero percent financing. The interest rate elasticity formula is (where interest rate is “r”): Ed = Change in Qty ÷ Change in interest rate (Q1 + Q2)/2 (r1 + r2)/2 These analyses are important to businesses in determining what issues are important to the successful sales of their products. There are industries that have not been particularly good at understanding the notions of cross elasticity or price elasticity – the airlines in particular, and many of these firms have suffered as a result. The bankruptcies of United Airlines and US Air being excellent examples. The automobile companies have been, in some measure, forced into the financing business because of the interest rate sensitivity of consumers. By offering financing the car companies are, essentially, maintaining some modicum of control over one important aspect of their business. Interest rate sensitivity can also be understood from another perspective. The total cost of a commodity is not just its price, but also what must be paid to borrow money to purchase that item. With modern views of instant gratification, it is rare for someone to save to purchase a house, or any other big ticket item, what is more common is to borrow the money, buy the item, and make installment payments. Therefore the interest charges are a part of the total cost of acquiring that big ticket item – hence consumer sensitivity to interest rates when buying a house or a car. It is also noteworthy, that purely competitive firms are price takers, and it is the imperfectly competitive firm that has a pricing policy. What is often referred to as “pricing power” in the business press, means the ability to take advantage of the price elasticity of demand or one of the other elasticities examined here – hence implying some market structure, hence market power not otherwise identified in the model of pure competition. 141 KEY CONCEPTS Price Elasticity of Demand Elasticity coefficient Elastic Demand Perfectly Elastic Demand Inelastic Demand Perfectly Inelastic Demand Unitary Elasticity Total Revenue Test Price and Total Revenue Marginal Revenue Determinants of Price Elasticity Substitutability Proportion of Income Luxuries v. Necessities Time Elasticity of Supply Time periods Market period Short
-run Long-run Cross Elasticity of Demand Income Elasticity Interest Rate Sensitivity Pricing Power 142 STUDY GUIDE Food for Thought: List and explain the determinants of the price elasticity of demand and of supply. What are the income and cross elasticities of demand? Why might they be useful? Explain. 3. Consider the following data: Price Quantity Total Revenue Marginal Revenue 1 2 3 4 5 6 7 8 2000 1900 1750 1550 1250 900 400 100 2000 3800 5250 6200 6250 5400 2800 800 Calculate the marginal revenue for each change in price. Perform a total revenue test and determine the ranges of price elastic and price inelastic demand. Draw the demand curve and the total revenue curve and show these ranges thereon. Using the data in question 3 above calculate the price elasticity coefficient moving from price of 3 to a price of 4; from a price of 5 to a price of 6. 143 Explain what the price elasticity of demand is and why it is of interest in examining markets. Might it be useful in the airline industry? Why? Sample Questions: Multiple Choice: Which of the following is a determinant of the price elasticity of demand? A. Proportion of income spent on commodity B. Price of complements C. Number of consumers D. None of the above Where is the range of unit price elasticity of demand for the following demand curve? Price Quantity. From price 8 to price 6 B. From price 6 to price 5 C. From price 5 to price 3 D. From price 7 to price 4 Calculate the elasticity coefficient from the data above for the interval where price changes from 8 to 7. That coefficient is: A. 0.47 B. 1.00 C. 2.14 D. None of the above 144 True - False: The longer the period the more suppliers can adjust to price changes, hence the greater the price elasticity of supply. {TRUE} The income elasticity of demand shows whether a product has a close substitute or complement. {FALSE} The maximum point on the total revenue curve correlates with the elastic range of the demand curve. {FALSE} 145 CHAPTER 6 Consumer Behavior The purpose of this chapter is to refine the income and substitution effects introduced in Chapter 4. This chapter will also introduce the idea of Giffin’s Paradox, consumer equilibrium, and the utility maximization rule. The appendix to this chapter also introduces you to indifference curves and budget constraints to analyze consumer behavior. Income
and Substitution Effects Revisited The income and substitution effects combine to cause the demand curve to slope downwards as was discussed earlier in Chapter 4. In fact, an individual consumer's demand curve can be rigorously derived using concepts from intermediate microeconomics (E321) called indifference curves which illustrate, graphically, the income and substitution effects. For students who are interested, it is recommended that you take E321, Intermediate Microeconomics; or at a minimum go through the appendix to this chapter. The results of the indifference curve analysis (presented in the appendix to this chapter) can be described in words. The income effect results from the price of a commodity going down having the effect of a consumer having to spend less on that commodity, hence the same as having more resources. However, as price increases, the consumer will purchase less of that commodity and buy more of a substitute, this is the substitution effect. It is the combination of the income and substitution effects, and their relative strength, that causes an individual (hence generally a market) demand curve to slope downward. However, there is an interesting exception to this general rule -- Giffin's Paradox. Giffin's Paradox is the fact that some commodities may have an upward sloping demand curve. Such commodities are called inferior products. (Not necessarily because of quality problems with the product, but because the analysis is inferior -- not generalizable to all commodities). This happens because the income effect results in a lesser demand for a product. (In other words, the income effect overwhelms the substitution effect). There are at least two types of goods that often exhibit an upward sloping demand curve. One is necessity for very poor people and the other is one for which a high price creates a snob effect. Each case will be reviewed, in turn, in the following paragraphs. 146 Price P1 P2 Demand with Giffin’s Paradox Quantity In the diagram above notice that as price is decreased from P1 to P2 the quantity demanded decreases, hence snob appeal may go down from the loss of a prestigiously high price – consumers who value the product simply because it is high priced leave the market as the price falls. As price increases from P2 to P1 poor people can’t afford other more luxurious items therefore they have to buy more of the very commodity whose price wrecked their budgets. In the case of poor people who experienced the price of necessity increasing, their limited resources may result in their buying more of the commodity when its price increases. For
example, if the price of rice increases in a less developed country, people may buy more of it because of the pressure placed on their budget prevents them from buying beans or fish to go with their rice. To maintain their caloric intake rice will be substituted for the still more expensive beans and fish. The other situation is where a luxury is involved. There is the snob appeal possibility where the higher the price, the more desired the commodity it. Often people will drive expensive cars, simply because of the image it creates. If the car is extremely expensive, i.e., Rolls Royce, the snob effect may be the primary motivation for the purchase. This also works with less expensive commodities. For example, Joy Perfume advertised itself as the world's most expensive to attract consumers that their marketing surveys indicated would respond to the snob effect. 147 Consumer Equilibrium Incentive and Economic Welfare Principles of Economics, 8th ed. (Alfred Marshall, London: Macmillan Publishing Company, 1920, pp. 15-16.)... If then we wish to compare even physical gratifications, we must do it not directly, but indirectly by the incentives which they afford to action. If the desires to secure with of two pleasures will induce people in similar circumstances each to do just an hour's extra work, or will induce men in the same rank of life and with the same means each to pay a shilling for it; we they may say that those pleasures are equal for our purposes, because the desires for them are equally strong incentives to action for persons under similar conditions. Rational behavior was defined as economic agents acting in their self interest. It is the idea of rational behavior that permits the rigorous examination of economic activity. Without rationality, our analyses fail to conform with the basic underlying assumption upon which most of economics is based. Consumers (when acting in their own self interest) will generally attempt to maximize their utility, given some fixed level of available resources and income with which to purchase goods and services. The utility maximizing rule is that consumers will balance the utility they receive from the consumption of each good or service against the cost of each commodity they purchase, to arrive at how much of each good they need to maximize their total utility. The algebraic restatement of the rule: MUa/Pa = MUb/Pb =... = MUz/Pz When the consumer reaches equilibrium each of the ratios of marginal utility to price will be equal to one. If any single ratio is greater than one
, the marginal utility received from the consumption of the good is greater than the price, and this means the consumer has not purchased enough of that good. Therefore the consumer must purchase more of that good (causing price to increase and marginal utility to go down to the point they are equal), where MU > P. If the ratio is less than one, where MU< P, then the consumer has purchased too much of the commodity (price is larger than the marginal utility received from the commodity) and needs to cut back. Whether consciously or not, rationality requires each individual consumer to allocate their resources in such a manner as to meet the restrictions of the above 148 equation that is when the consumer is said to be in equilibrium. In reality, a consumer is always seeking those levels, but because of changing prices and changing preferences, it is understood that the consumer is always seeking, but never quite at equilibrium. APPENDIX TO CHAPTER 6 Utility and Demand Curves The material in this appendix is not subject to testing and will not be included on any of the examinations or quizzes. It is provided simply to demonstrate how an individual demand can be derived. The demand curve is dependent on the individual consumer's tastes and preferences, as was shown in Chapter 5. Therefore we can derive an individual demand curve using what we have learned about utility in this chapter. Individual preferences can be modeled using a model called indifference curve - budget constraint and from this model we can derive an individual demand curve. A consumer's budget constraint is a mapping of the ability to purchase goods and services. We assume that there are two goods and that the budget constraint is linear. The following budget constraint shows the consumer's ability to purchase goods, beer and pizza. Budget Constraint Beer Pizza The consumer is assumed to spend their resources on only beer and pizza. If all resources are spent on beer then the intercept on the beer axis is the amount of beer the consumer can purchase; on the other hand, if all resources are spent on pizza then the intercept on that axis is the amount of pizza that can be had. 149 If the price of pizza doubles then the new budget constraint becomes the dashed line. The slope of the budget constraint is the negative of the relative prices of beer and pizza. An indifference curve is a mapping of a consumer's utility derived from the consumption of two goods, in this case beer and pizza. There are three assumptions necessary to show a consumer's utility with an indifference mapping. These three assumptions are: (1) every point in the positive/positive quad
rant is associated with exactly one indifference curve (every place thick), (2) indifference curves do not intersect (an indifference above another shows greater utility unequivocally), and (3) indifference curves are strictly convex toward the origin (bow toward the origin). The following indifference curve shows the consumer's preferences: Beer 2 1 Pizza The dashed line (2) shows a higher level of total satisfaction than does the solid line (1). Along each indifference curve is the mix of beer and pizza that gives the consumer equal total utility. Consumer equilibrium is where the highest indifference curve they can reach is exactly tangent to their budget constraint. Therefore if the price of pizza increases we can identify the price from the slope of the budget constraint and the quantities purchased from the values along the pizza axis and derive and individual demand curve for pizza: 150 Beer 2 1 2 1 Pizza When the price of pizza doubled the budget constraint rotated from the solid line to the dotted line and instead of the highest indifference curve being curve 1, the best the consumer can do is the indifference curve labeled 2. Deriving the individual demand curve is relatively simple. The price of pizza (with respect to beer) is given by the (-1) times slope of the budget constraint. The lower price with the solid line budget constraint results in the level the higher level of pizza being purchased (labeled 1for the indifference curve - not the units of pizza). When the price increased the quantity demanded of pizza fell to the levels associated with budget constraint 2. Price P2 P1 Quantity Q2 Q1 Notice that Q2 and P2 are associated with indifference curve 2 and budget constraint 2, and that Q1 and P1 result from indifference curve 1 and budget constraint 1. The above model shows this individual consumer's demand for pizza. 151 KEY CONCEPTS Revealed preference Utility Budget Constraint Indifference Curves Income Effect Substitution Effect Giffin’s Paradox, Inferior goods Consumer Equilibrium STUDY GUIDE Food for Thought: What is utility and diminishing marginal utility? Explain. In detail, explain the utility maximization rule? Critically evaluate this concept. How is a market demand curve derived? What does this have to do with indifference curves and budget constraints? 152 Sample Questions: Multiple Choice: Which of the following describes the utility maximization rule? (where MU is marginal utility and P is price) A. MUa/Pa = MUb/Pb =... = MUz/Pz B. Total MU = Total P C. MUa
= MUb =... = MUz D. None of the above describe the rule True - False: The law of diminishing marginal utility states that total utility will become negative as more units of a commodity are consumed. {FALSE} Typically, the income and substitution effects combine to cause a downward sloping demand curve. {TRUE} 153 CHAPTER 7 Costs of Production The purpose of this chapter is to examine the production costs of a firm. The first section develops the economic concepts of production necessary for understanding the cost structure of a firm. The second section presents the models of short-run costs. The final section develops the long-run average total cost curve and discusses its implications for the strategic management of a business. Production and Costs The reason that an entrepreneur assumes the risk of starting a business is to earn profits. The fundamental assumption in the theory of production is that a rational owner of a business will seek to maximize the profits (or minimize the losses) from the operation of his business. However, before anything can be said about profits we must first understand costs and revenues. This chapter will develop the basic concepts of production costs. An economist's view of costs includes both explicit and implicit costs. Explicit costs are accounting costs, and implicit costs are the opportunity costs of an allocation of resources (i.e., business decisions). Accountants subtract total cost from total revenue and arrive a total accounting profits. An economist, however, would include in the total costs of the firm the profits that could have been made in the next best business opportunity (e.g., the opportunity cost). Therefore, there is a significant difference in how accountants' and economists' view profits B economic profits versus accounting profits. For the purposes of economic analysis, a normal profit includes the cost of the lost opportunity of the next best alternative allocation of the firm=s resources. In a purely competitive world, a business should be able to cover their costs of production and the opportunity cost of the next best alternative (and nothing more in the long-run). In an accounting sense there is no benchmark to determine whether the resource allocation was wise. Instead various financial ratios are used to determine how the firm has done with respect to similarly situated companies. 154 Time Periods Revisited As was discussed briefly in the section of elasticity of supply in Chapter 5, time periods for economic analysis are defined by the types of costs observed. These time periods differ from industry to industry, and will differ by the technology employed between firms. Again, these time periods are;
(1) the market period, (2) the short-run, and (3) the long-run. In the market period, all costs are fixed costs (nothing can be varied). In the short-run, there are both fixed and variable costs observed. Generally, plant, equipment, and technology are fixed, and things like labor, electricity, and materials can still be varied. In the long-run everything is variable. That is, the plant, equipment, and even the business into which you put productive assets can all be changed. In the long-run, even the country in which the business is located can be changed. Because everything is fixed in the market period, this period is of little interest in economic analysis. Therefore, economists typically begin their analysis of costs with the short-run and proceed to examine the operation of the firm and the industry. The long-run is of interest because it is also the planning horizon for the business. Production Another view of the short-run cost structure is that fixed costs are those that must be paid whether the firm produces anything or not. Variable costs are called variable because they increase or decrease with the level of production. Therefore to understand short-run costs, you must first understand production. Total product or total output is the total number of units of production obtained from the productive resources employed. Average product is total product divided by the number of units of the variable factor employed. Marginal product is the change in total product associated with a change in units of a variable factor of production. As a firm increases its output it normally makes more efficient use of its available capital. However, with a fixed level of available capital as variable factors are added to the production process, there is a point where the increases in total output begin to diminish. The law of diminishing returns is the fact that as you add variable factors of production to a fixed factor, at some point, the increases in total output begin to become smaller. In fact, it is possible, at some point, that further additions in the units variable factors to a fixed level of capital could actually reduce the total output of the firm. This is called the uneconomic range of production. In reality, most firms come to realize that their total additions to total output diminish, long before they begin to experience negative returns to additions to their workforce or other variable factors. 155 The following diagram provides a graphical presentation of total, average, and marginal products for a hypothetical firm. The top graph shows total product. After total product reaches its maximum
marginal product where marginal product changes from positive to negative (first derivative is zero, second derivative is negative). When the total product curve reaches its maximum, increased output results in negative marginal product. The maximum on the marginal product curve is also associated with the first inflection point (the acceleration or where the curve becomes steeper) on the total product curve. The ranges of marginal returns are identified on the above graphs. The beginning point in developing the cost structure of a firm is to examine total costs in the short run. Total costs (TC) are equal to variable costs (VC) plus fixed costs (FC). TC = VC + FC Variable costs are those costs that can be varied in the short-run, i.e., the cost of hiring labor. Fixed costs are those costs that cannot be varied in the short-run, i.e., plant (interest). Therefore, total costs consist of a fixed component and a variable component. These relations are presented in a graphical form in the following diagram: 156 The fixed cost curve is a horizontal line. These costs are illustrated with a horizontal line because they do not vary with quantity of output. The variable cost curve has a positive slope because it varies with output. Notice that the total cost curve has the same shape as the variable cost curve, but is above the variable cost curve by a distance equal to the amount of the fixed cost. This is because we added fixed cost (the horizontal line) to variable cost (the positively sloped line). From the total, variable and fixed cost curves we can obtain other relations. These are the marginal cost, and the total, variable, and fixed costs relation to various levels of output (averages). Average total cost (ATC) is total cost (TC) divided by quantity of output (Q), average variable cost (AVC) is variable cost (VC) divided by quantity of output (Q), and average fixed cost (AFC) is fixed cost (FC) divided by quantity of output (Q). Marginal cost (MC) is the change (denoted by the Greek symbol delta), in total cost (TC) divided by the change in the quantity of output (Q). 157 These relations are presented in equation form below: ATC = TC/Q AVC = VC/Q AFC = FC/Q MC = ÎTC/ÎQ; where Î stands for change in. The following diagram presents the average costs and marginal cost curve in graphical form. Please notice that the average fixed cost approaches zero

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