Monday, March 8, 2010
Sunday, March 7, 2010
Taxation (Macro)
direct taxation: taxes paid directly to the government (i.e. income and corporate tax)
indirect taxation: taxes paid to the government via an intermediary (i.e. sales tax, value-added tax - VAT, sin taxes)
progressive taxation: tax rates that increase as income goes up (i.e. most countries income/corporate tax regimes)
regressive taxation: tax rates that decrease as income goes up (all sales taxes are regressive in nature...why?!)
proportional taxation: tax rate that are the same for all (i.e. everyone pays 15% regardless of income, seen in many East European countries like Ukraine).
transfer payments: payment by government as a "gift" or aid, not for g/s and not counted in GDP...a transfer (type of redistribution from richer to poorer includes welfare checks and social security).
Laffer curve: a graph showing the relationship between tax rate and government tax revenue (at zero tax rate, there is zero government revenue, at 100% tax rate, there is zero government tax revenue because no one works...the ideal is somewhere in the middle where revenue peaks).
Phillips Curves! SRPC and LRPC
An economist named Alban Phillips studied the interaction between inflation and unemployment in the mid-20th century and derived the so-called "Phillips curve". In the short-run, Phillips and his successors argued there was an inverse relationship between the inflation rate and the unemployment rate: as inflation goes up, unemployment goes down, and vice versa. They made this claim because since wages are so critical to all firms as costs of factors of production, if there are fewer and fewer unemployed people, wage levels (and thus the overall price level) would increase as firms have to pay more for scarcer labor. This graph shows the short-run Phillips curve (SRPC):
But then, the 1970s occurred. In this decade, we observed stagflation, or high inflation AND high unemployment. This caused the SRPC model to fall out of favor and led to a new theory of this relationship by a group of monetarists led by Milton Friedman. They argued there was no link between inflation and unemployment and, following the analysis of neo-Classical LRAS, said there would be a short-run fixed "natural" level of unemployment that would differ between countries. In fact, they maintain that if the government intervened to reduce unemployment, the only result would be a higher and higher inflation rate at the same original level of unemployment. Let's look at the graph:
We can see above that the initial equilibrium is an inflation rate of 2% and an unemployment rate of 4%. At this level, people expect 2% inflation. Monetarists would argue that if the government used demand-side policies to reduce unemployment (more demand for g/s means more workers are needed), the the short-run. As this occurs, the inflation rate increases to 5%, and unemployment will fall to 3% (lower red arrow). However, people will realize that although the number on their paycheck has increased (nominal figure), the real rate adjusted for inflation did not change, and anger rises. Some people thus leave their jobs and unemployment returns to 4% (lower blue arrow). If the government again tries to cut unemployment through expansionary fiscal or monetary policy, the rate will again fall to 3% and workers will again negotiate higher wages. Here we would be at an inflation rate of 9% with 3% unemployment. Yet, again the works will realize that their real income hasn't changed and unemployment will again rise to 4%. This is how the long-run Phillips cuve (LRPC) is derived, and this term is also called natural rate of unemployment (NRU). We can define the NRU as the rate of employment that occurs when at the full employment level of output (Yfe) and the labor market is in equilibrium.
One more graph. How can we lower the unemployment rate if we follow neo-Classical theory. Answer - shift the LRPC in! Monetarists would argue that a country can decrease it's NRU through achieving economic growth (see neo-Classical LRAS post) which would cause a leftward shift in LRPC. To do this, they encourage implementing market-oriented policies like reducng taxes and deregulating.
But then, the 1970s occurred. In this decade, we observed stagflation, or high inflation AND high unemployment. This caused the SRPC model to fall out of favor and led to a new theory of this relationship by a group of monetarists led by Milton Friedman. They argued there was no link between inflation and unemployment and, following the analysis of neo-Classical LRAS, said there would be a short-run fixed "natural" level of unemployment that would differ between countries. In fact, they maintain that if the government intervened to reduce unemployment, the only result would be a higher and higher inflation rate at the same original level of unemployment. Let's look at the graph:
One more graph. How can we lower the unemployment rate if we follow neo-Classical theory. Answer - shift the LRPC in! Monetarists would argue that a country can decrease it's NRU through achieving economic growth (see neo-Classical LRAS post) which would cause a leftward shift in LRPC. To do this, they encourage implementing market-oriented policies like reducng taxes and deregulating.
Saturday, March 6, 2010
Unemployment - Disequilibrium
The first type of disequilibrium unemployment is called real-wage or neo-Classical unemployment. Basically, this concept is the same as microeconomic price floors but applied to workers and minimum wages. A minimum wage, w1, is set above the market-clearing wage, we at quantity q*. Instead, a minimum wage has been set which guarantees workers a wage above where it would fall if the labor market were left to its own devices. Thus, there is real wage / neo-Classical unemployment from q1 to q2 at wage w1. Keynesian economists argue that such minimum wages are needed to protect the most vulnerable in society. Neo-Classical economists argue there would be no real-wage unemployment without a minimum wage and more people would be working. Big debate (as per usual with these schools of thought).
Unemployment - Equilibrium
Unemployment is the state in which someone is without work, available to work, and is currently seeking work. The unemployment rate is the number of people unemployed divided by the total labor force (everyone working plus everyone seeking work but unable or unwilling to take jobs). There are two types of disequilibrium unemployment: real-wage/Classical and cyclical/demand-deficient/Keynesian. The graph below shows equilibrium unemployment of which there are three types: frictional, seasonal and structural. Frictional unemployment occurs when a worker moves from one job to another, called job searching. Seasonal unemployment occurs because production in some sectors varies over the year, like farmers in winter or ski instructors in summer. Structural unemployment is caused by a mismatch (spatial or skill-based) between jobs offered by employers and potential workers.
In theory, the labor market may be in equilibrium but there may still be unemployment. When the labor market is in equilibrium, the number of job vacancies in the economy is the same as the number of people looking for work. Jobs exist, but people are either unwilling or unable to take jobs that are available. This graph shows the labor force (LF) curve in addition to the aggregate demand for labor (ADL) and aggregate supply for labor (ASL) curves. The ASL shows the number of people willing and able to work at every given wage rate. The ADL shows the demand of firms for all types of workers at different wage rates. Here, the labor force includes the aggregate supply for labor plus everyone unemployed and looking for work, and thus at we, qe, qe to q1 unemployment exists.
In theory, the labor market may be in equilibrium but there may still be unemployment. When the labor market is in equilibrium, the number of job vacancies in the economy is the same as the number of people looking for work. Jobs exist, but people are either unwilling or unable to take jobs that are available. This graph shows the labor force (LF) curve in addition to the aggregate demand for labor (ADL) and aggregate supply for labor (ASL) curves. The ASL shows the number of people willing and able to work at every given wage rate. The ADL shows the demand of firms for all types of workers at different wage rates. Here, the labor force includes the aggregate supply for labor plus everyone unemployed and looking for work, and thus at we, qe, qe to q1 unemployment exists.
Deflation: prices going down
Deflation is a persistent decrease in the average price level for a sustained period of time. Deflation can be good, deflation can be bad. "Good" deflation occurs when the LRAS shifts out symbolizing economic growth. Economic growth occurs when the quality or quantity of FoPs is increased. As we can see in the graph below, a rightward shift in LRAS leads to a fall in APL, showing deflation.
Yet, there is also "bad" deflation. This occurs when aggregate demand falls in the economy, leading to a decrease in output (meaning more unemployment) and a falling average price level (deflation). See the graph below:
A neo-Classical economist would argue that in the long run, the fall in the average price level would make the production process cheaper and thus eventually shift the SRAS out so that the full employment level of output is again achieved.
Inflation: prices going up
Inflation is defined as a persistent increase in the average price level for a sustained period of time (usually measured yearly). As prices around people go up, they can lose purchasing power (assuming their income isn't tied to inflation through a cost-of-living adjustment), they can start to feel uneasy and possibly get violent (or, at least strike), and they can switch from saving to spending if interest rates aren't properly adjusted. Countries with higher inflation see less demand for their products as consumers switch to countries with lower rates of inflation.
There are two main types of inflation besides simply increasing the money supply: demand-pull and cost-push. The graph above shows demand-pull inflation. Here, macroeconomic equilibrium starts at average price level APL1 and output level Y1. Then, the aggregate demand curve shifts out from AD1 to AD2 because of some sort of demand shock (i.e. confidence soars, interest rates fall, the FTSE goes up and stays up). This leads to a new equilibrium with higher output level Y2 (meaning less unemployment) and a higher average price level, inflation, to APL2. This is not necessarily bad and quite common over time.
The graph above shows cost-push inflation. Here, macroeconomic equilibrium starts at average price level APL1 and output level Y1. Then, the short-run aggregate supply curve shifts in from SRAS1 to SRAS2 because of some sort of supply-side shock (i.e. oil prices soar, natural disaster). This leads to a new equilibrium with a lower output level Y2 (meaning more unemployment) and a higher average price level, inflation, to APL2. This is usually bad.
Evaluation - How can these two types of inflation be treated? Don't forget the battle...Keynesians vs. neo-Classicals! Why is it hard to measure inflation?
Evaluation - How can these two types of inflation be treated? Don't forget the battle...Keynesians vs. neo-Classicals! Why is it hard to measure inflation?
Business Cycle, Multiplier and Accelerator
In the economy, we observe patterns of rising and falling growth that fluctuate around an upward-sloping line of best fit of LR potential growth. We can start at the peak, or boom, then fall down during a recession (contractionary period) until hitting rock bottom at the trough and then rising again in recovery (or expansionary period) until reaching a new (usually higher) peak. This is the business cycle. At a boom, the difference between the actual growth (which the squiggly line represents) and the line of best fit (potential growth trend) is a positive output gap and at a trough, the distance is a negative output gap (where actual growth is less than potential growth). During a downturn, we see a fall in aggregate demand which leads to unemployment. This pattern reverses itself during and upswing. A recession is technically defined as two consecutive quarters (three months plus three months) of negative GDP growth (-x%).
The multiplier, calculated by taking 1/1-the marginal propensity to consume or mpc), tells economists inevitably how big a governmental injection in monetary terms will be when expansionary fiscal policy occurs. Basically, income for people becomes the income for other people when the original people spend it. They can also save, be taxed and buy imports (all people), but some money will be consumed. This occurs again and again over time until the multiplier effect runs its course. This means a $10 million injection can turn into a $20 million injection if the pc is .5.
The accelerator describes how a small increase in aggregate demand can lead to a proportionally bigger increase in induced investment. Induced investment occurs when firms actively add to the capital stock of the economy to meet increasing demand for their products. This is contrasted with replacement investment which replaces capital that has depreciated over time and always takes place, even during recessions.
Lastly, the marginal propensity to save (mps) measures the percentage of income saved by consumers, the marginal propensity to tax (mpt) measures the percentage of income taxed by the government and the marginal propensity to import (mpm) measures the percentage of income used by consumers to buy imports. Algebraically, mpc + mps + mpt + mpm = 1.
The multiplier, calculated by taking 1/1-the marginal propensity to consume or mpc), tells economists inevitably how big a governmental injection in monetary terms will be when expansionary fiscal policy occurs. Basically, income for people becomes the income for other people when the original people spend it. They can also save, be taxed and buy imports (all people), but some money will be consumed. This occurs again and again over time until the multiplier effect runs its course. This means a $10 million injection can turn into a $20 million injection if the pc is .5.
The accelerator describes how a small increase in aggregate demand can lead to a proportionally bigger increase in induced investment. Induced investment occurs when firms actively add to the capital stock of the economy to meet increasing demand for their products. This is contrasted with replacement investment which replaces capital that has depreciated over time and always takes place, even during recessions.
Lastly, the marginal propensity to save (mps) measures the percentage of income saved by consumers, the marginal propensity to tax (mpt) measures the percentage of income taxed by the government and the marginal propensity to import (mpm) measures the percentage of income used by consumers to buy imports. Algebraically, mpc + mps + mpt + mpm = 1.
LRAS - A fight between Keynesians (K) and neo-Classicals (NC)!
Evaluation - Compare Keynesian and neo-Classical views of the economy? How does this impact normative economics?
Aggregate Demand (AD) / Aggregate Supply (AS) Model
Aggregate supply (AS) is the total supply of goods and services that firms are prepared to sell at a given time and (average) price level (APL). In the short run, the SRAS is upward-sloping because as more output is produced, firms must pay higher production costs (i.e. pay more for overtime, bid higher prices for scarcer raw materials), and firms pass these higher prices off in the form of a higher average price level. Short run macroequilibrium occurs at the price level APL* when all the output produced by the country’s firms is consumed (Y1). Firms have no incentive to raise prices or increase output.
Circular Flow of Income
Money can enter (injections) and leave (leakages) the circular flow. The three purple arrows show the three basic injections: investment (I), government spending (G), and exports (X). When firms spend money to add to the capital stock of the economy, that causes an injection of funds into the flow. Similarly, governments spend for projects and programs which also puts money into the economy. Lastly, when foreigners buy domestic g/s, that represents an injection into the circular flow of income. The three red arrows show the three basic leakages: savings (S), taxes (T), and imports (X). Money leave the economy (or "leaks" out) when households put their money in banks for a later ("rainy") day, when the government takes out taxes from peoples' paychecks and when households buy foreign goods. Another note: savings is required for investment (banks need money to lend) and governments spend with taxpayer money.
GDP or GNP? What’s the difference? How is it calculated?
Gross domestic product (GDP) is the total value of all the final g/s produced in an economy/country, regardless of who owns the FoPs, in a given time period, usually one year. For example, in Switzerland, we count all firms doing business within the borders…the Swiss ones, the Canadian ones, the Thai ones, etc.
Gross national product (GNP), on the other hand, counts the value of all the final g/s produced by an economy’s/country’s owned FoPs, regardless of where they are situated. For example, we take all the Swiss owned productive assets in Switzerland, minus all the foreign ones in the country, plus all those in Germany, South Africa, China, etc.
Net national product (NNP) takes the GNP and subtracts the depreciation of all the capital in that year. Nominal GDP is the number calculated that year for GDP, whereas real GDP takes that number and adjusts it for inflation compared to a base year. When we divide the GDP by the population, we get GDP per capita, one of our (many) indicators of economic development.
How is national income measured? Via calculating output, expenditure, and/or income, all of which should be equal. For the output method, the total value of all g/s from each sector is added. For the expenditure method, the spending by households (C - consumption), firms (I - investment), the government (G) and net exports (NX - exports minus imports) is added. For the income method, all the wages, rent, interest and profit is added. Remember, national output = national expenditure = national income!
Evaluation - What are the many limitations of national income data?
Gross national product (GNP), on the other hand, counts the value of all the final g/s produced by an economy’s/country’s owned FoPs, regardless of where they are situated. For example, we take all the Swiss owned productive assets in Switzerland, minus all the foreign ones in the country, plus all those in Germany, South Africa, China, etc.
Net national product (NNP) takes the GNP and subtracts the depreciation of all the capital in that year. Nominal GDP is the number calculated that year for GDP, whereas real GDP takes that number and adjusts it for inflation compared to a base year. When we divide the GDP by the population, we get GDP per capita, one of our (many) indicators of economic development.
How is national income measured? Via calculating output, expenditure, and/or income, all of which should be equal. For the output method, the total value of all g/s from each sector is added. For the expenditure method, the spending by households (C - consumption), firms (I - investment), the government (G) and net exports (NX - exports minus imports) is added. For the income method, all the wages, rent, interest and profit is added. Remember, national output = national expenditure = national income!
Evaluation - What are the many limitations of national income data?
Thursday, February 18, 2010
Tuesday, February 16, 2010
Positive Externalities of Consumption
Although some scientists (and self-labeled "experts") question the effectiveness and risk of inoculations (i.e. shots), many people argue that providing vaccinations against various diseases like H1N1 and the mumps prevents such illness from occurring. If I pay to get a shot for H1N1 because I do not want this flu, then I also will not pass this flu to those around me. However, those around me did not have to pay for my inoculation even though they reap the benefits. Therefore, the marginal social benefit of inoculations is greater than the marginal private benefit which does not include society's benefit from less infectious people (MSB > MPB). This is an example of a positive externality of consumption.
The free market for inoculations sees equilibrium at quantity Q1 (and price P1) which is below the socially efficient level of output Q*. Between Q1 and Q*, MSB > MSC and a potential welfare gain is possible (yellow triangles).
What can the government do to intervene in this market failure to achieve this potential welfare gain? First, they could subsidize the consumption of such forms of health care to make the consumption of such goods/services cheaper. In the graph, this is shown by the orange MSC + subsidy curve which reduces the price of inoculations (to P2) and increases quantity to the socially efficient level Q*. However, when governments spend money on subsidies, there is always the argument that this money could have been spent elsewhere (opportunity cost).
Another option would be to spend taxpayer money for a positive ad campaign that would encourage the community to get inoculated against various diseases like H1N1. The aim of this campaign would be to increase consumers' private benefit / utility for consuming vaccinations because they would feel better about protecting themselves against disease. Graphically, this is shown by the orange arrow indicating a rightward shift of MPB towards MSB (and thus Q*). Of course, the opportunity cost argument would apply here as well and often some members of the community are very critical of vaccinations.
Other possible government interventions include forcing the public to get inoculated which might violate civil rights.
Negative Externalities of Consumption
The link between the consumption of tobacco products like cigars and heart / lung disease is indisputable. When individuals smoke cigars, they are compromising their own health and the health of those around them who inhale the smoke. Therefore, smoking is (unfortunately) an excellent example of a negative externality of consumption.
In a free market, consumers as utility-maximizers will consume cigars where their marginal private benefit equals marginal social cost (= S). They do not have to consider the cost of their consumption of cigars on the rest of the community through smoking-related illness and increased public health care receipts. If social efficiency were occurring, the market would be in equilibrium at a quantity level Q* as opposed to the greater Q1. Instead, there is a welfare loss (red triangles) since between Q1 and Q*, MSC > MSB and the market is thus not Pareto optimal. We observe a negative externality of consumption between MPB and MSB (purple arrow).
To address this market failure of a negative externality of consumption of cigars, the government could take several courses of action. First, they could place a tax on cigars in order to increase their price which would drive down the quantity sold and consumed. This is shown above by the broken blue line which corresponds to a return to the socially optimal level of output Q* and a higher price of P2. The government could then use this tax revenue to alleviate stress on the health care system from smoking-related illnesses. Of course, there will be debate on how to spend such money, to what extent smokers have the right to smoke and to what means smokers who face inelastic demand for tobacco products will go to procure cheaper product.
Second, the government could implement a negative ad campaign featuring anti-smoking commercials on television / radio and graphic posters of smoking-related illness on billboards along motorways and in written press. The aim of such an ad campaign would be to reduce smokers' private benefit from smoking by reducing their utility of tobacco consumption. After all, does looking at a black, diseased lung make you feel eager or happy to light up another smoke? This is illustrated above by the horizontal blue arrow and a leftward shift of the MPB curve towards MSB (and, thus, Q* which is socially efficient). However, such a campaign costs (taxpayer) money so the opportunity cost argument will be in play.
Otherwise, the government could simply ban tobacco products. But how would that affect stakeholders in the economy?
Positive Externalities of Production
In this example, a computer company decides to enroll all of its employees in a workshop that aims to improve their efficiency through the development of more advanced skills. The workshop increases the private costs of the computer firm (MPC on the graph above), but the workers' skillset improves which is a benefit to other computer firms that haven't paid for such training and to the community at large. Therefore, as seen on the graph, the MPC for the firm is greater than the overall MSC because the MSC subtracts the benefit to society from the firm's private costs. Here, the firm is producing at quantity Q1 and charges price P1. However, this output level is less than the socially optimal level of output Q* and, between Q1 and Q*, there is a potential welfare gain (illustrated by the yellow triangles) because MSB > MSC.
If the government wants to achieve this welfare gain, they could subsidize firms that decide to provide such training to their employees. By making training cheaper, the firms' private costs decline. This is shown by a rightward shift of the MPC towards MSC. Yet, there is always an opportunity cost when governments use tax revenues to subsidize firms and it is difficult to calculate an appropriate subsidy. The government could also provide its own training, but the same evaluation that can be applied to giving subsidies applies here as well (i.e. costs of training).
Negative Externalities of Production
The graph above illustrates a negative externality of production of paper. To make paper, paper mills often have to use harsh chemicals like chlorine and sulfur-based products which, if released into the environment, are very harmful to ecosystems. Unfortunately, the production of paper continues to pollute worldwide to this day. These are called external costs of production of paper.
Without any government intervention, the paper mill would only be concerned about their private costs of production (indicated by MPC). Thus, the firm would produce where their MPC curve meets the marginal social benefit (MSB) curve at quantity Q1 and price P1. However, the firm's private costs do not include the social costs of production (MSC) of pollution described above. If the firm were producing where MSC = MSB (Pareto optimality / socially efficient level of output), then they would be producing quantity Q* at price P*. This is not occurring in the free market, and this negative externality of production is indicated by the distance between MPC and MSC (see purple arrow). The red traingles represent the welfare loss to society (where MSC > MSB).
Above, we see one possible solution to the negative externality of production for paper. If the government intervenes to correct this market failure by taxing the polluting paper mill, the firm's marginal private costs increase. This is illustrated by a leftward movement of the MPC curve towards the MSC curve (the magnitude which depends on the amount of the tax; the bigger the tax, the closer to MSC). In this case, the quantity falls to Q2 from Q1 which coincides with a reduction (but not elimination) of the welfare loss to society illustrated by the red traingle.
Other solutions - legislation to punish polluting firms, tradeable emission permits
Evaluation - How much and who should the government tax? What impacts will the tax have on the production process / employment / stakeholders? What are the opportunity costs of these tax revenues? Usefulness of tradeable emission permits?
Monday, February 15, 2010
Merit goods and demerit goods...what's the difference?
A merit good, which will be underprovided and thus underconsumed if the market is left to it's own devices, are goods or services that governments believe are important for society and include sports centers, public schools, and (public) healthcare. Merit goods cause positive externalities, and governments intervene by providing the g/s themselves or by subsidizing private firms for provision. Of course, when governments spend money, the issue of opportunity cost comes into play and an evaluative discussion can occur.
A demerit good, which will be overprovided and thus overconsumed if the market is left to it's own devices, are goods or services that governments believe are harmful for society and include illicit drugs, cigarettes and alcohol. Demerit goods cause negative externalities, and governments intervene by restricting the g/s through taxation or negative ad campaigns or by subsidizing programs aimed at reducing/eliminating consumption. Again, when governments spend money, the issue of opportunity cost comes into play and an evaluative discussion can occur.
A demerit good, which will be overprovided and thus overconsumed if the market is left to it's own devices, are goods or services that governments believe are harmful for society and include illicit drugs, cigarettes and alcohol. Demerit goods cause negative externalities, and governments intervene by restricting the g/s through taxation or negative ad campaigns or by subsidizing programs aimed at reducing/eliminating consumption. Again, when governments spend money, the issue of opportunity cost comes into play and an evaluative discussion can occur.
Sunday, February 14, 2010
Public goods : Non-excludable? Non-rivalrous? Help!
A public good can either be consumed by everyone or by no one. In other words, there is no change in cost when one more person consumes the good. A well-known example is that of national defense. Everyone in Switzerland is protected by the Swiss Army (not to be confused with the Vatican's funny-dressed Swiss Guard). If one more person comes to Switzerland, there is no change in cost to defend him/her.
Public goods are non-excludable and non-rivalrous. To be non-excludable means it is impossible to stop someone from consuming a good or service once it's been providable. The opposite is true if the good is excludable. To be non-rivalrous means that consumers are not competing for the same g/s and, thus, all can enjoy the g/s at the same time. The opposite is true if the good is rivalrous.
Here are some helpful terms and examples
excludable/rivalrous : private goods, i.e. cars and cheese
excludable/non-rivalrous : club goods, i.e. satellite radio
non-excludable/rivalrous : common goods, i.e. fish, deer
non-excludable/non-rivalrous : public goods, i.e. national defense, a dam
Public goods are non-excludable and non-rivalrous. To be non-excludable means it is impossible to stop someone from consuming a good or service once it's been providable. The opposite is true if the good is excludable. To be non-rivalrous means that consumers are not competing for the same g/s and, thus, all can enjoy the g/s at the same time. The opposite is true if the good is rivalrous.
Here are some helpful terms and examples
excludable/rivalrous : private goods, i.e. cars and cheese
excludable/non-rivalrous : club goods, i.e. satellite radio
non-excludable/rivalrous : common goods, i.e. fish, deer
non-excludable/non-rivalrous : public goods, i.e. national defense, a dam
Wednesday, February 10, 2010
What is the theory of contestable markets?
Here in the village of Leysin, Switzerland, there is one firm that sells kebabs. The owner of this restaurant therefore has a monopoly on the sale of kebabs on this mountain. So why can't he produce where MC = MR to achieve abnormal profits by restricting output and charging high prices like a typical monopoly? Short answer: the theory of contestable markets. Because barriers to entry / exit are low for kebab shops, it is very possible that a competitor from the village or the valley will open his/her own kebab shop to start competing away some of the original owner's profits. For this theory to work, there must be low barriers to entry and exit. Therefore, this seeming monopolist must assume more competitive behavior to avoid the kebabs sharks that are looming in the area.
Tuesday, February 9, 2010
Consumer and Producer Surplus = Community Surplus
In this graph, we can see the equilibrium price of the good is $5.00 and the quantity demanded / supplied is 10 million. The blue triangle above the price line and below the demand curve represents consumer surplus. Consumer surplus is the benefit consumers get from being able to purchase a good or service at a price lower than what they were expecting to pay. In this example, we can see that at a price of $8.50, two million units of the good would be demanded. However, those consumers only have to pay $5.00, and thus they get a benefit from paying less than that which they were prepared. The same is true for the six million units demanded at a price of $6.50. Therefore, the entire blue triangle represents the total consumer surplus for this particular good.
The red triangle below the price line and above the supply curve represents producer surplus. Producer surplus is the benefit producers get from being able to receive a price for a good or service higher than what they were expecting. In this example, we can see that at a price of $1.50, two million units of the good would be supplied. However, those producers get to receive $5.00, and thus they get a benefit from receiving more than that which they were expecting. The same is true for the six million units supplied at a price of $3.50. Therefore, the entire red triangle represents the total producer surplus for this particular good.
Together with consumer surplus, we have the total economic benefit of the transaction, or community surplus (red plus blue triangles). With equilibrium quantity Q* and price P* determined by the forces of supply and demand, there is no way to make one person better off by making someone else worse off. This is called Pareto optimality and means that resources have been allocated efficiently.
This analysis allows us to see supply and demand in a different way. If we consider the supply curve to be the sum of the firms' costs of production for a good or service, we can consider how these costs apply to the community at large and call this the marginal social cost (MSC) curve. If we consider the demand curve to be the sum of consumers' utility in consuming a good or service, we can consider how these benefits apply to the community at large and call this the marginal social benefit (MSB) curve. These terms replace standard supply (S) and demand (D) in market failure analysis.
What is price discrimination?
Price discrimination happens when firms charge different people different prices for the exact same good or service. For example, a student at Shorewood High School gets to pay $8 to see "Billy Elliot" whereas I (an adult) have to pay $12 to see the exact same (amazing) movie at the exact same time.
1st degree price discrimination: when different people pay different prices for the same product because they have different price elasticities of demand; the value of the good is subjective and people are willing to pay different prices depending on their desire.
example: (identical) goods at the flea market in Lausanne
2nd degree price discrimination: when different people pay different prices for the same product because they purchase different amounts; the more consumers buy, the less (per unit) they have to pay.
example: Coca-Cola's purchase of sugar versus your purchase of sugar (per unit).
3rd degree price discrimination: when different people pay different prices for the same product because they fit into different market segments like age or location. The market segmentation is derived by different price elasticities of demand (i.e. students have more elastic demand than adults due to their having much less disposable income).
example: student discount at a sporting event
1st degree price discrimination: when different people pay different prices for the same product because they have different price elasticities of demand; the value of the good is subjective and people are willing to pay different prices depending on their desire.
example: (identical) goods at the flea market in Lausanne
2nd degree price discrimination: when different people pay different prices for the same product because they purchase different amounts; the more consumers buy, the less (per unit) they have to pay.
example: Coca-Cola's purchase of sugar versus your purchase of sugar (per unit).
3rd degree price discrimination: when different people pay different prices for the same product because they fit into different market segments like age or location. The market segmentation is derived by different price elasticities of demand (i.e. students have more elastic demand than adults due to their having much less disposable income).
example: student discount at a sporting event
Economics du jour
Price discrimination of the 2nd degree in the Daily Bulletin!
Valentine's roses are available! You can order roses for your friends and loved ones on Monday and Tuesday with Mrs. H, and proceeds from the sale will go to Habitat, ACN and the Nepal trip. 6 CHF for a single rose, 5 CHF each for 2 or more, and 50 CHF for a bouquet of a dozen (12). Pick up your orders on Friday between 9am and 5pm in the BE office. Happy Valentine's Day to all!
Valentine's roses are available! You can order roses for your friends and loved ones on Monday and Tuesday with Mrs. H, and proceeds from the sale will go to Habitat, ACN and the Nepal trip. 6 CHF for a single rose, 5 CHF each for 2 or more, and 50 CHF for a bouquet of a dozen (12). Pick up your orders on Friday between 9am and 5pm in the BE office. Happy Valentine's Day to all!
Sunday, January 17, 2010
Oligopoly (O)
4. Oligopoly
Assumptions of the model -
- A few firms dominate the industry (look up concentration ratio)
- There are many consumers and fewer producer (towards monopolistic assumption)
- Products can be identical (i.e. OPEC and oil), slightly differentiated (i.e. shower gel) or highly differentiated (i.e. cars).
- Tendency to try to block entry
- Non-price competition : Because firms can't compete using prices (to be analyzed below), they compete in other ways, for example through promotions, quality, coupons, advertising, special deals, etc.
There are two types of oligopolies. The easiest to understand and the one that's illegal (unless it's by countries) is the collusive oligopoly. These occur when firms agree upon a price or market share to charge consumers for the g/s. A cartel is a formal (explicit) agreement among firms that establishes such monopolistic prices. The quintessential example of this is the Organization for Petroleum Exporting Countries (OPEC) which controls one-third of the world's oil supply. Obviously, this can't be outlawed, but if they were firms and not countries, they would be. Tacit collusion occurs when firms secretly work together to restrict higher prices and restrict output. This is hard to prove and also very illegal. Fortunately, for our analysis, collusive oligopolies (formal and tacit) act exactly like monopolies, so see the post on "monopoly" for demand curve, profit maximization, SR and LR profit scenarios and efficiency.
A non-collusive oligopoly occurs when firms compete against each other in a non-monopolistic, "normal" manner. For this analysis, we used what's called a "kinked demand curve". Not kinky....kinked! This curve shows that firms can't just increase the price of their g/s nor lower the price...called price stickiness. If the firm raises the price, competitors will not follow and the original firm will lose business. If the firm lowers the price of it's g/s, other firms will follow and potentially undercut their competitor continuously, causing the price to plummet until MC no longer equals MR. This is obviously disadvantageous to all firms operating in this market structure. Therefore, we have price rigidity around the original price point because it doesn't move for these reasons. Firms will produce wherever MC=MR, which as can be seen in the graph below, can vary in the kinked demand curve. There is stability in the market (quantity) even though the price would differ. This reinforces the idea of price rigidity in this model.
Assumptions of the model -
- A few firms dominate the industry (look up concentration ratio)
- There are many consumers and fewer producer (towards monopolistic assumption)
- Products can be identical (i.e. OPEC and oil), slightly differentiated (i.e. shower gel) or highly differentiated (i.e. cars).
- Tendency to try to block entry
- Non-price competition : Because firms can't compete using prices (to be analyzed below), they compete in other ways, for example through promotions, quality, coupons, advertising, special deals, etc.
There are two types of oligopolies. The easiest to understand and the one that's illegal (unless it's by countries) is the collusive oligopoly. These occur when firms agree upon a price or market share to charge consumers for the g/s. A cartel is a formal (explicit) agreement among firms that establishes such monopolistic prices. The quintessential example of this is the Organization for Petroleum Exporting Countries (OPEC) which controls one-third of the world's oil supply. Obviously, this can't be outlawed, but if they were firms and not countries, they would be. Tacit collusion occurs when firms secretly work together to restrict higher prices and restrict output. This is hard to prove and also very illegal. Fortunately, for our analysis, collusive oligopolies (formal and tacit) act exactly like monopolies, so see the post on "monopoly" for demand curve, profit maximization, SR and LR profit scenarios and efficiency.
A non-collusive oligopoly occurs when firms compete against each other in a non-monopolistic, "normal" manner. For this analysis, we used what's called a "kinked demand curve". Not kinky....kinked! This curve shows that firms can't just increase the price of their g/s nor lower the price...called price stickiness. If the firm raises the price, competitors will not follow and the original firm will lose business. If the firm lowers the price of it's g/s, other firms will follow and potentially undercut their competitor continuously, causing the price to plummet until MC no longer equals MR. This is obviously disadvantageous to all firms operating in this market structure. Therefore, we have price rigidity around the original price point because it doesn't move for these reasons. Firms will produce wherever MC=MR, which as can be seen in the graph below, can vary in the kinked demand curve. There is stability in the market (quantity) even though the price would differ. This reinforces the idea of price rigidity in this model.
Monopolistic Competition (MC, the market structure, not to be confused with the cost!)
3. Monopolistic Competition (MC)
Assumptions of the model -
- Many relatively small firms vis-a-vis the industry.
- Near perfect knowledge of product, prices and costs of production.
- Differentiated products : Making products (slightly or significantly) different from one another to attract different segments of the market and different customer loyalty levels (i.e. different types of cheese pizzas at restaurants in Rome)
- Low barriers to entry or exit.
In the short-run, abnormal profits and losses can be earned at the profit-maximizing level of output, MC=MR. In the long-run, like perfect competition (and very UNLIKE monopoly), only normal profits can be earned. If the AC curve is below the AR line, then there will be abnormal profits for monopoly and firms in monopolistic competition. If the AC curve is above the AR line, then there will be abnormal profits for monopolies and firms in monopolistic competition.
This graph looks identical to the monopoly graph because it is. However, in the long run, profits always return to normal from abnormal or loss. In the SR, if firms are making abnormal profits, over time, firms with enter the market to capture some of these profits because barriers to entry are low. When this occurs, the demand for each individual firm (which this graph shows) shifts in, and this will continue until MC=MR=AC and normal profits are achieved. If firms are making losses, the reverse will happen. Firms will start leaving the industry, demand will shift out until normal profits are achieved.
Firms that are monopolistically competitive are never efficient. But is this bad? Not necessarily! These efficiencies stem from the fact consumers get to choose between differentiated products. Therefore, it can be easily and logically argued that the disadvantages of not being efficient are made up by the advantages of choice. Can you imagine if all cheese pizzas tasted the same?
Assumptions of the model -
- Many relatively small firms vis-a-vis the industry.
- Near perfect knowledge of product, prices and costs of production.
- Differentiated products : Making products (slightly or significantly) different from one another to attract different segments of the market and different customer loyalty levels (i.e. different types of cheese pizzas at restaurants in Rome)
- Low barriers to entry or exit.
In the short-run, abnormal profits and losses can be earned at the profit-maximizing level of output, MC=MR. In the long-run, like perfect competition (and very UNLIKE monopoly), only normal profits can be earned. If the AC curve is below the AR line, then there will be abnormal profits for monopoly and firms in monopolistic competition. If the AC curve is above the AR line, then there will be abnormal profits for monopolies and firms in monopolistic competition.
This graph looks identical to the monopoly graph because it is. However, in the long run, profits always return to normal from abnormal or loss. In the SR, if firms are making abnormal profits, over time, firms with enter the market to capture some of these profits because barriers to entry are low. When this occurs, the demand for each individual firm (which this graph shows) shifts in, and this will continue until MC=MR=AC and normal profits are achieved. If firms are making losses, the reverse will happen. Firms will start leaving the industry, demand will shift out until normal profits are achieved.
Firms that are monopolistically competitive are never efficient. But is this bad? Not necessarily! These efficiencies stem from the fact consumers get to choose between differentiated products. Therefore, it can be easily and logically argued that the disadvantages of not being efficient are made up by the advantages of choice. Can you imagine if all cheese pizzas tasted the same?
Saturday, January 16, 2010
Sources of Monopoly Power and PC vs. M
The following are sources of monopoly power -
- Economies of scale (see earlier post) : When monopolist firms get big, their average costs can get very low for the industry, making competition by other difficult if not impossible.
- Patents / copyrights : The protect firms' intellectual property, and give them the incentive to innovate and to create g/s that make our lives better (i.e. medications, the new Glee song).
- Natural monopoly : In some industries, costs are so high that the market can only be profitable for one firm. If another firm entered, demand would be split and, because average costs are high, both would make losses. Thus, the government allows such "natural" monopolies to exist. Examples : gas and electricity companies.
- Control over supply : Firms that control what's effectively the whole supply of a good have a monopoly in that goods (i.e. De Beers and diamonds).
- Brand loyalty : Did you know a Kleenex is a facial tissue? Or a Hoover is a vacuum cleaner? Sometimes brand names become the product, leading to monopolies.
- Use of force / anti-competitive behavior : When a firm tries to prevent competition, it is acting in an anti-competitive manner. This is illegal, but difficult to prove legally. Example : Microsoft and it's software.
Pros and Cons of PC vs. M-
In PC, prices are low (derived from industry supply curve) and, in the long-run, only normal profit can be made. Furthermore, this type of market structure is both productively and allocatively efficient. In a monopoly, output is restricted, prices are "too" high, and the structure is inefficient. Both produce where MC=MR to maximize profits. Monopolies can achieve economies of scale which can drive prices down. Furthermore, monopoly profits could be directed to R&D which leads to technological advancement which is good for economic/potential growth. However, because prices are high, some consumers will not be able to afford the good.
- Economies of scale (see earlier post) : When monopolist firms get big, their average costs can get very low for the industry, making competition by other difficult if not impossible.
- Patents / copyrights : The protect firms' intellectual property, and give them the incentive to innovate and to create g/s that make our lives better (i.e. medications, the new Glee song).
- Natural monopoly : In some industries, costs are so high that the market can only be profitable for one firm. If another firm entered, demand would be split and, because average costs are high, both would make losses. Thus, the government allows such "natural" monopolies to exist. Examples : gas and electricity companies.
- Control over supply : Firms that control what's effectively the whole supply of a good have a monopoly in that goods (i.e. De Beers and diamonds).
- Brand loyalty : Did you know a Kleenex is a facial tissue? Or a Hoover is a vacuum cleaner? Sometimes brand names become the product, leading to monopolies.
- Use of force / anti-competitive behavior : When a firm tries to prevent competition, it is acting in an anti-competitive manner. This is illegal, but difficult to prove legally. Example : Microsoft and it's software.
Pros and Cons of PC vs. M-
In PC, prices are low (derived from industry supply curve) and, in the long-run, only normal profit can be made. Furthermore, this type of market structure is both productively and allocatively efficient. In a monopoly, output is restricted, prices are "too" high, and the structure is inefficient. Both produce where MC=MR to maximize profits. Monopolies can achieve economies of scale which can drive prices down. Furthermore, monopoly profits could be directed to R&D which leads to technological advancement which is good for economic/potential growth. However, because prices are high, some consumers will not be able to afford the good.
Monopoly (M)
2. Monopoly
Assumptions of the model -
- One firm dominates a market, and thus the firm is the industry
- High barriers to entry and exit
- The firm has power to determine the price for its g/s (“price-maker”)
Demand curve facing the monopolist is typical (downward-sloping) with an MR that is twice as steeply sloped
Profit-maximizing level of output : MC=MR (go up to demand curve)
Efficient? - monopolies are neither allocatively or productively efficient
Assumptions of the model -
- One firm dominates a market, and thus the firm is the industry
- High barriers to entry and exit
- The firm has power to determine the price for its g/s (“price-maker”)
Demand curve facing the monopolist is typical (downward-sloping) with an MR that is twice as steeply sloped
Profit-maximizing level of output : MC=MR (go up to demand curve)
Efficient? - monopolies are neither allocatively or productively efficient
Friday, January 15, 2010
Monday, January 11, 2010
Perfect Competition (PC)
1. Perfect Competition (PC)
Assumptions of the model -
- There are many buyers and sellers, none of whom are able to influence the market (= ”price-taker”)
- Each firm is very small relative to the industry.
- Products are identical (homogenous).
- There are no barriers to entry or exit.
- There is perfect knowledge of prices, costs of production, a product quality
Example – Wheat farms in Canada, milk producers in China
The demand curve facing the industry and the firm in perfect competition:
The graph shows that price, demand, average revenue, (p x q / q leaving p), and marginal revenue (the revenue of selling one more unit of the good) are all equal. The y-axis is price (and costs too if you want) and the x-axis is quantity in whatever units used.
Profit-maximizing level of output:
The profit maximizing level of output is where MC = MR.
There are three SR possibilities: abnormal profits, losses and normal profits. If firms are making abnormal profits, the profit maximizing level of output dashed line hits the average cost curve (AC1) below where p* equals MC, AR, MR and D. The box that is constructed using the line by which the average cost curve hits the profit maximizing line represents abnormal profits (blue box above).
On the flip side, if average costs are higher than where p* equals MC, AR, MR and D, we have losses which can be shown by the corresponding red box in the graph (AC2).
It is theoretically possible to be at normal profits in the short run. This has no box and is simply shown by having the AC curve hit MC, p*, AD, MR and D.
It's important to use the vertical line which passes through the point by which MC=MR to construct these diagrammatical representations.
It is possible to achieve abnormal profits or losses in the short-run. However, normal profits prevail in the long-run. This is due to adjustments in the industry supply and demand curve. If firms are making SR abnormal profits, soon enough producers will enter the market to shift out the industry supply curve. This lowers the price (and thus the D, AR, MR curve) to the point at which normal profits are made. Alternatively, if firms are making SR losses, soon enough producers will leave that the industry supply curve will shift inwards and find equilibrium at a higher price. This shifts the firm's D, AR, MR curve up and will continue until normal profits are made. Note I have not included an industry supply and demand curve in this post, but it looks like the one in the supply and demand post earlier.
productive efficiency : occurs when a firm produces at the lowest possible cost per unit, AC = MC
allocative efficiency (=socially efficient level of output) : occurs when output is at society's optimum level, AR = MC
Perfect competition (PC) is both productively and allocatively efficient. However, all products are consider to be identical so there is no chance to choose between slightly differentiated products.
Assumptions of the model -
- There are many buyers and sellers, none of whom are able to influence the market (= ”price-taker”)
- Each firm is very small relative to the industry.
- Products are identical (homogenous).
- There are no barriers to entry or exit.
- There is perfect knowledge of prices, costs of production, a product quality
Example – Wheat farms in Canada, milk producers in China
The demand curve facing the industry and the firm in perfect competition:
The graph shows that price, demand, average revenue, (p x q / q leaving p), and marginal revenue (the revenue of selling one more unit of the good) are all equal. The y-axis is price (and costs too if you want) and the x-axis is quantity in whatever units used.
Profit-maximizing level of output:
The profit maximizing level of output is where MC = MR.
Below, we see possible SR profit situations (abnormal profits, normal profits and losses, all moving towards long-run normal profits).
There are three SR possibilities: abnormal profits, losses and normal profits. If firms are making abnormal profits, the profit maximizing level of output dashed line hits the average cost curve (AC1) below where p* equals MC, AR, MR and D. The box that is constructed using the line by which the average cost curve hits the profit maximizing line represents abnormal profits (blue box above).
On the flip side, if average costs are higher than where p* equals MC, AR, MR and D, we have losses which can be shown by the corresponding red box in the graph (AC2).
It is theoretically possible to be at normal profits in the short run. This has no box and is simply shown by having the AC curve hit MC, p*, AD, MR and D.
It's important to use the vertical line which passes through the point by which MC=MR to construct these diagrammatical representations.
It is possible to achieve abnormal profits or losses in the short-run. However, normal profits prevail in the long-run. This is due to adjustments in the industry supply and demand curve. If firms are making SR abnormal profits, soon enough producers will enter the market to shift out the industry supply curve. This lowers the price (and thus the D, AR, MR curve) to the point at which normal profits are made. Alternatively, if firms are making SR losses, soon enough producers will leave that the industry supply curve will shift inwards and find equilibrium at a higher price. This shifts the firm's D, AR, MR curve up and will continue until normal profits are made. Note I have not included an industry supply and demand curve in this post, but it looks like the one in the supply and demand post earlier.
productive efficiency : occurs when a firm produces at the lowest possible cost per unit, AC = MC
allocative efficiency (=socially efficient level of output) : occurs when output is at society's optimum level, AR = MC
Perfect competition (PC) is both productively and allocatively efficient. However, all products are consider to be identical so there is no chance to choose between slightly differentiated products.
Sunday, January 10, 2010
Maximizing Total Revenue (TR)
Firms need to be aware of the price elasticity of demand (PED) for their products (i.e. where they are on their demand curves) to determine the level of profit maximization. For most products (all non-perfectly competitive goods), firms face a normal downward-sloping demand curve which implies PED falls as firms make more output. To sell more, the firm needs to lower the price, and, thus, demand and average revenue (AR) fall accordingly. Marginal revenue, which is twice as steeply sloped as AR, also falls as output increases and goes beneath the x-axis, representing diminishing returns and falling revenue as output grows too big. MR falls faster than AR because revenue is lost as firms have to lower prices to sell more product.
As shown by this graph, firms should lower prices if in the elastic part of their demand curve until unit elasticity is achieved. Similarly, firms should raise prices if in the inelastic part of their demand curve until unit elasticity is achieved. Unit elasticity is the key point, where total revenue (TR) is maximized. This relationship is critical for firms determine and give employment to many economists!
Introduction to Product, Cost, Revenue, Profit Theory (Theory of the Firm Basics)
total product (TP) : total output produced by FoPs in a given time period.
average product (AP) : the output per unit of variable factor. TP/V = AP
marginal product (MP) : the extra output from using an additional variable factor. ∆TP/∆V = MP
fixed costs (FC) : costs a firm must pay regardless of output. A firm could produce absolutely nothing and still face fixed costs, and this is the definition of the short-run in microeconomics. These are things such as rent, insurance payments, depreciation, etc.
variable costs (VC) : costs that depend on the level of production
total cost (TC) : variable costs plus fixed costs - TC = FC + VC
average total cost (AC) : total cost divided by units of output. TC/Q = ATC
marginal cost (MC) : the cost of producing one extra unit of output. ∆TC/∆Q = MC
short-run cost curves : cost curves used in the short run (AFC, AVC, ATC, MC). MC cuts AVC and ATC at their minimums.
long-run cost curves : defined as the period of time in which all factors of production are variable, the long run features cost curves in this time period (i.e. economies of scale).
economies of scale : occur when an increase in a firm's scale of production leads to lower average costs per unit produced (graph - downward-sloping LRAC curve as quantity increases).
diseconomies of scale : occur when an increase in a firm's scale of production leads to a higher average cost per units produced (graph - upward-sloping LRAC curve as quantity increases beyond economies of scale).
returns to scale: if output (y) increases by the same amount, we have constant returns to scale; if output increases by less than the proportional change, we have decreasing returns to scale; if output increases by more than the proportion, we have increasing returns to scale.
law of diminishing returns: MP eventually falls as variable factors are added to fixed factors and MP falls (i.e. Kebab shop in the Swiss mountain village of Leysin)
total revenue (TR) : price times quantity; total amount firm receives in sales.
average revenue (AR) : the revenue gained from selling one unit; equal to price. TR/Q
marginal revenue (MR) : the extra revenue a firm takes in when increasing output by one extra unit. ∆TR/∆Q = MR
normal profit : occurs when all costs are covered including the entrepreneur’s OC; anything above is considered abnormal profit, anything below is a loss.
profit maximization (MR = MC) : occurs when marginal revenue, the revenue gained from producing one extra unit of output, equals the marginal cost of producing that unit.
shut-down price(P ≤ AVC): occurs if marginal revenue is equal to or below average variable cost at the profit-maximizing output.
break-even price (P = ATC) : the point at which cost or expenses and revenue are equal, the firm has “broken even”.
average product (AP) : the output per unit of variable factor. TP/V = AP
marginal product (MP) : the extra output from using an additional variable factor. ∆TP/∆V = MP
fixed costs (FC) : costs a firm must pay regardless of output. A firm could produce absolutely nothing and still face fixed costs, and this is the definition of the short-run in microeconomics. These are things such as rent, insurance payments, depreciation, etc.
variable costs (VC) : costs that depend on the level of production
total cost (TC) : variable costs plus fixed costs - TC = FC + VC
average total cost (AC) : total cost divided by units of output. TC/Q = ATC
marginal cost (MC) : the cost of producing one extra unit of output. ∆TC/∆Q = MC
short-run cost curves : cost curves used in the short run (AFC, AVC, ATC, MC). MC cuts AVC and ATC at their minimums.
long-run cost curves : defined as the period of time in which all factors of production are variable, the long run features cost curves in this time period (i.e. economies of scale).
economies of scale : occur when an increase in a firm's scale of production leads to lower average costs per unit produced (graph - downward-sloping LRAC curve as quantity increases).
diseconomies of scale : occur when an increase in a firm's scale of production leads to a higher average cost per units produced (graph - upward-sloping LRAC curve as quantity increases beyond economies of scale).
returns to scale: if output (y) increases by the same amount, we have constant returns to scale; if output increases by less than the proportional change, we have decreasing returns to scale; if output increases by more than the proportion, we have increasing returns to scale.
law of diminishing returns: MP eventually falls as variable factors are added to fixed factors and MP falls (i.e. Kebab shop in the Swiss mountain village of Leysin)
total revenue (TR) : price times quantity; total amount firm receives in sales.
average revenue (AR) : the revenue gained from selling one unit; equal to price. TR/Q
marginal revenue (MR) : the extra revenue a firm takes in when increasing output by one extra unit. ∆TR/∆Q = MR
normal profit : occurs when all costs are covered including the entrepreneur’s OC; anything above is considered abnormal profit, anything below is a loss.
profit maximization (MR = MC) : occurs when marginal revenue, the revenue gained from producing one extra unit of output, equals the marginal cost of producing that unit.
shut-down price(P ≤ AVC): occurs if marginal revenue is equal to or below average variable cost at the profit-maximizing output.
break-even price (P = ATC) : the point at which cost or expenses and revenue are equal, the firm has “broken even”.
Saturday, January 9, 2010
Taxes and Subsidies
TAXES
Taxes are money collected by the government. They can be collected by federal governments (i.e. the United States of America), subnational governments (i.e. the state of Wisconsin) and local governments (i.e. the locality of Shorewood, WI). There are two main types of taxes: direct and indirect. Direct taxes are those paid directly to the government, for example income and corporate taxes. Indirect taxes are first collected by an intermediary, for example a store when one buys food or clothes, who then sends the taxes to the government. Sales taxes and sin taxes (i.e. taxes on cigarettes, alcohol and other “sinful” g/s) are indirect taxes. Governments tax for four reasons commonly known as the four Rs: revenue (taxes = money for governments to spend), redistribution (from the rich to the poor for societal equity), repricing (to make “bad” g/s more expensive), and representation (so that citizens have some sort of say over how their money is spent…the idea behind the original Tea Party).
In this example, q0 quantity of rum is demanded and supplied at $10.00. If the government places a $5.00 tax on rum to say, discourage consumption of this so-called "sin good", we see that the supply curve S0 will shift inwards to S1 because supply shifts in when it costs more to produce. The distance between the two supply curves is the value of the tax ($5.00 here). Because demand is inelastic for rum in this example, the quantity demanded only falls to q1 and consumers now pay $4.00 of the $5.00 tax. The rum producers, who have no choice but to pay the tax to the government, take a $1.00 "hit" per unit. The green rectangle shows the incidence of the tax on the consumers and the blue rectangle shows the incidence of the tax on the producers. Governments tend to tax inelastic goods because of the relatively large impact on consumers as opposed to the producers.
Above, q0 quantity of biscuits (a.k.a. cookies) is demanded and supplied at $10.00. If the government places a $5.00 tax on biscuits for whatever reason, we see that the supply curve S0 will shift inwards to S1 because, again, supply shifts in when it costs more to produce. The distance between the two supply curves is the value of the tax ($5.00). Because demand is elastic for biscuits in this example, the quantity demanded falls by a lot to q1 and consumers now pay only $1.00 of the $5.00 tax. The biscuit producers who have to pay the tax to the government take a big $4.00 "hit" per unit. Again, the green rectangle shows the incidence of the tax on the consumers (small) and the blue rectangle shows the incidence of the tax on the producers (big). Because of the adverse effects on producers, governments tend to not tax elastic goods as it doesn't achieve the four Rs of taxation very well.
SUBSIDIES
Subsidies are financial aid to firms, or money given to producers to make production cheaper. They lower the cost of production and are used to encourage production (graphically, supply shifts out). This assistance keeps prices artificially low for consumers, ensures supply from producers of "valuable goods", helps domestic firms compete internationally and, thus, are highly debated and can be evaluated from various points of view (especially via OC analysis).
Looking at the three subsidy graphs above (PED < PES, PED = PES, PED > PES), we see that the incidences from the tax graphs have flipped (now, producers on top, consumers on bottom). Moreover, as stated above, instead of the supply curves shifting in, they shift out because subsidies make production cheaper (one of our "shifters" of supply). Before the subsidy, in all three instances, the equilibrium price is $3.50 and the equilibrium quantity is q0. The value of the subsidy is $1.00, which is also the distance between S0 and S1. If PED equals PES, the incidence of the subsidy is shared equally between consumers and producers. The market price of the product falls by exactly half the value of subsidy (in this case, $0.50). Thus, producers are encouraged to produce and consumers are encouraged to consume (milk in this example).
Evaluative questions: aren't subsidies funded by taxes? Yes! Thus, an evaluative discussion around OCs and taxation in general could occur.
When PED < PES (or demand is inelastic), quantity demanded falls very little and consumers receive the bulk of the incidence of the subsidy. In this case, the price falls by more than half the value of the subsidy ($0.90). Conversely, when demand is relatively elastic, quantity demanded does not fall by much and producers receive the bulk of the subsidy. The market price falls by less than half the value of the subsidy ($0.10). For all cases of subsidies, market price falls, producers receive more income and consumers buy more. However, money is spent by government so subsidies can be polarizing.
Taxes are money collected by the government. They can be collected by federal governments (i.e. the United States of America), subnational governments (i.e. the state of Wisconsin) and local governments (i.e. the locality of Shorewood, WI). There are two main types of taxes: direct and indirect. Direct taxes are those paid directly to the government, for example income and corporate taxes. Indirect taxes are first collected by an intermediary, for example a store when one buys food or clothes, who then sends the taxes to the government. Sales taxes and sin taxes (i.e. taxes on cigarettes, alcohol and other “sinful” g/s) are indirect taxes. Governments tax for four reasons commonly known as the four Rs: revenue (taxes = money for governments to spend), redistribution (from the rich to the poor for societal equity), repricing (to make “bad” g/s more expensive), and representation (so that citizens have some sort of say over how their money is spent…the idea behind the original Tea Party).
In this example, q0 quantity of rum is demanded and supplied at $10.00. If the government places a $5.00 tax on rum to say, discourage consumption of this so-called "sin good", we see that the supply curve S0 will shift inwards to S1 because supply shifts in when it costs more to produce. The distance between the two supply curves is the value of the tax ($5.00 here). Because demand is inelastic for rum in this example, the quantity demanded only falls to q1 and consumers now pay $4.00 of the $5.00 tax. The rum producers, who have no choice but to pay the tax to the government, take a $1.00 "hit" per unit. The green rectangle shows the incidence of the tax on the consumers and the blue rectangle shows the incidence of the tax on the producers. Governments tend to tax inelastic goods because of the relatively large impact on consumers as opposed to the producers.
Above, q0 quantity of biscuits (a.k.a. cookies) is demanded and supplied at $10.00. If the government places a $5.00 tax on biscuits for whatever reason, we see that the supply curve S0 will shift inwards to S1 because, again, supply shifts in when it costs more to produce. The distance between the two supply curves is the value of the tax ($5.00). Because demand is elastic for biscuits in this example, the quantity demanded falls by a lot to q1 and consumers now pay only $1.00 of the $5.00 tax. The biscuit producers who have to pay the tax to the government take a big $4.00 "hit" per unit. Again, the green rectangle shows the incidence of the tax on the consumers (small) and the blue rectangle shows the incidence of the tax on the producers (big). Because of the adverse effects on producers, governments tend to not tax elastic goods as it doesn't achieve the four Rs of taxation very well.
SUBSIDIES
Subsidies are financial aid to firms, or money given to producers to make production cheaper. They lower the cost of production and are used to encourage production (graphically, supply shifts out). This assistance keeps prices artificially low for consumers, ensures supply from producers of "valuable goods", helps domestic firms compete internationally and, thus, are highly debated and can be evaluated from various points of view (especially via OC analysis).
Looking at the three subsidy graphs above (PED < PES, PED = PES, PED > PES), we see that the incidences from the tax graphs have flipped (now, producers on top, consumers on bottom). Moreover, as stated above, instead of the supply curves shifting in, they shift out because subsidies make production cheaper (one of our "shifters" of supply). Before the subsidy, in all three instances, the equilibrium price is $3.50 and the equilibrium quantity is q0. The value of the subsidy is $1.00, which is also the distance between S0 and S1. If PED equals PES, the incidence of the subsidy is shared equally between consumers and producers. The market price of the product falls by exactly half the value of subsidy (in this case, $0.50). Thus, producers are encouraged to produce and consumers are encouraged to consume (milk in this example).
Evaluative questions: aren't subsidies funded by taxes? Yes! Thus, an evaluative discussion around OCs and taxation in general could occur.
When PED < PES (or demand is inelastic), quantity demanded falls very little and consumers receive the bulk of the incidence of the subsidy. In this case, the price falls by more than half the value of the subsidy ($0.90). Conversely, when demand is relatively elastic, quantity demanded does not fall by much and producers receive the bulk of the subsidy. The market price falls by less than half the value of the subsidy ($0.10). For all cases of subsidies, market price falls, producers receive more income and consumers buy more. However, money is spent by government so subsidies can be polarizing.
Elasticity...PED, yED, XED and PES
The demand for g/s is NOT static nor uniform! For some products, like medication, when the price increases, the quantity demanded will not fall dramatically. However, if the price for a trip to Tahiti increases, quantity demanded plummets. Why? The answer is that g/s have different price, cross and income elasticities of demand.
Price elasticity of demand (PED) is the measure of responsiveness of the quantity demanded for a g/s as a result of change in price of the same g/s.
PED = %∆Qd/%∆p
PED = 0 : perfectly inelastic
PED < 1 : inelastic (i.e. insulin)
PED = 1 : unit elastic
PED > 1 : elastic (i.e. restaurant dinners)
PED = 1 : unit elastic
PED > 1 : elastic (i.e. restaurant dinners)
PED = ∞ : perfectly elastic
Income elasticity of demand (yED) is the measure of the responsiveness of the quantity demanded of a g/s as a result of a change in the income of the consumers demanding the good.
yED = %∆Qd/%∆y
yED > O : normal good (i.e. shirts, cars, haircuts)
yED < 0 : inferior good (i.e. poor cut of meat, public transportation)
0 < yED < 1 : necessity good (still normal)
yED > 1 : superior good (still normal)
0 < yED < 1 : necessity good (still normal)
yED > 1 : superior good (still normal)
Cross elasticity of demand (XED) measures the responsiveness of the quantity demanded of one g/s as a result of the change to the price of another g/s. XED = %∆Qda/%∆pb
XED > O : substitutes (i.e. Pepsi and Coke)
XED < 0 : complements (i.e. mp3s and mp3 players)
Price elasticity of supply (PES) measures the responsiveness of the quantity supplied of g/s as a result of a change in price of product.
Price elasticity of supply (PES) measures the responsiveness of the quantity supplied of g/s as a result of a change in price of product.
PES = %∆Qs/%∆p
PES < 1 : inelastic (harder to supply more quickly)
PES > 1 : elastic (easier to supply more quickly)
PES > 1 : elastic (easier to supply more quickly)
A minimum price is a government-imposed price control whereby the price is set at a level above the equilibrium (or market-clearing) price. Because producers cannot charge a price below the minimum price, it is also called a price floor (cannot go below a floor). Price floors are set up primarily for two reasons. First, it allows producers to receive more income for the sale of their goods and services, and targets such products that governments consider “good” for society like agricultural products (i.e. milk). Second, when applied to workers, it establishes a minimum wage by which workers are guaranteed a “high” wage to live reasonably in an economy. According to neo-Classical economists, this causes real-wage unemployment (see relevant post).
Before the price floor, the market is in equilibrium at price p* and quantity q*. The government then sets a price floor (pmin), which causes demand at q1 to be less than supply at q2, and is called excess supply. This causes a surplus. Regarding the surplus good, the government can store it, destroy it or attempt to sell it.
A maximum price is a government-imposed price control whereby the price is set at a level below the equilibrium (or market-clearing) price. Because producers cannot charge a price above the minimum price, it is also called a price ceiling (cannot go above a ceiling). Price ceilings give consumers with less purchasing power access to their goods and services, and targets such products that governments consider “good” for society like rent control in a major city like New York. This causes quantity demanded to increase. However, we will see some producers leave the market because the price is too low to supply the product, and quantity supplied decreases.
More explicitly, before the price floor, the market is in equilibrium at price p* and quantity q*. The government then sets a price ceiling (pmax), which causes demand at q1 to be greater than supply at q2, and is called excess demand. This causes a shortage. Regarding the good, the government can supply the g/s itself or subsidize private firms to supply the g/s. In an incredibly misguided example of a real-world application reported by the BBC, Venezuelan President Hugo Chavez placed maximum prices on staple foods like milk and rice to ensure his people would have access to cheaper products starting in 2003. Unfortunately, this (obviously) led to shortages of such important goods.
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