price
EC120 FINAL EXAM-AID (Post-Midterm) Tutors: Fisnik “Fiz” Lokku “Princess Leila” Bautista Coordinator: “Action Jackson” Hounsell Some images used from course and textbook slides. 1
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Costa Rica
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Costa Rica
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Costa Rica
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AGENDA Chapters 15,16,17,9,11,18,19 – Go through them all – Answer any questions – A few examples – Leave you with the package
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Chapter 15 Monopoly
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Monopolies • Monopoly – a firm that is the only seller of a certain product (without many close substitutes). • Monopolies are formed by attaining market power through entry barriers that include: • Single firm owns a key resource to production • A firm has exclusive rights to a product (copyrights, patents, etc.) • Economies of scale (a “natural monopoly” situation) • In this case, large initial investments and lump capital requirements, allow ATC minimization to only occur with one firm. 9
Cost and Revenue in the Short Run – Because a monopolist is the sole producer of the product that it sells, its demand curve is the market demand curve for that product. – The monopoly seller therefore faces a negatively sloped demand curve; implying a tradeoff between the price charged and the quantity sold. – When the monopolist charges the same price for all units sold, its total revenue (TR) is equal to the price times the quantity sold. TR = p x q 10
Cost and Revenue in the Short Run • Average revenue (AR) is total revenue divided by quantity. • If the monopoly charges the same price for each unit sold (cannot “price discriminate”), average revenue = price. AR = TR / q = (p x q) / q = p
• Marginal revenue (MR) is the revenue resulting from the sale of an additional (or marginal) unit of production. MR = ΔTR / Δq
• Since the monopoly faces a negatively sloped demand curve, and because it charges the highest price possible (given Q), it must reduce the price to increase sales. • MR equals the revenue gained on new units sold (the output effect) less the revenue loss on existing units from cutting P (the price effect). That is why the MR curve lies below the AR curve. 11
“MR.” and “DARP” Separate Quantity Price Sold 10 9 8 7 6 5 4 3 2 1 0
0 10 20 30 40 50 60 70 80 90 100
TR 0 90 160 210 240 250 240 210 160 90 0
MR ΔTR (ΔTR/Δq) 90 70 50 30 10 -10 -30 -50 -70 -90
9 7 5 3 1 -1 -3 -5 -7 -9
MR is less than price because the price must be reduced in order to sell more units. 12
Profit Maximization • A monopolist maximizes profit by… – Producing where MR = MC (provided that MR is less the MC for subsequent units) – Pricing above marginal cost (i.e. P>MR and MR=MC so P>MC) – Shutting down in SR if P < AVC because then the firm will not be covering its VC and adding to its losses – Exiting in LR if P < ATC.
Image from: http://cdn.pastemagazine.com/www/blogs/playlist/money%20large.jpg?1239964072
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$/Unit
Calculating Monopoly Profits Step 1: Find QM (profitmaximizing quantity of output) where MC = MR.
MC
P(QM)
ATC1
Profit
Step 2: Determine price at QM (highest possible)
D MR QM
Step 3: Determine Average Total Cost at QM
Output
Total Profit = [P(QM) - ATC(QM)] x [QM] 14
Short-Run Profit Maximization The profit-maximizing level of output is where MC = MR. When a monopolist is maximizing its profit, the price it charges is always greater than its MC.
For a given MC curve, the monopolist may earn positive economic profits or may suffer losses, depending on the position of the ATC curve (and thus on its fixed costs). 15
Monopoly Profit Maximization EXAMPLE
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Example!
The answer is b)! MR = Change in TR/Change in Q Change in TR = 6000*7 – 4000*(10-7) = $30,000 Change in Q = 6000 MR = 30/6 = $5 unit MC = $6/unit > MR Therefore, profits fall.
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Welfare Cost (DWL) of Monopoly Monopolies are.. Allocatively inefficient because P > MC and thus all those willing to pay MC are not served.
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Public Policies to Fix DWL Economic and allocative efficiency can be promoted through: • Public ownership (government owns/runs the business – Crown Corporations) which means that the firm’s objective is total surplus instead of profits. • Economic regulation which means government control over price and/or entry. – Example: MC pricing, in which firms are forced to price equal to their MC. If this produces losses, the government can subsidize the losses or instead enforce ATC pricing instead.
• Competition policy which refers to the laws designed to prevent anticompetitive behaviour. – Example: Laws dealing with mergers, price fixing, unfair trade practices
• No Action – as all other actions have disadvantages, some argue that no action is the best policy. 19
Price Discrimination Price discrimination occurs when a producer charges different prices for different units of the same product for reasons not related to cost differences. If price differences reflect cost differences, they are not discriminatory. When a price difference is based on different buyers’ valuations of the same product, it is discriminatory. Any firm that faces a downward-sloping demand curve can increase its profits if it is able to charge different prices for different units of its product. 20
Different Degrees of Price Discrimination • A firm can try to charge each buyer a price which reflects their willingness to pay. This is an attempt at capturing the CS in the market. There are different degrees. • First Degree: “perfect price discrimination” occurs when the entire consumer surplus is obtained by the firm as profit. • This usually requires each unit be sold at a different price. • Second Degree: when different prices of a good are charged to the same customer (I.e. selling at a discount in bulk). • Third Degree: charging different prices to different segments of the market based on their elasticities (seen in next slide). • I.e. in an inelastic market, firms would charge a higher price to make more money. 21
Discrimination Among Markets
Profit maximization requires that marginal cost be set equal to marginal revenue in each market. A firm with market power that can identify distinct market segments will maximize its profits by charging higher prices in those segments with less price elastic demand. 22
Chapter 16 Monopolistic Competition
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Monopolistic Competition Monopolistic competition – a market structure in which many firms sell products that are similar, but not identical. (I.e. Dallas, Phil’s, Fox and the Fiddle, Titanium, Turret, Caesar’s, Cameo, Chainsaw, etc.). Assumptions: 1. Each firm produces one variety of a differentiated product (e.g., Crest, Aquafresh, Colgate—all are toothpastes, yet each is identifiably different-done through advertising and brand loyalty). Each firm thus faces a demand curve that, …though negatively sloped, is highly elastic because other firms produce close substitutes. 2. The industry contains so many firms that each one ignores the possible reaction of its many competitors when it makes its own price and output decisions. 3. There is freedom of entry and exit in the industry.
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Predictions of the Theory In the short run, a monopolistically competitive firm, like a monopoly, faces a downward sloping demand curve and maximizes profits by equating MR and MC.
Short-run profits provide an incentive for new firms to enter the industry, thereby causing total demand for the product to be shared among a larger number of firms.
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Adjustment to LR As new firms enter, each firm’s demand curve pivots/shifts to the left until profits are eliminated… * More firms means profits are divided more thinly across the market. at the output at which the demand curve is tangent to the LRAC curve.
Note that in the zero-profit long-run equilibrium, each firm is producing at a point where long-run average costs are not minimized — each firm has excess capacity. As well, there is still a mark-up of price over marginal cost. It is because of this excess capacity result and mark-up that the market is considered socially inefficient.
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EXAMPLE Suppose that a firm in a monopolistically competitive industry produces an output level at which P = $50, MR = $30, AVC = $40, ATC = $60, MC = $30. Is the firm maximizing profits? IF not then what should the firm do (shutdown/exit). What will happen to this industry in the long-run? SHORT- RUN
LONG-RUN
Profit Maximization: Compare MC and MR MR = 30 MC = 30 MR = MC The firm is maximizing profits. Should it shutdown? Compare P and AVC P = 50 AVC = 40 P > AVC = don’t shutdown
What will happen in LR? Compare P and ATC P = 50 ATC = 60 P < ATC = firms exit D shifts right until P is tangent to LRAC (i.e. profits = 0)
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Analysis Difficulties • Monopolistic competition markets are very hard for policy makers to analyze and essentially solve (the social inefficiency problem). • Further distorting possible analysis is two opposite, but present externalities – Positive: the “product-variety externality” in which consumers experience positive benefit from being able to choose from a variety of products (I.e. I enjoy being able to pick Old Spice over Axe or other brands). – Negative: the “business-stealing externality” in which businesses bare the cost of losing customers and profits when new competitors enter the mkt.
• These issues combined make it difficult to measure and effectively approach these markets.
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Advertising • A big driver of the perceived differences between products is their advertising. Branding is a direct product of advertising. • Critiques of advertising include: – It’s a waste of money because it’s about fooling consumers into perceiving a difference that fully isn’t there – This perceived difference than allows the seller to charge a markup – By driving prices higher than they need to be, firms decrease efficiency
• Defense of advertising: – Advertising encourages a more informed buying population – It increases competition -> good for efficiency and reducing market power possibilities – Advertising may act as a signal of quality (firms won’t do expensive advertising if they don’t think you will be a repeat buyer after)
• These are similar to the critiques/defense of branding.
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Chapter 17 Oligopoly
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Oligopoly • An oligopoly is a market in which there are only a few sellers that provide similar or identical products. • A “duopoly” is an oligopoly that contains only two sellers. • Oligopolies are dependent have an interesting struggle/ tension between each firm’s self interests and cooperation. • Firms seek to act like a monopoly (P > MC), but need to consider the actions of the other firms in the market. • One method of cooperation: collusion. Collusion entails firms coming together to agree upon prices and quantities each will produce. • Another method of cooperation: cartels. This is a group of firms acting in unison – colluding together. 31
Problems That Cartels Face Any one firm within the cartel has an incentive to cheat — to increase output so as to benefit from the high price caused by the other members’ output restrictions. However, if all of the firms cheat in this way, the price will fall back toward the competitive level. Firms will no longer be maximizing their joint profits. A cartel must therefore police the behaviour of its members AND it must also prevent the entry of new producers. Thus, a successful cartel must create barriers to prevent the entry of new firms that are attracted by the cartel’s high profits. 32
Problems That Cartels Face (extra) If all firms reduce output so that industry output is Q1, price rises from p0 to to p1 and all firms produce q1 and earn profit πCartel. But if price is p1, each firm wants to produce q2, where price = MC, increasing its profit by πcheater (Cheating Option).
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Problems That Cartels Face (extra) If all firms produce output q2, price falls (*Recall: when positive economic profits made, supply increases and drops the price). The high price p1 was maintained because all firms agreed to restrict output. If all firms maximize profits individually (in competition with other firms), the price falls to the competitive level p0; firms each produce q0 (for a total industry output of Q0) and all firms earn zero profit.
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Nash Equilibrium No, not this guy…
Image from: http://www.steve-nash.net/ images/steve4.jpg
• A Nash Equilibrium is a “situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosen.” – I.e. if my best strategy is to give you 2 slices of pizza when you teach me BU111, and your best strategy is to teach me BU111 for 2 slices of pizza – 35 then we have a Nash equilibrium.
Oligopoly Considerations • As firms in an oligopoly seek to act like a monopoly but aren’t fully one: – Monopoly Q < Olig. Q < Perfect Competition Q – Perfect Competition P < Olig. P < Monopoly P
• Output effects and price effects still remain true. • As the number of firms in the oligopoly increases, it starts to get closer and closer to the perfect competition outcome (lower prices, higher Q, and more socially optimal). – This is because the only difference between an oligopoly and perfect competition is the number of firms selling. – Therefore, as number of firms ↑ -> Market Power ↓ -> P ↓ -> Q ↑ -> DWL ↓ -> TS and Happiness ↑ 36
Game Theory • Game theory is used to study decision making in situations where a number of players compete. • It is useful when the reward of a person, firm, economic agent, etc. depends not only on their action but also on the actions of others. • To illustrate this concept of depending on other’s actions, we study the prisoner’s dilemma. • A Dominant Strategy is a best response to any strategy the rival may choose (i.e. doing the same thing no matter what the rival does) 37
Prisoner’s Dilemma • Prisoner’s Dilemma is a game in which it is a dominant strategy for players NOT to choose the co-operative strategy (i.e. not to choose a strategy where their results/ pay-offs are maximized) • EXAMPLE: – Two prisoners that have committed a crime – Pay-offs: Both Confess – 10 years each Both don’t confess – 1 year each Only 1 confesses – Confess 0, Don’t Confess 20 Lets start by first making a pay-off matrix!
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Prisoner's Dilemma .
Pay-off Matrix PRISONER B Confess
Don’t Confess
Confess
A gets 10 years B gets 10 years
A gets 0 years B gets 20 years
Don’t Confess
A gets 20 years B gets 0 years
A gets 1 year B gets 1 year
PRISONER A
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Prisoner’s Dilemma (cont’d) • A’s best response function – If B confesses then A confesses because 10 yrs < 20 yrs – If B doesn’t confess then A confesses because 0 yr < 1 yr
• B’s best response function – If A confesses then B confesses because 10 yrs < 20 yrs – If A doesn’t confess then B confesses because 0 yr < 1 yr
• Hence, the Nash Equilibrium is BOTH CONFESS because if either player unilaterally altered their strategy their punishment would rise from 10 to 20. – Another way to put this is that NEITHER player has the alternative to alter their choice. The dominant strategy for both is to confess, hence that is there NE. 40
Uncooperative Motives Sometimes firms are asked to pick simultaneously and sometimes one firm is given the advantage to pick first. Here’s an example: Canada and the US are the only 2 countries in OPEC (I.e.). They need to decide how they wish to honour their collusion. US
CANADA
Don’t Honour
Honour
Don’t Honour
Canada earns $12 b US earns $16 b
Canada earns $48 b US earns $8 b
Honour
Canada earns $6 b US earns $60 b
Canada earns $36 b US earns $40 b
Each firm’s dominant strategy is to not honour the agreement, and therefore NE occurs at Don’t Honour and Don’t Honour (both firms suffer). 41
Thoughts on Cooperation • The uncooperation caused by self interests in oligopolies is bad for their business but good for society: • Lower price -> closer to MC -> less DWL • Greater quantity -> quantity approaches social optimum (monopolistic behaviour causes underproduction). • Cooperation may be possible in the case that these “games” are repeated many times over and the “players” realize the error in their self-interest ways. • As oligopolistic cooperation moves the economy away from allocative efficiency, it is the responsibility of policymakers to follow through with antitrust laws to encourage competition. • Some however believe that these anti-trust policies go too far and stifle business activity that can occur. 42
Downsides of Anti-Trust 1) Fair Trade or “Resale Price Maintenance” • Can occur when manufacturers impose lower limits on the price of their products when being sold by discount retailers that don’t offer full service. • The full service encourages customers to see how good the product is. However, it won’t be provided if discount retailers can undercut the full service ones in price and the full service retailer has nothing extra to offer. 2) Predatory Pricing • Can occur when firms cut prices to either keep competition out, or put them out of business. • This is illegal but its hard to prove intent. • As well, firms that cut prices need deep pockets to be able to sustain losses (better be able to hold your breath longer than it takes for your parents to give in). 3) Tying • Can occur when bundling items together for sale. • Some argue that tying weak products to strong ones increases market 43 power. This is pretty weak though, and has little substance.
Chapter 9 International Trade
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World Price (PW) - Small economy assumption -> assumes that economy being examined is too small to have any effect of the world price (PW) of a good. - Goods that are easy to transport will sell at the same price worldwide because if Pdomestic > PW: - Consumers will not pay more than PW - Sellers will not accept less than PW - Therefore moving the Pdomestic to PW
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Exporting and Importing • Canada will export... – Good X if the world price of X (Pw) exceeds the pre-trade domestic price of X – The difference between quantity demanded and supplied at Pw – Trade in export markets increases producer surplus by more than it lowers consumer surplus
• Canada will import… – Good Y if the world price of Y (Pw) is less than the pre-trade domestic price of Y – The difference between domestic quantity demanded and supplied of good Y at Pw – Trade in import markets increases consumer surplus by more than it lowers producer surplus 46
Exporting Example
A B C
D
Canada consumes 30 thousand of cans Canada produces 70 thousand cans Will Canada import or export tuna? EXPORT 40 thousand cans Trading causes… CS to fall (the change is shown by the shaded area; falls by B) PS to rise (the change is shown by the striped area; PS increases by B + D)
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Trade Generalities • Free trade increases TS. It increases either CS or PS and decreases the other by a lesser amount. – This means that gains of trade > losses of trade
• Other benefits of trade include: increased variety, economies of scale, increased competition, and integration. • However, winners and losers are produced by trade -> usually minimal win for many but huge loss for few -> leads to a stronger voice/lobby against free trade. 48
Methods of Protection • Import tariffs or duties… – are taxes applied to an imported good – can be applied in response to unfair actions by foreign firms or governments (e.g. subsidies) – raise tariff revenue for the government – reduce domestic consumption(quantity demanded), imports & CS. – raise domestic production(quantity supplied), revenues & PS. – cause deadweight loss for importing countries (total surplus will fall)
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Tariff Example Find the tariff revenue, ∆CS, ∆PS, and deadweight loss created by $0.50 tariff The $0.50 tariff imposed raises the price of tuna to $2.00. The blue box is the tariff revenue generated. It is simply the area of the box (20 x 0.5 = 10) The red triangles represent the deadweight loss The loss of CS is the striped portion + the DWLs + tariff revenue. The gain in PS is represented only by the striped portion. 50
Import Quotas • Voluntary export restraints or import quotas – Result in reduced imports – Raise the domestic price of the good – Raise no tariff revenue for the government but creates profits for the import license holder (Pdomestic > PW). – Reduce domestic consumption, imports, & CS. – Increase domestic production and PS. – Cause more deadweight loss for importing countries than tariffs or duties (since there is no tax revenue)
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Quota Example Find the ∆CS, ∆PS, and deadweight loss created by a 20,000 import quota. A quota is always placed parallel to the x-axis for the corresponding amount. The quota raises the price to $2.00/can. The fall in CS is represented by the area A+B+C+D The rise in PS is represented by the area A The deadweight loss equals the red area (B+C+D) The domestic consumption decreases by 20,000 and domestic production increases by 20,000. 52
Arguments Against Trade • Domestic jobs are lost in competition. – Jobs lost in import industries can be gained back from jobs gained in export industries.
• National security can be compromised if we are reliant on others in the production of our weapons. – Fair enough, but make sure producers don’t exaggerate their importance
• Infant industries need protection so they can develop. – Difficult to tell which infant industries will actually be successful. If they are good, temporary losses in the SR should not phase them.
• Unfair competition may stem from foreign producers getting more gov’t support. – Gain to our consumers from the even cheaper products > loss to producers.
• Restricting trade can be used as a bargaining chip. – If you make a threat and your bluff is called – you’re screwed (either lose beneficial trade or lose your reputation on the world stage). 53
Chapter 11 Public Goods and Common Resources
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Private Goods and Common Resource • A common resource is owned by no one (is not private property). – It is non-excludable which means that it is difficult or impossible to prevent anyone from using it – It is rivalrous which means that if one person uses it, there is one less unit available for others to consume
• A private good is a good or service that is both rivalrous and excludable. – Your consumption of food, clothing, or Dr.Pepper (absolutely delicious) is only possible because you pay the seller for the right to have them(excludable) – Also, the consumption of the good reduces the amount available to others (rivalrous) 55
Public Goods and Natural Monopoly • A good can also be excludable along with being nonrivalrous (known as a natural monopoly). – Example: Museums, Art galleries, National Parks – These goods are provided by the government because private provision would result in allocative inefficiency since users would be charged above the zero marginal cost (i.e. natural monopoly problem)
• If a good is non-rivalrous and it is impossible to prevent anyone from using the good (i.e. it is nonexcludable) then the good is a public good. – Example: Information, National Defense, Public protection – Private provision is impossible here as well because sellers cant make users pay(free-rider problem) 56
Rivalrous
Non-Rivalrous
Excludable Private goods: - Dr. Pepper - Power Ranger Costumes
Non-Excludable Common resource: - Fish - Environment - Clean water
Natural monopoly: - Art galleries - ETR on a Tuesday at 1PM - Jersey Shore
Public goods: - National Defense - Information - Lighthouses
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Free-Ridin’ • Goods that are non-excludable have difficulty in unregulated markets because there is no way for sellers/ producers to ensure collection of payment. – So, they don’t produce (even though the benefit to users may have been greater than their costs -> market inefficiency). – This is also known as the free-rider problem (benefiting w/o paying).
Image from: http://newsletter.davos.ch/3/archive/ newsletter_davos_C09.001_20070112155000936/imgen/ 20070112091352992882000000.jpg
• Therefore, in the case of a public good, if the collective benefits are greater than the costs (CBA is positive), then the gov’t should tax those who benefit equal to the cost and provide the good. • Measuring benefits is often difficult and imprecise though 58
Common Resources • Common resources are also non-excludable but face an extra problem because they are rivalrous. – The gov’ts role is then to ensure that the resources are provided but not overused (sustainability is usually a key question). • Tragedy of the commons: a bunch of people had sheep -> population grew -> need more sheep -> stayed on the same land (common resource) -> ran out of grass -> ran out of sheep -> everyone dies an awful awful death. – (my interpretation) – This tragedy shows that private incentives often outweigh social incentives, and we therefore collectively make many bad individual decisions. – Failing to internalize the external cost of overusing land led to the tragedy. It could have been fixed through direct regulation of sheep ownership, taxing sheep, issuing grazing permits, or land privatization. 59
Market Failure • In the case of public goods, we have the issue that they are normally underprovided. • In the case of common resources, we have the issue that they are over-consumed. • If property rights were well established, these issues would be minimized (too much pollution in un-owned air, and not enough charge for general information leads to less R&D). 60
Chapter 18 Factor Markets
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Factor Market Demand • Factors of production of the inputs used in making goods and providing services. (I.e. land, labour, capital). • The demand for a factor on the market can be derived from the products that it produces. – If the demand for these products increase, the demand for the factor increases as well. – If overall MP of the factor increases, the demand for the factor will increase as well.
• It will be assumed that all markets are competitive and that firms are motivated by one thing: profit. 62
MRP and MFC • When a firm hires one more unit of a factor, the firm’s total costs rise. This increase in total cost is the marginal factor cost (MFC). • Hiring an extra unit of factor also leads to an increase in the firm’s output/revenue. This increase is called the factor’s marginal revenue product (MRP). – The factor’s MRP has two components: • Physical – how much 1 unit of factor adds to total output (MP). • Dollar – how much 1 unit adds to the total revenue (MR). • HENCE, It is safe to say that MRP = MR x MP
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MRP and MFC • In competitive factor markets (e.g. perfect competition) the marginal cost of the factor is simply the factor’s price, since the firm can hire any amount of factor at a given price (i.e. the firm is a price-taker) • Also, we know that in these markets, the firm’s MR is just the market price of the product, “P”. • Therefore, MRP = P x MP. • When wage is constant, MFC = wages
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Profit Maximizing Factor Use • The profit maximizing factor use involves setting MFC = MRP • The key is to.. – increase factor use if MFC < MRP – decrease factor use if MFC > MRP
• The profit maximizing output is the output where MRP is just above or equal to MFC • If the firm is a price taker in both the product and the factor markets then: MFC = w and MR = P. In that case, profit maximization can be re-written as w = (MP)*(P) or w = MRPL – This is assuming that P > AVC and therefore the firm does not shut down. – As well, by logic, w < Average Revenue Product of Labour.
• The rule of rational life: increase an activity if the gain from the increase is greater than the cost of increasing the activity (and 65 vice versa).
EXAMPLE! Find the profit maximizing level of employment by calculating MRP and MFC MRP = P x MP Always use this formula when price is constant! L
Q
P
MRP
w
MFC
0
0
blank
blank
6
blank
1
10
2
2 x 10 = 20
6
MRP>MFC
2
18
2
2 x 8 = 16
6
MRP>MFC
3
24
2
2 x 6 = 12
6
MRP>MFC
4
28
2
2x4=8
6
MRP>MFC Profit MAX
5
30
2
2x2=4
6
MRP<MFC
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Changes in Wage and Price • When
wages increase, MFC increases. This will cause a decrease in production, as well as labour use (employment). • On the cost graphs, MC and AVC shift up (due to their relationship to w) which causes a decrease in output per firm. • When wages decrease the opposite occurs.
• When prices increase, the MRP and ARP increase for each amount of labour (when the item they produce sells at a higher price, hiring one more person brings in more revenue then before). • The MRP and ARP curves shift up but there is no change to the cost curves (why would there be). • With a higher MR.DARP, it intersects MC at a later point and increases quantity per firm. 67 • The opposite occurs with a price decrease.
Factor-Price Demand Elasticity • Elasticity measures responsiveness. I.e. factor-price elasticity could measure how responsive employers will be to wage increases or firms will be to factory-leasing prices. • This elasticity will be higher (firms more responsive) if: – The lesser the effect of diminishing marginal product (if MP is not decreasing fast, then hiring the next unit makes more sense than if the next unit MP decreased rapidly). – The easier substitution is (if I can replace you with a machine and wages go up, I just might… so watch out). – The more important (or the larger its effects on your costs) it is. I.e. if labour represents the bulk of your costs and wages increase, then costs will go up hugely, therefore decreasing quantity by a large amount. 68
Market Factor Supply • Market factor supply depends on a variety of things: land (fixed, but fertile is not), labour (based on participation rates and population), capital (increases/decrease based on net investment vs. depreciation). • Market factor supply can be measured on three levels: for the economy, for the market, and for the firm. – Individual firms commonly face perfectly elastic supply, even though overall factor supply for the economy or industry may be relatively inelastic. (The more narrow the definition the more elastic supply is.)
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Factor (Labour) Mobility • Refers to the ease with which factors can be transferred between uses (how easy it is for me to do another job) • Increases the elasticity of supply (i.e. a little change in wage will cause workers to move to different areas) • Increases with time (i.e. more time = more mobile) • Ensures that wage differentials reflect – – – –
Different costs of acquiring skills Different working conditions Different quality inputs (intrinsic differences) Demand changes in SR but not in LR
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Chapter 19 Earnings and Discrimination
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Earnings and Discrimination • In an equilibrium market, the wage paid to a worker equals his or her marginal contribution to production • If you work as a wall street trader, a lot more is required from you, so you should get paid more than someone working at McDonald’s
• Temporary Factors as well as Long-Run changes in equilibrium can affect earnings levels. • The changes from equilibrium are caused by intrinsic differences in the factors themselves as well as the cost of acquiring skills 72
Factor Price Differentials • Temporary differentials in factor prices are caused by shifts in labour supply and demand. • These differentials balance themselves out by the chain reaction of effects that occur after the market disruption • If a differential exists while in equilibrium, it will stay there (If we’re in equilibrium, we’re doing the best we can, so there’s a good reason some factors are valued more)
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Temporary Differentials in Factor Prices Example • Simple laws of supply and demand! – An increase in the demand for labour to make cocaine will push up its wage. Firms need more people, so they’re willing to pay more as an incentive. – People in comparable industries (let’s say crack) will leave to earn more dolla billz, which lowers the demand in their market. – As more people go to make cocaine, the wage paid to produce it goes down (Excess supply of labour; no way can we afford benjamins for all these people) – People who still make crack will see their wages go up (Excess demand for labour at their low wage) – As wages adjust to demand in both markets, the differential disappears. 74
Compensating Differential • Difference in wages that arise to offset the non-monetary aspects of jobs – Getting paid more for high risk or unpleasant jobs
• Factor price differentials that exist in equilibrium are known as compensating differentials, because they compensate for parts of a job you can’t put a dollar amount on. 75
Ability, effort, and chance • Basically, you gotta have skills • If you can provide a higher marginal product level than your competition, you should be paid more
• But then there’s Chance – Technological progress eliminates demand for some industries and increases it for others • Eg. Who would want to buy a disc man these days?
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Education and Earnings • Education is a measure of ability – If you go to university and get your degree, you have a greater level of ability in that area than someone who just left high school
• Education is also Privately valuable – It benefits the individual who earns more dolla billz, and the employer who has a more educated worker, but that’s it.
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Above-Equilibrium Wages • Above Equilibrium wages can result when there is market interference 1 Minimum Wage Laws •
Creates a price floor above equilibrium
2 Unions •
Can negotiate their wages to higher than their value
3 Efficiency Wages •
Firms can pay individuals more as an incentive to be more productive 78
Discrimination • Offering of different opportunities to those who differ only by personal characteristics • There has been a ton of research on the topic, and the exact causes of wage differences are still not clear • Firms that discriminate hurt themselves in the long run
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Example • Suppose I make hats, and I can hire men and women to do this, but I hire more men than women. – The demand for women in my labour market goes down.
• The decrease in demand lowers the wage for females, giving other firms incentives to hire them. The discriminating firm ends up paying higher wages than the nondiscriminating firm 80
Graph
The wages paid for Females are a lot lower than men, so firms that hire women will earn a greater profit than those that discriminate.
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Government Discrimination • Governments that discriminate against individuals prevent the market from correcting factor wage differentials • Therefore, a permanent wage differential only exists in competitive markets if the firms discriminate, or if the government discriminates. 82
That is the END! If you have any individual ques?ons feel free to come to the front now! THANK YOU SO MUCH FOR A GREAT TERM! The Dream Team will be returning for EC140. So keep your eyes open for upcoming sessions GOOD LUCK ON YOUR FINAL!! 83
BONUS! Great Summary Chart
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AGENDA Chapters 15,16,17,9,11,18,19 – Go through them all – Answer any questions – A few examples – Leave you with the package
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Chapter 15 Monopoly
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Monopolies • Monopoly – a firm that is the only seller of a certain product (without many close substitutes). • Monopolies are formed by attaining market power through entry barriers that include: • Single firm owns a key resource to production • A firm has exclusive rights to a product (copyrights, patents, etc.) • Economies of scale (a “natural monopoly” situation) • In this case, large initial investments and lump capital requirements, allow ATC minimization to only occur with one firm. 9
Cost and Revenue in the Short Run – Because a monopolist is the sole producer of the product that it sells, its demand curve is the market demand curve for that product. – The monopoly seller therefore faces a negatively sloped demand curve; implying a tradeoff between the price charged and the quantity sold. – When the monopolist charges the same price for all units sold, its total revenue (TR) is equal to the price times the quantity sold. TR = p x q 10
Cost and Revenue in the Short Run • Average revenue (AR) is total revenue divided by quantity. • If the monopoly charges the same price for each unit sold (cannot “price discriminate”), average revenue = price. AR = TR / q = (p x q) / q = p
• Marginal revenue (MR) is the revenue resulting from the sale of an additional (or marginal) unit of production. MR = ΔTR / Δq
• Since the monopoly faces a negatively sloped demand curve, and because it charges the highest price possible (given Q), it must reduce the price to increase sales. • MR equals the revenue gained on new units sold (the output effect) less the revenue loss on existing units from cutting P (the price effect). That is why the MR curve lies below the AR curve. 11
“MR.” and “DARP” Separate Quantity Price Sold 10 9 8 7 6 5 4 3 2 1 0
0 10 20 30 40 50 60 70 80 90 100
TR 0 90 160 210 240 250 240 210 160 90 0
MR ΔTR (ΔTR/Δq) 90 70 50 30 10 -10 -30 -50 -70 -90
9 7 5 3 1 -1 -3 -5 -7 -9
MR is less than price because the price must be reduced in order to sell more units. 12
Profit Maximization • A monopolist maximizes profit by… – Producing where MR = MC (provided that MR is less the MC for subsequent units) – Pricing above marginal cost (i.e. P>MR and MR=MC so P>MC) – Shutting down in SR if P < AVC because then the firm will not be covering its VC and adding to its losses – Exiting in LR if P < ATC.
Image from: http://cdn.pastemagazine.com/www/blogs/playlist/money%20large.jpg?1239964072
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$/Unit
Calculating Monopoly Profits Step 1: Find QM (profitmaximizing quantity of output) where MC = MR.
MC
P(QM)
ATC1
Profit
Step 2: Determine price at QM (highest possible)
D MR QM
Step 3: Determine Average Total Cost at QM
Output
Total Profit = [P(QM) - ATC(QM)] x [QM] 14
Short-Run Profit Maximization The profit-maximizing level of output is where MC = MR. When a monopolist is maximizing its profit, the price it charges is always greater than its MC.
For a given MC curve, the monopolist may earn positive economic profits or may suffer losses, depending on the position of the ATC curve (and thus on its fixed costs). 15
Monopoly Profit Maximization EXAMPLE
16
Example!
The answer is b)! MR = Change in TR/Change in Q Change in TR = 6000*7 – 4000*(10-7) = $30,000 Change in Q = 6000 MR = 30/6 = $5 unit MC = $6/unit > MR Therefore, profits fall.
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Welfare Cost (DWL) of Monopoly Monopolies are.. Allocatively inefficient because P > MC and thus all those willing to pay MC are not served.
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Public Policies to Fix DWL Economic and allocative efficiency can be promoted through: • Public ownership (government owns/runs the business – Crown Corporations) which means that the firm’s objective is total surplus instead of profits. • Economic regulation which means government control over price and/or entry. – Example: MC pricing, in which firms are forced to price equal to their MC. If this produces losses, the government can subsidize the losses or instead enforce ATC pricing instead.
• Competition policy which refers to the laws designed to prevent anticompetitive behaviour. – Example: Laws dealing with mergers, price fixing, unfair trade practices
• No Action – as all other actions have disadvantages, some argue that no action is the best policy. 19
Price Discrimination Price discrimination occurs when a producer charges different prices for different units of the same product for reasons not related to cost differences. If price differences reflect cost differences, they are not discriminatory. When a price difference is based on different buyers’ valuations of the same product, it is discriminatory. Any firm that faces a downward-sloping demand curve can increase its profits if it is able to charge different prices for different units of its product. 20
Different Degrees of Price Discrimination • A firm can try to charge each buyer a price which reflects their willingness to pay. This is an attempt at capturing the CS in the market. There are different degrees. • First Degree: “perfect price discrimination” occurs when the entire consumer surplus is obtained by the firm as profit. • This usually requires each unit be sold at a different price. • Second Degree: when different prices of a good are charged to the same customer (I.e. selling at a discount in bulk). • Third Degree: charging different prices to different segments of the market based on their elasticities (seen in next slide). • I.e. in an inelastic market, firms would charge a higher price to make more money. 21
Discrimination Among Markets
Profit maximization requires that marginal cost be set equal to marginal revenue in each market. A firm with market power that can identify distinct market segments will maximize its profits by charging higher prices in those segments with less price elastic demand. 22
Chapter 16 Monopolistic Competition
23
Monopolistic Competition Monopolistic competition – a market structure in which many firms sell products that are similar, but not identical. (I.e. Dallas, Phil’s, Fox and the Fiddle, Titanium, Turret, Caesar’s, Cameo, Chainsaw, etc.). Assumptions: 1. Each firm produces one variety of a differentiated product (e.g., Crest, Aquafresh, Colgate—all are toothpastes, yet each is identifiably different-done through advertising and brand loyalty). Each firm thus faces a demand curve that, …though negatively sloped, is highly elastic because other firms produce close substitutes. 2. The industry contains so many firms that each one ignores the possible reaction of its many competitors when it makes its own price and output decisions. 3. There is freedom of entry and exit in the industry.
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Predictions of the Theory In the short run, a monopolistically competitive firm, like a monopoly, faces a downward sloping demand curve and maximizes profits by equating MR and MC.
Short-run profits provide an incentive for new firms to enter the industry, thereby causing total demand for the product to be shared among a larger number of firms.
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Adjustment to LR As new firms enter, each firm’s demand curve pivots/shifts to the left until profits are eliminated… * More firms means profits are divided more thinly across the market. at the output at which the demand curve is tangent to the LRAC curve.
Note that in the zero-profit long-run equilibrium, each firm is producing at a point where long-run average costs are not minimized — each firm has excess capacity. As well, there is still a mark-up of price over marginal cost. It is because of this excess capacity result and mark-up that the market is considered socially inefficient.
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EXAMPLE Suppose that a firm in a monopolistically competitive industry produces an output level at which P = $50, MR = $30, AVC = $40, ATC = $60, MC = $30. Is the firm maximizing profits? IF not then what should the firm do (shutdown/exit). What will happen to this industry in the long-run? SHORT- RUN
LONG-RUN
Profit Maximization: Compare MC and MR MR = 30 MC = 30 MR = MC The firm is maximizing profits. Should it shutdown? Compare P and AVC P = 50 AVC = 40 P > AVC = don’t shutdown
What will happen in LR? Compare P and ATC P = 50 ATC = 60 P < ATC = firms exit D shifts right until P is tangent to LRAC (i.e. profits = 0)
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Analysis Difficulties • Monopolistic competition markets are very hard for policy makers to analyze and essentially solve (the social inefficiency problem). • Further distorting possible analysis is two opposite, but present externalities – Positive: the “product-variety externality” in which consumers experience positive benefit from being able to choose from a variety of products (I.e. I enjoy being able to pick Old Spice over Axe or other brands). – Negative: the “business-stealing externality” in which businesses bare the cost of losing customers and profits when new competitors enter the mkt.
• These issues combined make it difficult to measure and effectively approach these markets.
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Advertising • A big driver of the perceived differences between products is their advertising. Branding is a direct product of advertising. • Critiques of advertising include: – It’s a waste of money because it’s about fooling consumers into perceiving a difference that fully isn’t there – This perceived difference than allows the seller to charge a markup – By driving prices higher than they need to be, firms decrease efficiency
• Defense of advertising: – Advertising encourages a more informed buying population – It increases competition -> good for efficiency and reducing market power possibilities – Advertising may act as a signal of quality (firms won’t do expensive advertising if they don’t think you will be a repeat buyer after)
• These are similar to the critiques/defense of branding.
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Chapter 17 Oligopoly
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Oligopoly • An oligopoly is a market in which there are only a few sellers that provide similar or identical products. • A “duopoly” is an oligopoly that contains only two sellers. • Oligopolies are dependent have an interesting struggle/ tension between each firm’s self interests and cooperation. • Firms seek to act like a monopoly (P > MC), but need to consider the actions of the other firms in the market. • One method of cooperation: collusion. Collusion entails firms coming together to agree upon prices and quantities each will produce. • Another method of cooperation: cartels. This is a group of firms acting in unison – colluding together. 31
Problems That Cartels Face Any one firm within the cartel has an incentive to cheat — to increase output so as to benefit from the high price caused by the other members’ output restrictions. However, if all of the firms cheat in this way, the price will fall back toward the competitive level. Firms will no longer be maximizing their joint profits. A cartel must therefore police the behaviour of its members AND it must also prevent the entry of new producers. Thus, a successful cartel must create barriers to prevent the entry of new firms that are attracted by the cartel’s high profits. 32
Problems That Cartels Face (extra) If all firms reduce output so that industry output is Q1, price rises from p0 to to p1 and all firms produce q1 and earn profit πCartel. But if price is p1, each firm wants to produce q2, where price = MC, increasing its profit by πcheater (Cheating Option).
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Problems That Cartels Face (extra) If all firms produce output q2, price falls (*Recall: when positive economic profits made, supply increases and drops the price). The high price p1 was maintained because all firms agreed to restrict output. If all firms maximize profits individually (in competition with other firms), the price falls to the competitive level p0; firms each produce q0 (for a total industry output of Q0) and all firms earn zero profit.
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Nash Equilibrium No, not this guy…
Image from: http://www.steve-nash.net/ images/steve4.jpg
• A Nash Equilibrium is a “situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosen.” – I.e. if my best strategy is to give you 2 slices of pizza when you teach me BU111, and your best strategy is to teach me BU111 for 2 slices of pizza – 35 then we have a Nash equilibrium.
Oligopoly Considerations • As firms in an oligopoly seek to act like a monopoly but aren’t fully one: – Monopoly Q < Olig. Q < Perfect Competition Q – Perfect Competition P < Olig. P < Monopoly P
• Output effects and price effects still remain true. • As the number of firms in the oligopoly increases, it starts to get closer and closer to the perfect competition outcome (lower prices, higher Q, and more socially optimal). – This is because the only difference between an oligopoly and perfect competition is the number of firms selling. – Therefore, as number of firms ↑ -> Market Power ↓ -> P ↓ -> Q ↑ -> DWL ↓ -> TS and Happiness ↑ 36
Game Theory • Game theory is used to study decision making in situations where a number of players compete. • It is useful when the reward of a person, firm, economic agent, etc. depends not only on their action but also on the actions of others. • To illustrate this concept of depending on other’s actions, we study the prisoner’s dilemma. • A Dominant Strategy is a best response to any strategy the rival may choose (i.e. doing the same thing no matter what the rival does) 37
Prisoner’s Dilemma • Prisoner’s Dilemma is a game in which it is a dominant strategy for players NOT to choose the co-operative strategy (i.e. not to choose a strategy where their results/ pay-offs are maximized) • EXAMPLE: – Two prisoners that have committed a crime – Pay-offs: Both Confess – 10 years each Both don’t confess – 1 year each Only 1 confesses – Confess 0, Don’t Confess 20 Lets start by first making a pay-off matrix!
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Prisoner's Dilemma .
Pay-off Matrix PRISONER B Confess
Don’t Confess
Confess
A gets 10 years B gets 10 years
A gets 0 years B gets 20 years
Don’t Confess
A gets 20 years B gets 0 years
A gets 1 year B gets 1 year
PRISONER A
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Prisoner’s Dilemma (cont’d) • A’s best response function – If B confesses then A confesses because 10 yrs < 20 yrs – If B doesn’t confess then A confesses because 0 yr < 1 yr
• B’s best response function – If A confesses then B confesses because 10 yrs < 20 yrs – If A doesn’t confess then B confesses because 0 yr < 1 yr
• Hence, the Nash Equilibrium is BOTH CONFESS because if either player unilaterally altered their strategy their punishment would rise from 10 to 20. – Another way to put this is that NEITHER player has the alternative to alter their choice. The dominant strategy for both is to confess, hence that is there NE. 40
Uncooperative Motives Sometimes firms are asked to pick simultaneously and sometimes one firm is given the advantage to pick first. Here’s an example: Canada and the US are the only 2 countries in OPEC (I.e.). They need to decide how they wish to honour their collusion. US
CANADA
Don’t Honour
Honour
Don’t Honour
Canada earns $12 b US earns $16 b
Canada earns $48 b US earns $8 b
Honour
Canada earns $6 b US earns $60 b
Canada earns $36 b US earns $40 b
Each firm’s dominant strategy is to not honour the agreement, and therefore NE occurs at Don’t Honour and Don’t Honour (both firms suffer). 41
Thoughts on Cooperation • The uncooperation caused by self interests in oligopolies is bad for their business but good for society: • Lower price -> closer to MC -> less DWL • Greater quantity -> quantity approaches social optimum (monopolistic behaviour causes underproduction). • Cooperation may be possible in the case that these “games” are repeated many times over and the “players” realize the error in their self-interest ways. • As oligopolistic cooperation moves the economy away from allocative efficiency, it is the responsibility of policymakers to follow through with antitrust laws to encourage competition. • Some however believe that these anti-trust policies go too far and stifle business activity that can occur. 42
Downsides of Anti-Trust 1) Fair Trade or “Resale Price Maintenance” • Can occur when manufacturers impose lower limits on the price of their products when being sold by discount retailers that don’t offer full service. • The full service encourages customers to see how good the product is. However, it won’t be provided if discount retailers can undercut the full service ones in price and the full service retailer has nothing extra to offer. 2) Predatory Pricing • Can occur when firms cut prices to either keep competition out, or put them out of business. • This is illegal but its hard to prove intent. • As well, firms that cut prices need deep pockets to be able to sustain losses (better be able to hold your breath longer than it takes for your parents to give in). 3) Tying • Can occur when bundling items together for sale. • Some argue that tying weak products to strong ones increases market 43 power. This is pretty weak though, and has little substance.
Chapter 9 International Trade
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World Price (PW) - Small economy assumption -> assumes that economy being examined is too small to have any effect of the world price (PW) of a good. - Goods that are easy to transport will sell at the same price worldwide because if Pdomestic > PW: - Consumers will not pay more than PW - Sellers will not accept less than PW - Therefore moving the Pdomestic to PW
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Exporting and Importing • Canada will export... – Good X if the world price of X (Pw) exceeds the pre-trade domestic price of X – The difference between quantity demanded and supplied at Pw – Trade in export markets increases producer surplus by more than it lowers consumer surplus
• Canada will import… – Good Y if the world price of Y (Pw) is less than the pre-trade domestic price of Y – The difference between domestic quantity demanded and supplied of good Y at Pw – Trade in import markets increases consumer surplus by more than it lowers producer surplus 46
Exporting Example
A B C
D
Canada consumes 30 thousand of cans Canada produces 70 thousand cans Will Canada import or export tuna? EXPORT 40 thousand cans Trading causes… CS to fall (the change is shown by the shaded area; falls by B) PS to rise (the change is shown by the striped area; PS increases by B + D)
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Trade Generalities • Free trade increases TS. It increases either CS or PS and decreases the other by a lesser amount. – This means that gains of trade > losses of trade
• Other benefits of trade include: increased variety, economies of scale, increased competition, and integration. • However, winners and losers are produced by trade -> usually minimal win for many but huge loss for few -> leads to a stronger voice/lobby against free trade. 48
Methods of Protection • Import tariffs or duties… – are taxes applied to an imported good – can be applied in response to unfair actions by foreign firms or governments (e.g. subsidies) – raise tariff revenue for the government – reduce domestic consumption(quantity demanded), imports & CS. – raise domestic production(quantity supplied), revenues & PS. – cause deadweight loss for importing countries (total surplus will fall)
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Tariff Example Find the tariff revenue, ∆CS, ∆PS, and deadweight loss created by $0.50 tariff The $0.50 tariff imposed raises the price of tuna to $2.00. The blue box is the tariff revenue generated. It is simply the area of the box (20 x 0.5 = 10) The red triangles represent the deadweight loss The loss of CS is the striped portion + the DWLs + tariff revenue. The gain in PS is represented only by the striped portion. 50
Import Quotas • Voluntary export restraints or import quotas – Result in reduced imports – Raise the domestic price of the good – Raise no tariff revenue for the government but creates profits for the import license holder (Pdomestic > PW). – Reduce domestic consumption, imports, & CS. – Increase domestic production and PS. – Cause more deadweight loss for importing countries than tariffs or duties (since there is no tax revenue)
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Quota Example Find the ∆CS, ∆PS, and deadweight loss created by a 20,000 import quota. A quota is always placed parallel to the x-axis for the corresponding amount. The quota raises the price to $2.00/can. The fall in CS is represented by the area A+B+C+D The rise in PS is represented by the area A The deadweight loss equals the red area (B+C+D) The domestic consumption decreases by 20,000 and domestic production increases by 20,000. 52
Arguments Against Trade • Domestic jobs are lost in competition. – Jobs lost in import industries can be gained back from jobs gained in export industries.
• National security can be compromised if we are reliant on others in the production of our weapons. – Fair enough, but make sure producers don’t exaggerate their importance
• Infant industries need protection so they can develop. – Difficult to tell which infant industries will actually be successful. If they are good, temporary losses in the SR should not phase them.
• Unfair competition may stem from foreign producers getting more gov’t support. – Gain to our consumers from the even cheaper products > loss to producers.
• Restricting trade can be used as a bargaining chip. – If you make a threat and your bluff is called – you’re screwed (either lose beneficial trade or lose your reputation on the world stage). 53
Chapter 11 Public Goods and Common Resources
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Private Goods and Common Resource • A common resource is owned by no one (is not private property). – It is non-excludable which means that it is difficult or impossible to prevent anyone from using it – It is rivalrous which means that if one person uses it, there is one less unit available for others to consume
• A private good is a good or service that is both rivalrous and excludable. – Your consumption of food, clothing, or Dr.Pepper (absolutely delicious) is only possible because you pay the seller for the right to have them(excludable) – Also, the consumption of the good reduces the amount available to others (rivalrous) 55
Public Goods and Natural Monopoly • A good can also be excludable along with being nonrivalrous (known as a natural monopoly). – Example: Museums, Art galleries, National Parks – These goods are provided by the government because private provision would result in allocative inefficiency since users would be charged above the zero marginal cost (i.e. natural monopoly problem)
• If a good is non-rivalrous and it is impossible to prevent anyone from using the good (i.e. it is nonexcludable) then the good is a public good. – Example: Information, National Defense, Public protection – Private provision is impossible here as well because sellers cant make users pay(free-rider problem) 56
Rivalrous
Non-Rivalrous
Excludable Private goods: - Dr. Pepper - Power Ranger Costumes
Non-Excludable Common resource: - Fish - Environment - Clean water
Natural monopoly: - Art galleries - ETR on a Tuesday at 1PM - Jersey Shore
Public goods: - National Defense - Information - Lighthouses
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Free-Ridin’ • Goods that are non-excludable have difficulty in unregulated markets because there is no way for sellers/ producers to ensure collection of payment. – So, they don’t produce (even though the benefit to users may have been greater than their costs -> market inefficiency). – This is also known as the free-rider problem (benefiting w/o paying).
Image from: http://newsletter.davos.ch/3/archive/ newsletter_davos_C09.001_20070112155000936/imgen/ 20070112091352992882000000.jpg
• Therefore, in the case of a public good, if the collective benefits are greater than the costs (CBA is positive), then the gov’t should tax those who benefit equal to the cost and provide the good. • Measuring benefits is often difficult and imprecise though 58
Common Resources • Common resources are also non-excludable but face an extra problem because they are rivalrous. – The gov’ts role is then to ensure that the resources are provided but not overused (sustainability is usually a key question). • Tragedy of the commons: a bunch of people had sheep -> population grew -> need more sheep -> stayed on the same land (common resource) -> ran out of grass -> ran out of sheep -> everyone dies an awful awful death. – (my interpretation) – This tragedy shows that private incentives often outweigh social incentives, and we therefore collectively make many bad individual decisions. – Failing to internalize the external cost of overusing land led to the tragedy. It could have been fixed through direct regulation of sheep ownership, taxing sheep, issuing grazing permits, or land privatization. 59
Market Failure • In the case of public goods, we have the issue that they are normally underprovided. • In the case of common resources, we have the issue that they are over-consumed. • If property rights were well established, these issues would be minimized (too much pollution in un-owned air, and not enough charge for general information leads to less R&D). 60
Chapter 18 Factor Markets
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Factor Market Demand • Factors of production of the inputs used in making goods and providing services. (I.e. land, labour, capital). • The demand for a factor on the market can be derived from the products that it produces. – If the demand for these products increase, the demand for the factor increases as well. – If overall MP of the factor increases, the demand for the factor will increase as well.
• It will be assumed that all markets are competitive and that firms are motivated by one thing: profit. 62
MRP and MFC • When a firm hires one more unit of a factor, the firm’s total costs rise. This increase in total cost is the marginal factor cost (MFC). • Hiring an extra unit of factor also leads to an increase in the firm’s output/revenue. This increase is called the factor’s marginal revenue product (MRP). – The factor’s MRP has two components: • Physical – how much 1 unit of factor adds to total output (MP). • Dollar – how much 1 unit adds to the total revenue (MR). • HENCE, It is safe to say that MRP = MR x MP
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MRP and MFC • In competitive factor markets (e.g. perfect competition) the marginal cost of the factor is simply the factor’s price, since the firm can hire any amount of factor at a given price (i.e. the firm is a price-taker) • Also, we know that in these markets, the firm’s MR is just the market price of the product, “P”. • Therefore, MRP = P x MP. • When wage is constant, MFC = wages
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Profit Maximizing Factor Use • The profit maximizing factor use involves setting MFC = MRP • The key is to.. – increase factor use if MFC < MRP – decrease factor use if MFC > MRP
• The profit maximizing output is the output where MRP is just above or equal to MFC • If the firm is a price taker in both the product and the factor markets then: MFC = w and MR = P. In that case, profit maximization can be re-written as w = (MP)*(P) or w = MRPL – This is assuming that P > AVC and therefore the firm does not shut down. – As well, by logic, w < Average Revenue Product of Labour.
• The rule of rational life: increase an activity if the gain from the increase is greater than the cost of increasing the activity (and 65 vice versa).
EXAMPLE! Find the profit maximizing level of employment by calculating MRP and MFC MRP = P x MP Always use this formula when price is constant! L
Q
P
MRP
w
MFC
0
0
blank
blank
6
blank
1
10
2
2 x 10 = 20
6
MRP>MFC
2
18
2
2 x 8 = 16
6
MRP>MFC
3
24
2
2 x 6 = 12
6
MRP>MFC
4
28
2
2x4=8
6
MRP>MFC Profit MAX
5
30
2
2x2=4
6
MRP<MFC
66
Changes in Wage and Price • When
wages increase, MFC increases. This will cause a decrease in production, as well as labour use (employment). • On the cost graphs, MC and AVC shift up (due to their relationship to w) which causes a decrease in output per firm. • When wages decrease the opposite occurs.
• When prices increase, the MRP and ARP increase for each amount of labour (when the item they produce sells at a higher price, hiring one more person brings in more revenue then before). • The MRP and ARP curves shift up but there is no change to the cost curves (why would there be). • With a higher MR.DARP, it intersects MC at a later point and increases quantity per firm. 67 • The opposite occurs with a price decrease.
Factor-Price Demand Elasticity • Elasticity measures responsiveness. I.e. factor-price elasticity could measure how responsive employers will be to wage increases or firms will be to factory-leasing prices. • This elasticity will be higher (firms more responsive) if: – The lesser the effect of diminishing marginal product (if MP is not decreasing fast, then hiring the next unit makes more sense than if the next unit MP decreased rapidly). – The easier substitution is (if I can replace you with a machine and wages go up, I just might… so watch out). – The more important (or the larger its effects on your costs) it is. I.e. if labour represents the bulk of your costs and wages increase, then costs will go up hugely, therefore decreasing quantity by a large amount. 68
Market Factor Supply • Market factor supply depends on a variety of things: land (fixed, but fertile is not), labour (based on participation rates and population), capital (increases/decrease based on net investment vs. depreciation). • Market factor supply can be measured on three levels: for the economy, for the market, and for the firm. – Individual firms commonly face perfectly elastic supply, even though overall factor supply for the economy or industry may be relatively inelastic. (The more narrow the definition the more elastic supply is.)
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Factor (Labour) Mobility • Refers to the ease with which factors can be transferred between uses (how easy it is for me to do another job) • Increases the elasticity of supply (i.e. a little change in wage will cause workers to move to different areas) • Increases with time (i.e. more time = more mobile) • Ensures that wage differentials reflect – – – –
Different costs of acquiring skills Different working conditions Different quality inputs (intrinsic differences) Demand changes in SR but not in LR
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Chapter 19 Earnings and Discrimination
71
Earnings and Discrimination • In an equilibrium market, the wage paid to a worker equals his or her marginal contribution to production • If you work as a wall street trader, a lot more is required from you, so you should get paid more than someone working at McDonald’s
• Temporary Factors as well as Long-Run changes in equilibrium can affect earnings levels. • The changes from equilibrium are caused by intrinsic differences in the factors themselves as well as the cost of acquiring skills 72
Factor Price Differentials • Temporary differentials in factor prices are caused by shifts in labour supply and demand. • These differentials balance themselves out by the chain reaction of effects that occur after the market disruption • If a differential exists while in equilibrium, it will stay there (If we’re in equilibrium, we’re doing the best we can, so there’s a good reason some factors are valued more)
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Temporary Differentials in Factor Prices Example • Simple laws of supply and demand! – An increase in the demand for labour to make cocaine will push up its wage. Firms need more people, so they’re willing to pay more as an incentive. – People in comparable industries (let’s say crack) will leave to earn more dolla billz, which lowers the demand in their market. – As more people go to make cocaine, the wage paid to produce it goes down (Excess supply of labour; no way can we afford benjamins for all these people) – People who still make crack will see their wages go up (Excess demand for labour at their low wage) – As wages adjust to demand in both markets, the differential disappears. 74
Compensating Differential • Difference in wages that arise to offset the non-monetary aspects of jobs – Getting paid more for high risk or unpleasant jobs
• Factor price differentials that exist in equilibrium are known as compensating differentials, because they compensate for parts of a job you can’t put a dollar amount on. 75
Ability, effort, and chance • Basically, you gotta have skills • If you can provide a higher marginal product level than your competition, you should be paid more
• But then there’s Chance – Technological progress eliminates demand for some industries and increases it for others • Eg. Who would want to buy a disc man these days?
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Education and Earnings • Education is a measure of ability – If you go to university and get your degree, you have a greater level of ability in that area than someone who just left high school
• Education is also Privately valuable – It benefits the individual who earns more dolla billz, and the employer who has a more educated worker, but that’s it.
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Above-Equilibrium Wages • Above Equilibrium wages can result when there is market interference 1 Minimum Wage Laws •
Creates a price floor above equilibrium
2 Unions •
Can negotiate their wages to higher than their value
3 Efficiency Wages •
Firms can pay individuals more as an incentive to be more productive 78
Discrimination • Offering of different opportunities to those who differ only by personal characteristics • There has been a ton of research on the topic, and the exact causes of wage differences are still not clear • Firms that discriminate hurt themselves in the long run
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Example • Suppose I make hats, and I can hire men and women to do this, but I hire more men than women. – The demand for women in my labour market goes down.
• The decrease in demand lowers the wage for females, giving other firms incentives to hire them. The discriminating firm ends up paying higher wages than the nondiscriminating firm 80
Graph
The wages paid for Females are a lot lower than men, so firms that hire women will earn a greater profit than those that discriminate.
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Government Discrimination • Governments that discriminate against individuals prevent the market from correcting factor wage differentials • Therefore, a permanent wage differential only exists in competitive markets if the firms discriminate, or if the government discriminates. 82
That is the END! If you have any individual ques?ons feel free to come to the front now! THANK YOU SO MUCH FOR A GREAT TERM! The Dream Team will be returning for EC140. So keep your eyes open for upcoming sessions GOOD LUCK ON YOUR FINAL!! 83
BONUS! Great Summary Chart
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