Circular Flow of Income

 In order to develop a simple short-run model of the economy, we make the following assumptions:

·         That technical knowledge and resources are fixed in the short run

·         That there is a fixed relationship between output and employment

·         There is no international trade

·         There is no government sector; ie there are no taxes and no government expenditure

·         Firms distribute all profit to their owners (households) immediately when it is earned

·         All investment is carried out by firms

·         All prices are constant, so that any change in numeric GNP is caused by a change in real GNP.

 

Firms produce all consumption goods and services, which are purchased by households. Households own all factors of production (resources) – labor, land, capital goods, etc. – as well as the firms themselves. This results in a circular flow of income.

 The national output (GNP) is the flow of all final goods and services in an economy within a given period. The Net National Product (NNP) is GNP less depreciation, or in other words the level of output above and beyond that which would be required simply to maintain the existing stock of capital goods. In calculating GNP and NNP, only final goods and services are included. Intermediate goods, which is to say goods that are used in the production of other goods, are not included, because otherwise double-counting would occur.

 GNP can be calculated in three different ways:

·         By finding the total expenditure on final goods and services

·         By finding the value added by each producer

·         By finding the total income earned by each factor of production

 In practice, it can be quite difficult to make the determination between final and intermediate goods. The second method may be easier because it only requires knowing the value of output and the value of factor inputs for each firm in the economy. The final method is perhaps the easiest, since it is a simple sum of all household incomes.

 Inputs to production include primary factors and intermediate goods. Intermediate goods are those factor inputs that were produced in the current period. All other inputs used in the current period are primary factors. Labor input is a primary factor, as are (most) buildings and machinery. The income paid to owners of primary factors must be financed by a firm’s sales and are normally classified as:

·         Wages and salaries – paid in exchange for the use of labor services

·         Rent – paid in return for the use of land and capital goods not owned by the producer

·         Interest – paid to the households who have loaned money to purchase land and capital

·         Gross profits – residual money accruing to the firm after payment has been made to all other factors, usually distributed in the form of dividends to the households that own the firm

 The sum of payments by a firm for primary factors and intermediate goods will equal the firm’s receipts from sales. As a result, the value added by the firm is equal to the sum of payments to primary factors, because this will equal sales (total value of production) less payments to intermediate goods (value that came from somewhere else). Since GNP equals the sum of producers’ value added, GNP is also equal to the sum of producers’ payments to primary factors of production (GNP=GNI).

 The equivalency between GNP and GNI depends on the definition of profits as a residual amount obtained after deducting the value of all other inputs to production; and on the assumption that all profits are immediately distributed to households. In the real world, these assumptions may not hold.

 Given that GNP=GNI, it follows that the income received by households must be just sufficient to purchase all output produced by the economy. It would seem that by the act of establishing a firm and producing output, sufficient income must thereby be produced so that the firm’s output can be paid for. While this is true, it is not guaranteed that this new income will result in effective demand for the firm’s goods. Some income might not find its way into expenditure at all, at least in the short run.

 The level of output that can be sustained is therefore dependent on the level of expenditure or effective demand. Potential output sets the limit to the level of income and expenditure possible, but actual output may fall short of this limit. The short run theory of income determination sees acual output as dependent on effective (aggregate) demand.

 Households engage in two activities, consumption and savings. Consumption (C) consists of expenditure on goods and services to satisfy current needs or wants. For the purpose of this simple model, we shall ignore the problems raised by consumer durables (like cars), which yield a flow of services over time. Savings (S) is whatever income is left over after C. It follows that gross national income (GNE aka Y) = C+S.

 Firms also engage in two activities, investment and production. Production occurs to satisfy the consumption demand of households and is in equilibrium only when it is equal to that expenditure, so it is also represented by the symbol C. Investment is the production of goods and services which are not used for consumption purposes. There are two main categories of investment: Inventory and capital goods. Buildup of unsold inventory is a form of investment; reduction in inventory is a form of disinvestment. Some investment in capital goods is required just to maintain current levels of production, but additional investment over and above this amount will result in increased productive capacity in the future. Investment expenditure is given the symbol I. Total output will equal C+I. Total output is GNP, which is equal to Y, so: Y=C+I.

 If Y=C+I and Y=C+S it follows that I=S. Investment and savings are defined in such a way that they must be equal. This does not mean that planned saving always equals planned investment; quite the contrary. However, by the definitions of the model, actual savings is the amount of money that will be available for acual investment and thus the two will be equal. If planned investment is lower or higher than planned savings, firms will find themselves encountering an unplanned investment or disinvestment.

 If all income were consumed, then all value added (output) would accrue to private households through factor incomes, and all factor incomes would be used by households to purchase consumption goods and services from firms. In such an economy, supply would create its own demand, as all income would be consumed. There would be no withdrawals or injections to the circular flow of income, so that any flow of national income would continue in an indefinite equilibrium, with no tendency for GNP (or GNI or GNE) to change. This of course assumes a fixed capacity output, but this is a short-run model. In reality, if all income were to be consumed, the stock of capital goods would decline and output would be reduced.

 In practice, most economies save and invest a proportion of national income, as shown in the diagram above. Savings are not passed on in the circular flow of income, but constitute a withdrawal from it. In other words, savings do not constitute a component of aggregate demand, because the act of saving does not generate a demand for current output. Investment, on the other hand, is an injection into the circular flow of income. It is part of aggregate demand because the act of investing (buying more capital goods) does indeed generate a demand for current output.

 Any withdrawal has a contractionary effect on the level of national income. Any injection has an expansionary effect. Equilibrium can only occur when the contractionary and expansionary effects are in balance, or in other words when there is consistency between the savings plans of households and the investment plans of firms. If planned savings and planned investments are equal, the economy will be in equilibrium. If they are not equal, the economy will be in disequilibrium and must expand or contract until the plans again come into balance. In the equilibrium diagram above, households elect to save 10% their income. If households change their plans and choose to save twice that amount (20%) then the economy will be in a contractionary disequilibrium:

 Under these conditions, and if there are no changes to the planss of investors or savers, national income will fall. In the earlier, equilibrium model, aggregate demand (Y) was equal to $100 billion, equal to C ($90 bln) + I ($10 bln). Now, C has fallen to $80 billion with I unchanged at $10 billion, resulting in aggregate demand (Y) or $90 billion. The sales reciepts of firms will have fallen accordingly. As a result, firms will not be able to sell all the output produced, so there will be an unplanned increase in inventories. Inventories will continue to increase so long as output is maintained at the original level. Soon, firms will react by reducing the level of output. Assuming that firms  continue to plan to invest $10 billion, and households continue to plan to invest 20% of their income, a new equilibrium will be established:

 

The result of Y=$50 billion is a result of the savings plans of households. If firms output Y by a lesser amount, say to Y=$70 billion, then households will plan to save $14 billion, which is still higher than the investment plans of firms. A new equilibrium will not be reached until the savings plans of households again equal the investment plans of firms. There is a multiplier effect in evidence here: A change of $10 billion in the savings plans of households has caused a change of $50 billion in GNP.

 The motives for households to save and for firms to invest are quite different. Households save so that they can buy expensive goods in the future, or to protect against becoming unemployed, or to leave wealth for their children, or through sheer miserliness. Firms invest in the expectation of profits, and the volume of investment is clearly a function of the availability of profitable investment opportunities. But even when investment opportunities are poor, households will still wish to save. Because of these divergent motives, there is no guarantee that the plans of savers and investors will be consistent, even in the short run with which this model is concerned. For this reason, the level of national income realized can and does depart from full employment income.

Output and Inflation, Inflationary Bias, Properties of the Phillips Curve

 Output and Inflation

 Aggregate demand determines the actual output of goods and services produced. Given a fixed potential output for any short-term period, aggregate demand will thus determine the unemployment rate. In the simple model used above, when aggregate demand exceeds potential output, an inflationary gap exists and the price level rises. However, in the real world, inflation occurs at or below full employment.

 The inflation rate for a given time period is the per year change in price level: INF_T = (P_T+1-P_T)/P_T. The price level represents the overall price of all goods and services taken together. The most commonly cited measure of the average price level is the Consumer Price Index (CPI). This provides an index of typical consumer products purchased by average households. However, it does not take into account the roughly one-third of total output represented by investment expenditure. The price level index which includes all goods and services in the economy is called the GDP deflator.

 Most firms set their prices based on the anticipated costs of production and the anticipated demand for the goods and services produced. These expectations are based on past performance, economic indicators, and the thought processes of managers. The most recent level of aggregate demand is one of the key factors determining these expectations. The higher aggregate demand, the higher the firm’s own recent demand is likely to have been, and the higher its expectations of future demand. In addition, the higher the aggregate demand, the higher the firm’s expectations about the cost of labor, materials and other factor inputs. As a result, the higher recent aggregate demand has been, the higher a firm is likely to set its prices. If all firms operate in this fashion, then the rate of increase of the price level will be directly and positively related to the level of aggregate demand.

 In any short run period, therefore, aggregate demand will influence both the unemployment rate and the inflation rate. As a result, there will be an implied relationship between unemployment and inflation. For each possible level of aggregate demand, there will be corresponding rate of unemployment and of inflation. The graph of unemployment against inflation for a varying level of aggregate demand in the short run is called a Phillps Curve:

In the real world, the constraint that Y cannot exceed Q is somewhat relaxed, because of the way we have defined full employment. Facing demand exceeding Q, some fatories and workers can work overtime and the average frictional and structural rates of unemployment will fall because there are so many unfilled vacancies.  Thus the economy in the short run can ‘squeeze’ some extra production out of its resources. However, the cost of this economic ‘boom’ is that factor prices will rise and consequently the price level will rise at a rate higher than normal. This is represented by the increasing slope of the Phillips Curve as unemployment goes above U_F.

 One might expect inflation at full employment to be zero, because at over-full employment, scarcity of factors of production will lead to rising demand and thus rising prices; at under-full employment, abundance of factors of production will lead to reduced demand and thus reduced prices; and at exact full employment, demand and supply will be in equilibrium, resulting in stable prices. Empirically, however, the position of the Phillips Curve has been such that some positive rate of inflation occurs at the full emploment rate of unemployment. This is caled the inflationary bias.

 Inflationary Bias

 The labor market is quantitatively the most important factor of production, since it accounts for roughly two-thirds of all income payments by firms. The ‘labor market’ is in fact many different markets, as workers are specialized in many different skills. At any given time, there will probably be some skills that have excess demand while other skills have excess supply. All these markets operate imperfectly, in the sense that wages do not adjust immediately to equate supply and demand. This is particularly evident in many markets where there is excess supply; wage rates are observed not to respond to the downward pressure. Wage rates appear to be ‘sticky’ in the face of high unemployment.

 Many reasons are given for this observation. One is that in many labor markets, wages are determined by collective bargaining between unions and management, sometimes for an entire industry. The political nature of union decision-making is such that a reduction in wages is exceedingly difficult to obtain, regardless of economic circumstances. A reduction in wages makes everyone somewhat worse off. However, a failure to reduce wages makes certain people (those laid off) much worse off, to the benefit of others (those who keep their jobs). If the economic downturn is anything short of catastrophic, less than half the workers are likely to be laid off. If the workers have a good idea who will be axed, then the majority of workers, voting in their own self-interest, will elect to keep their current wages. In addition, those workers with the most seniority are the least likely to be laid off, therefore the most likely to oppose wage reductions—but this group of people are also likely to hold the most influential positions within the union. Another explanation is that given that the government will pay unemployment benefits for a while, a typical worker may be better off accepting work at a high wage in the knowledge that there will be occasional layoffs, than accepting work at a lower wage that continues indefinitely.

 This rigidity does not occur in the upwards direction. Workers are always generally happy to accept more money. As discussed previously, full employment does not mean zero unemployment. It is still possible (even likely) that under full employment, some labor markets will have excess demand while others will have excess supply. In markets with excess demand, wages can be expected to rise relatively quickly, but in markets with excess supply, wages will only fall slowly, if at all. Firms which face excess demand for labor will expect their costs to rise and will therefore set higher prices. However, firms which face excess supply of labor will not have a reasonable expectation of falling costs, and will therefore leave prices unchanged. This will result in an increase in the average price level.

 If unemployment rates are high enough, the downward pressure on wages will be sufficient to overcome downward wage rigidity and wages and prices will fall. There have been very few occasions where this has occurred; the most striking example is the Great Depression in the 1930s, where, in the face of extremely high unemployment rates, the inflation rate was negative for several years on many countries.

 Properties of the Phillips Curve

 The Phillips Curve has another important property: It is not linear. Its curvature suggests that the nature of the trade-off between inflation and unemployment depends on where the economy currently falls on the curve. At high rates of unemployment, the curve is relatively flat: It takes a large increase in unemployment to effect a small increase in inflation. At lower rates of unemployment, a small change in unemployment will result in a much larger change in inflation.

 This can be explained as follows: If the initial condition is high unemployment, then most labor markets will be characterized by excess supply and very few by excess demand. If unemployment increases, the excess demand in those few markets will be reduced, so those few firms will still increase their prices but not by as much as they would have otherwise. However, the downward rigidity of the labor markets already experiencing excess supply will be such that the firms operating in those markets will not change their prices. As a result, the change in the rate of inflation will be small. However, if the initial condition is very low unemployment, most labor markets will be characterized by excess demand and very few by excess supply. If unemployment increases, the upward pressure on wages will be decreased, perhaps sharply in those cases where the initial excess demand was severe. Since very few labor markets were in excess supply conditions, most firms will still expect an increase in labor costs, but less (possibly much less) than previously. As a result, price increases for the majority of firms will be less than they would have been, and there will be some firms which might otherwise have set very sharp price increases who no longer need to do so. The reduction in the rate of incrase of the average price level will be very noticeable.

 The existence of a Phillips Curve causes a problem for government policymakers. A choice must be made between the evils of unemployment and of inflation. Policy tools that affect aggregate demand cannot be used to fight inflation and unemployment at the same time. If aggregate demand is controlled to achieve full employment, some inflation will generally result. If aggregate demand is controlled to eliminate inflation, high unemployment will generally result.

Employment vs. Inflation in the Long Run

 The Phillips Curve is a short run relationship. In the long run, the Phillips Curve can shift its position and change its curvature. Thus, the rate of inflation in the long run depends not only on where on the Phillips Curve the economy is operating, but also where the Phillips Curve is positioned. The fact that the Phillips Curve can shift over time causes some difficulty in interpreting historical data, because it is hard to know whether any given change reflects a shift in or a movement along the Phillips Curve. A moving Phillips Curve can result in a situation where unemployment and inflation move in the same direction. This has caused some to conclude that there is no Phillips Curve. It is important to remember that the Phillips Curve is a short run relationship.

 However, short-run decisions should not be made in the absence of consideration of their long-run impacts. It might be possible, in normal situations, that high unemployment and low inflation today might permit preferred combinations of unemployment and inflation that would not have been possible otherwise. In such situations, the appropriate sort-term policy goal might be to choose an aggregate demand target below potential output.

Demand Deficient Unemployment

 Once all the factors causing ‘full employment unemployment’ are taken into account, any additional unemployment left over must be the result of too little aggregate demand. This is called demand deficient unemployment. Demand deficient unemployment occurs when the number of people unemployed (U) is greater than the number of unfilled job vacancies (V). If accurate values could be determined for U and V, full employment could be defined as occuring when V >= U. Unfortunately, even though reasonably good unemployment data exists, the number of job vacancies is difficult to determine—many job vacancies are never advertised, and sometimes managers may even disagree over whether a particular vacancy exists or not! For this reason, full employment is usually taken to be some set target  rate of unemployment. The full employment rate of employment varies over time for any one country and varies substantially between countries.

 If we know that the economy is operating at full employment, then actual (Y) and potential (Q) output will be equal. When this occurs, we can measure the potential output of the economy. It also follows that the larger the gap between Y and Q, the higher will be unemployment. The output gap, as a percentage, is equal to (Q-Y)/Q x 100. Arthur Okun has conducted research on the empirical relationship between the unemployment rate and the output gap and has found a stable relationship for a 25-year period in the U.S. economy, starting in the late 1940s, with the following equation, known as Okun’s Law:

 

In other words, for each 3% that actual output falls short of potential output, the unemployment rate will exceed the full employment rate by 1%. So if Y is 12% below Q, U will be 4% above U_F. Looking at it another way, Okun’s Law states that for every 1% additional unemployment, 3% of potential output is lost and gone forever.

 Since Okun’s Law was formulated in 1962, further empirical evidence has suggested that the parameter value of 1/3 is not immutable. However, the law provides a reasonable measurement of the loss in real output attributable to demand deficient unemployment.

 

Factors Determining Unemployment

 The most important factors determining the level of frictional, structural and seasonal unemployment are:

Level of Economic Activity – When actual output is close to potential output, employers will face a competitive labor market. Employers will be more likely to advertise and to spend on recruiting. Employers will also likely offer better retraining programs and relocation assistance. These measures will reduce structural unemployment. When unemployment is high, companies will have an easier time finding employees to hire and will be less willing to pay for this type of program.

Transmission of Information – Jobs cannot be filled unless job-seekers can find out about openings and hiring managers can find out about candidates. The more effectively the information is transferred, the lower frictional (and to some extent structural) unemployment will be.

Structural Change – The overall composition of the goods produced by an economy changes with time, as tastes change, new products are invented, world trade patterns move production of particular goods between different nations, etc. Sometimes it changes quickly, sometimes slowly. If structural change is occuring at a rapid pace, the number of people unemployed due to having the wrong skills or living in the wrong location will tend to be higher.

Workforce Mobility – The easier it is to change location, and the easier it is to gain training in new fields, the lower structural unemployment will be. This will depend on factors such as the cost and availability of training, the cost of travel and moving expenses, the degree to which appropriate schools and hospitals are universally available, and so forth.

Institutional Restrictions and Barriers – Governments, trade unions and even employers will sometimes take actions designed to protect particular groups of workers. These actions reduce the efficiency of the labor market and lead to additional structural and frictional unemployment. Examples: restrictive union practices, required professional certifications, pension and medical plans tied to the job, or even local policies which favor existing residents over new arrivals.

Seasonal Industries – Some industries are seasonal by nature: Fishing, farming, forestry, tourism, construction. Despite the fact that predictable unemployment will occur in some periods of the yearly cycle, some economies have clear natural advantages in these industries and find it worthwhile to pursue them.

Potential Output in the Short Run, Potential Output in the Long Run

 If we could take a snapshot of the economy at a specific point in time, it would be possible to enumerate all available resources, both capital and labor, and calculate the maximum possible output if all resources were put to their most productive use. This is the potential output of the economy.

 If sufficient time, energy and resources were applied, the available human and capital resources of a nation can always be increased. In addition, more productive uses of resources can be devised (technological advancement). However, in the short run, it is reasonable to assume that these factors are fixed; i.e. potential ouptut is constant. Thus it follows that there must be a fixed upper limit to the amount of production possible. This leaves open the question of which products compose the potential output. In a two-good economy producing guns and butter (where guns symbolize military spending and butter symbolizes peaceful spending), if the economy is operating at potential output, it is only possible to produce more guns by producing less butter and vice versa. This creates a range of production possibilities at potential output. Any combination lower than potential output is possible, so this curve is a ‘frontier’ that shows the boundary above which additional production is not possible.

 

This graph can be shown to illustrate the microeconomic question of what to produce. At the point X on the graph, the production of B2-B1 additional butter requires the sacrifice (opportunity cost) of the production of G1-G2 additional guns. The opportunity cost is determined by the slope of the production possibility frontier. When society is operating at some point within but not on the frontier, it is possible to produce additional units of one or both goods with no sacrifice to production of the other good; ie, no opportunity cost. An economically rational society will therefore always desire to operate on the frontier.

 

The situation when attempting to decide if more of one good should be produced is different depending on whether society is on the production possibilities frontier. If the economy is currently operating below the frontier, then any decision to produce more of one good can be taken in the absence of information about other goods. However, if the economy is at the frontier, the decision must also include the opportinity cost of output foregone in the other good. The first major macroeconomic question is therefore whether or not the economy is operating on the frontier.

 A point like Z represents a situation that has been experienced from time to time by all major capitalist economies, for example during the Great Depression of the 1930s. Clearly it would be preferable to operate at point X or Y than at Z. There must be highly compelling reasons if a government enacts policies designed to keep the economy at point Z.

 Potential Output in the Long Run

 In the long run, the quantity and quality of labor and capital stock is not fixed; neither is the state of technological advancement. Certain items are relatively fixed over time, such as the amount of land area available. The supply of labor is heavily dependent on the population and its age structure, and by social customs like the common retirement age, the number of hours worked per week, the extent to which people participate in the labor force, and so forth. These are demographic features that change only slowly. Other items can change relatively rapidly in the long run, such as the number and type of factories operational, improvements in technology, and the training of particular segments of the workforce.

 The second major macroeconomic question is: What determines the rate of growth of potential output through time?

 The ultimate objective of economic activity is consumption, which is the present enjoyment of material goods and services. If a society uses all available resources to satisfy present consumption, then no further resources will be available to countract the inevitable decline in productivity of existing capital and labor as machinery gets older and requires more maintenance, as training is not renewed so professional skills diminish, etc. Some level of expenditure on capital goods is required simply to maintain the current level of potential output. If more than this is spent, then potential output will increase. Net investment is equal to the total spent on capital goods, less the amount required simply to maintain current levels. A production possibilities frontier exists between capital formation and current consumption, similar to the one shown above with guns and butter. In order to maintain or increase productive capacity, society must operate at a point on the graph (presumably on the frontier) which is above the replacement investment level on the vertical axis. The vertical distance between this line and the actual operating level will determine the net gain or loss in potential output over time.

 Small differences in growth rate are of substantial importance to the material standards of living. At a growth rate of 2%, standards of living double every 35 years, but at 4% they double every 18 years. The rule of thumb to get the number of years between doublings is to divide 70 by the growth rate.

Aggregate Demand

 GNP is purchased by four groups. The sume of the expenditure of the four groups is known as aggregate demand. The four groups are:

·         Consumers (households)

·         Firms

·         Government

·         International (foreign households, firms and governments)

 This is represented by the equation: Y = C + I + G + X – Z, where:

-          Y = aggregate demand, aka GNP, GNI, GNE

-          C = consumption expenditure

-          I = investment expenditure

-          X = production of export goods

-          Z = expenditure on import goods

Balance of Payments

 A nation’s balance of payments is a complex set of accounts. There are three major accounts involved:

 ·         Current Account (aka Trade Account): Imports and exports of goods and services.

·         Capital Account: Records all trades which affect the amount of claims the nation has abroad, both for and against. Or in other words, all borrowing and lending activity.

·         Official Settlements Account: Records the changes in currency reserves held in all foreign currencies.

 These three accounts sum to zero. The total import and export activity, plus the net effect of borrowing and lending, must equal the change in currency reserves. The term “balance of trade deficit” refers to the current account, and the term “balance of payments defecit” refers to the capital account. A balance of payments defecit can be thought of as the excess supply of a country’s currency—this is the amount of foreign currency that the government must buy if the exchange rate is to be preserved. If the government does not act, a defecit in this account will result in a currency devaluation.

 The total value of world trade is more than 3 trillion dollars a year, but this is a small amount compared to the total value of worldwide currency trading. If currencly fluctuations only occurred as a result of trade, currencies would be quite stable. However, currencies are not stable, because fluctuations also occur due to currency trading that has nothing to do with goods or services trading. For example, if our interest rates are higher than another nation’s, then citizens (and fund managers) in the other nation can improve their returns by buying our currency. Expectations about the future appreciation or depreciation of our currency will also make it more or less attractive to buy. As a result, it is very difficult to predict how exchange rates will change with time. Note that the supply of our currency will affect these expectations and so the supply and demand of our currency are not entirely independent.

Foreign Exchange

 When an individual in one country wants to buy products from another, they must first buy some of the currency of the other country. The exchange rate between country A and country B (in a two-country model) is the same as a price in any competitive market. The demand curve for A’s currency is determined by the people who want to buy products produced by A, and the supply curve is determined by the people from A who want to buy products produced in B. As the exchange rate fluctuates, goods produced in country A will seem more or less expensive to residents of country B and vice versa, altering the quantity demanded and supplied. This is called a flexible exchange rate.

 Some countries adhere to a fixed exchange rate policy, under which the governments of the nations involved agree to buy or sell enough of the currencies involved to keep the exchange rate at an agreed-upon value. The governments involved must add or subtract to demand and supply by amounts just sufficient to push the intersection to the price point desired. This involves adding to or subtracting from a currency reserves account, which will eventually run out of money. So fixed exchange rates cannot be maintained under all conditions.

 The movement from fixed to flexible exhange rates was actually intended to stabilize prices. Under fixed exchange rate policies, large devaluations and revaluations occurred by when the official exchange rate was altered by government fiat. However, stability has not emerged. This is because the demand for a country’s currency does not depend exclusively on that nation’s exports.

Support for Trade Restrictions

 There are some economically valid arguments in favor of trade restrictions. The major ones are:

 -          Infant Industry: Developing nations need to protect their local industry until it can grow to a scale where it is able to compete internationally.

-          Dumping: Dumping is the practice of selling goods in a foreign market at a price lower than that which prevails in the domestic market. The intent is (presumed to be) to drive domestic producers out of business, after which a price hike can be expected.

-          Countervailing Duties: If goods are produced in a nation where the industry is subsidized, and then sold in a nation where no such subsidy exists, then domestic producers will be at a competitive disadvantage to imports from the subsidizing nation. Where such an imbalance exists, it is acceptable to impose a tariff intended to just equal the advantage provided by the subsidization.

-          Squeaky Wheels: While on average everyone benefits from free trade, individually some people lose badly—because they are laid off, or their business cannot compete, or what have you. It is difficult to build a political organization a large number of small gainers, but it is relatively easy to build a political organization around a small number of big losers; say, unemployed steel workers in Pennsylvania. While theoretically it is possible for the losers to be compensated from the benefits of the gainers, in practice this rarely (if ever) happens.

Tariffs and Quotas

 Tariffs and quotas are sometimes imposed to “protect” domestic industry from international competition. The effect of a tariff is similar to any other unit tax: The supply curve price at all quantities is raised by the amount of the tax.

 From an economic viewpoint, the protection of domestic industry through tariffs and quotas is a poor notion. The resources used to produce goods domestically must be drawn from other industries, so domestic production is no better than it was. At the same time, the country against which the tariff was imposed will now have less of our currency to trade back to us for our goods. Everyone eventually suffers by paying more for both domestically produced and imported goods, and total world production is reduced. In the short term, workers in the “protected” industry benefit because they do not have to be retrained. But the rest of society is subsidizing these workers at many times their wages/salaries. It would be cheaper to pay them not to work.

 A quota is a somewhat different situation. In this case, there is no tax revenue for the government. The supply and demand curves do not change. However, the quantity exchanged is forced to a point below equilibrium. (If this were not the case, there would be no reason to impose the quota.) As a result, trade occurs at a quantity where the price at which suppliers are willing to sell is substantially lower than the price at which purchasers are willing to buy. Importers make out like bandits because they can buy at the low “supply” price and sell at the high “demand” price. Some method will have to be found to allocate the quote between different importers.

 If an importer can negotiate an exclusive agreement to supply the domestic market with the entire quota of goods shipped from the foreign producer, then a question of economic rent arises. If the best use of the goods is to export up to the amount of the quota, then the next best use is to sell the goods locally in the country of origin. The amount by which the demand price exceeds the supply price, times the quantity of the quota, is the economic rent of the goods. The importer and the supplier will have to negotiate who gets what percentage of this amount.

 From a consumer point of view there is no difference between a tariff and a quota so long as they result in the same final price. The main difference is that under a tariff, the government gets all the extra money; but under a quota, the money will wind up in a combination of the foreign manufacturer, an import business, and perhaps the government if it insitutes some sort of program like selling quota allocations to importers for a fee.

Absolute Advantage, Comparative Advantage

 Absolute Advantage

When countries cannot produce desirable goods at all, the advantages of trade are obvious. For example, Britain is too cold to produce coffee, but posesses reserves of oil in the North Sea. Jamaica, on the other hand, can easily grow coffee, and has no domestic petroleum. The mutual advantage of trade between Jamaica and Britain is obvious.

 In other cases, the advantages might be less obvious but are still present. For example, Germany and France are similar-sized economies, with similar social and climatic conditions and natural resources. Both nations manufacture automobiles. However, Germany posesses factories and specialized labor for the production of expensive, high-performance luxury and sports cars like Porches. France, on the other hand, posesses factories and specialized labor for the production of inexpensive, everyday cars like Citroens. Producing an additional Porshce in Germany is much cheaper than establishing a whole new production line in France. Germany has an absolute cost advantage in the production of Porshces. Similarly, France has an absolute advantage in the production of Citroens. It is to Germany and France’s mutual benefit to trade Porches for Citroens for the same reason that Jamaica and Britain would trade coffee and petroleum.

 But what if France has unemployed resources? Wouldn’t it be better to put the unemployed resources to work building high-performance cars within France? The answer is no: In the two-country example, ceasing imports of Porsches will also cause exports of Citroens to fall.

 Absolute advantage also explains the movement of resources across national boundaries. Where an absolute advantage exists in a given industry, and where resource movement is possible, resources will tend to move to where they can find the most productive employment.

 Comparative Advantage

 It is also possible for two nations to trade to mututal benefit where one nation has no absolute advantage over the other in the production of any good, so long as a comparative advantage exists. David Ricardo showed that a poor country without any absolute industrial advantage can still trade to mutual benefit with a rich country.

 Given the following assumptions:

 (a)    Both the United States and India produce only two goods, wheat (food) and burlap (clothing).

(b)   Labor is the only variable factor of production, but its productivity differs in each country.

(c)    In each country, the productivity of labor is constant respective to the scale of production.

(d)   Labor in each country is fully employed.

(e)    There is no migration of labor between the two nations.

(f)    Although output per man-hour is greater in the United States than in India for both products, the productivity gap in wheat is not proportional to the productivity gap in burlap.

 Also suppose the following schedule:

Product	Hours of labor in United States	Hours of labor in India
1 Bushel of Wheat	1	10
1 Meter of Burlap	2	10

 The United States is absolutely more efficient in both products. However, it takes 10 times as much effort to produce wheat in India than in the U.S., but only 5 times as much effort to produce burlap. India has a comparative advantage in burlap and the U.S. has a comparative advantage in wheat.

 If I live in the U.S. and I want a meter of burlap, I can pay the value of 2 hours of labor and buy one locally. Alternately, I can pay the value of 1½ hours of labor for 1½ bushels of wheat, which I trade to India for a meter of burlap. This is to India’s benefit since wheat and burlap cost the same on Indian market. I now have my meter of burlap for less than it would have cost to produce locally, so I have benefited.

 If two countries engage in mutual trade where a comparative advantage exists, the actions of independent traders will tend to establish a market price for different goods. In the example above, we start out with a bushel of wheat worth 1 meter of burlap in India, and 2 meters in the U.S. As trading occurs, the U.S. will specialize in wheat and India will specialize in burlap, and eventually the relative prices will be equal in both markets. Without knowing more about the preferences of consumers, all that can be said is that the price ratio will be somewhere between 1 and 2. As long as the ratio is different in the two countries, there will be an incentive for trading and specialization to occur that will tend to move the ratio closer to equal.

 Each country has a production possibility frontier that shows the efficient combinations of wheat and burlap that can be produced in that country. It is also possible to draw a production possibility frontier that shows the efficient production possibilities across both countries. This frontier will show that specialization allows greater total production between the two countries than they would have been able to achieve acting independently.

Income Distribution

 Economic efficiency can exist in a world of 2% millionaires and 98% paupers. Economic efficiency maximizes total social good, but says nothing about how well off individual families are. The average income of each family will be the nation’s GNP divided by the total number of families. However, the actual income of any individual family depends not only on this number but also on how much of a claim that family has on the nation’s output.

 The income earned by factors of production are wages and salaries paid for labor, interest and dividends paid to the owners of capital, and rent paid to the owners of land and mineral resources. In all capitalist countries, labor earns by far the highest proportion of national income. While each individual has the same amount of time to offer prospective employers per week, the price for wages which different individuals can command varies enormously.

 The demands for goods and services determine the demands for the factor inputs required to produce them. The supply curve of factors of production is determined by resource owners’ willingness to sell at various prices. Ignoring immigration, the supply of labor in any given country at a given wage rate is the number of people willing and able to work at that wage rate. The equilibrium wage rate for a given type of worker is determined by the demand and supply curves for workers of that type.

 A profit maximizing firm will hire labor or any other resource up to the point where the marginal benefit of that resource equals its marginal cost. The marginal benefit of a resource is the change in revenue which would result from hiring one additional unit. The value of marginal product (VMP) curve shows the marginal benefit at each level of employment of a resource. The point where the VMP curve crosses the going price for the resource is the point where the firm ceases to employ more resources; i.e. the VMP, or marginal benefit, has become equal to the marginal cost.

 If a worker wants to increase his income, he can either increase his VMP by investing in additional training or skills development; or he can reduce his consumption expenditure and become a resource owner, thus deriving income not only from the product of his own labor but from the profits of firms as well. His income might also increase (or decrease) if the relevant demand or supply curves shift, but he has no control over this.

The Voting Paradox

 Three people, A, B and C go to a restaurant. They are told that their dinners will be half price if the all order the same thing, and they all agree to do so. The choices are chicken and steak. The three vote, and steak wins 2 to 1. So steak is chosen.

 However, the waitress then informs the group that a third option exists: Ham. The group votes again, listing the three choices in order of preference. The results are: SCH, CHS and HSC. The textbook claims that this means you will select chicken because: “In the original steak/chicken choice you chose steak. However, we now see that ham is preferred to steak. Thus steak is out. However, in comparing chicken with ham, chicken is prefered to ham, so ham is out. Yes, you finish up selecting chicken!” This is obvious nonsense, since all members of the group would not agree to order chicken at that point. The person who voted for steak would make known that in comparing chicken with steak, steak is preferred. What has resulted is not a paradox but a simple tie, no different from what would happen if each person voted simply for their preferred meal and the votes came out: Chicken, Ham, Steak.

 

Various methods of voting can result in various “undesired” outcomes. Example: In 1992, Bill Clinton won the sufficient electoral college votes to become President. However, it is speculated that this occurred only because the conservative vote was split between George Bush and Ross Perot. If Perot had not run, George Bush might very well have won the election.

 Under a parliamentary system, the final membership could wind up with 101 seats Liberal, 99 seats Conservative, and 4 seats Reform. Whenever the liberals and conservatives disagree in a vote, the Reform party wields power completely disproportionate to its representation.

 

Perfect Competition, Monopoly, Imperfect Competition , Monopolistic Competition, Oligopoly

 Perfect Competition

 Perfect competition assumes that consumers are rational utility maximizers, know their own tastes and preferences, and have perfect information on prices and other characteristics of goods and services; and that firms are rational profit maximizers, produce homogeneous, identical goods within each industry, face no restriction moving into or out of an industry, and have perfect information on the opportunity cost of all resources. Both consumers and firms are price takers; there are such a large number of both that their individual actions have a negligible effect on the price and quantity exchanged in the market.

 Each individual firm under perfect competition faces a perfectly elastic demand curve: Each firm can sell all the output it can produce at the going price, but it cannot sell any output at higher than the going price and has no incentive to sell any output at lower than the going price. This means AR=MR=Price. The firm cannot control price, so it controls quantity and chooses to produce the quantity that maximizes profit, which is the quantity where MC=MR (=AR=Price). If, at this quantity, the price is higher than the average total cost, then excess profit exists and resources will move into the industry, shifting the supply curve to the right and reducing price and profits. Resources will continue to move into the industry until ATC=MC (=MR=AR=Price). If below normal profit exists, then resources will move out of the industry, shifting the supply curve to the left and increasing price and profits. Resources will continue to move out of the industry until ATC=MC.

 Economic efficiency requires that the ratio MU/MC be equal for all goods. Under perfect competition, utility maximizing consumer behavior will ensure that MU/P is equal for all goods, and the behavior of profit maximizing firms will ensure that P=MC for all goods. Therefore, MU/MC will be equal for all goods, and economic efficiency will be achieved.

 Monopoly

 A monopolist is a producer who supplies the complete market for a good or service. Barriers to entry prevent new firms from entering the market. Barriers to entry could be patents, legal protections, or financial disincentives such as economies of scale.

 Since a monopolist is the sole provider, the firm’s marginal cost curve (which is the firm’s supply curve) becomes the industry supply curve. There is also no difference between the market and individual demand curves for a monopolist, since there is only one firm.

 The monopolist faces a downward sloping demand curve, which is the same as its average revenue curve. When average revenue is decreasing, marginal revenue must by definition be less than average revenue. The monopolist follows the same profit maximization rule as anyone else: Produce until MR=MC. But since AR (the demand curve) is greater than MC at this quantity, the monopolist earns above normal profits. This is a short run equilibrium position. However, there are no new firms to enter the profit and drive down the above normal profit in the long run. The only change in the long run is that the monopolist will adjust plant size so that LRMC=MR. But the monopolist will only act to increase profit, so the above normal profit is the same or higher in the long run.

 Economic efficiency, which requires that the ratio of MU/MC be equal for all goods, will not exist when monopoly conditions exist. The ratio of MU/P will still be equal for all goods because of utility maximizing consumer behavior. However, the monopolist sets P=AR and MR=MC where AR>MR, hence P>MC. The ratio MU/MC for the monopolistic good will be higher than for other goods.

 Despite this economic inefficiency, it may be in society’s best interest to have only one producer of a good or service when economies of scale exist. Economies of scale exist where average costs decline as plant size and output increases. Under these conditions, one firm can produce a given output for less cost than would be incurred if many small firms attempted to produce the same total output. Under these conditions, in the absence of government intervention, there will be a tendency for monopoly to arise. The largest firm in the industry has a cost advantage over all smaller firms and can charge a lower price that drives all competitors out of the market. The alternative is for firms to get together and act like a monopoly, splitting the profits between them—an illegal activity in many countries.

 Many competitive firms, each operating a small plant at a high average cost, may cost society more resources to produce the same output as a monopolist, even including the monopolist’s above normal profit.

 Imperfect Competition / Monopolistic Competition

 An imperfectly competitive industry consists of large numbers of firms each facing a downward sloping demand curve for its goods or services. Firms have a degree of control over price, possibly because there are real or imagined differences between their products and those of competitors, due to elements of local monopoly like the corner grocery store being more convenient to consumers who live nearby, or perhaps for other reasons. The more these factors exist, the more inelastic the firm’s demand curve will be. In the case of a corner store, if they increase prices they will certainly lose some business, but some people will continue to pay the higher price because of the time and inconvenience involved in going “into town.”

 Since each firm faces a downward sloping demand curve, average revenue and marginal revenue will diverge, as they do under a monopoly, but by much less. Again as with a monopoly, firms will expand or contract output so that MC=MR. But since the demand curve (AR) is greater than MR, above normal profits will be earned. This will provide an incentive for new firms to move into the industry. Assuming factor prices remain constant, the demand curve of existing firms will shift to the left until, in long run equilibrium, the firm’s demand curve is tangential to its average cost curve (AR < ATC for all points except one where AR=ATC, which also happens to be the quantity where MR=MC). Normal profit is thus earned.

 However, the point where AR=ATC is not the point of minimum ATC. A monopolistic competitor in long-term equilibrium produces at a quantity where ATC is higher than minimum, or in other words where spare capacity exists. At the same time, price is higher than MC, so economic inefficiency results. If the firm were to produce at minimum ATC, at which point price would equal MC since MC intersects ATC at the minimum point, ATC would be higher than AR and the firm would incur a loss. There is therefore no incentive for firms to produce beyond the point where AR=ATC (and MR=MC).

 The implication of imperfect competition is that spare capacity exists and this produces economic inefficiency, even though above normal profits are not being earned. This inefficiency must be set against the product differentiation which such firms provide society.

 Oligopoly

 An oligopoly is an industry where a small number of firms produce the bulk of the industry’s output. Each firm competes with the others in an interdependent manner; every firm’s sales depends not only on the price it charges, but also on the prices charged by its competitors. Because there are few firms and because there are real or imagined differences between them, the demand curve faced by each firm is downward sloping. However, many of the goods and services produced by oligopolists are essentially homogeneous. Barriers to entry in oligopolies are largely the same as for monopolies: Economies of scale, patents, or the sheer size and complexity of the firms involved.

 Unlike perfect competition, when an oligopolist changes their price, the other producers are likely to react. If one firm raises its price, most of its customers will switch to other firms (assuming they do not raise prices to match). So above the going price, the demand curve is highly elastic. If one firm lowers its price, the other firms will lower theirs to match, so the quantity sold will not change much. So below the going price, the demand curve is relatively inelastic. This results in a “kinked” demand curve. Since the demand curve (=average revenue curve) is downward sloping, the marginal revenue curve is also downward sloping and below the demand curve. At the point where the kink appears in the demand curve, the marginal revenue curve is vertical over some price range. As a result, there is a range of marginal costs over which the profit maximizing price is the same.

 The long term profit maximizing strategy for an oligopolist is not simple because it depends on what the competitors will do. This is what has led to the compexity of airline pricing. The easiest solution is for the oligopolists to to form a cartel, establish the industry-wide profit maximizing price, and earn monopoly profits. Fortunately this is illegal. What oligopolists can do legally is to implicitly elect one firm as the “price leader” and have all other firms match any price changes. This is legal so long as the firms act only on publically available data and do not collude.

The Marginal Equivalency Condition

 The Marginal Equivalency Condition

 A consumer will maximize utility when the last dollar spent on every good or service yields an equal benefit. This is true when the marginal utility of the last units purchased, divided by the price, is equal: MU_A/P_A = MU_B/P_B = MU_C/P_C = MU_D/P_D = etc. In perfect competition, price=marginal cost. So in an economically efficient, perfectly competitive market, MU_A/MC_A = MU_B/MC_B = MU_C/MC_C = MU_D/MC_D = etc. This is an equilibrium situation and any other allocation of resources will tend to move towards this equilibrium as profit maximizing producers and utility maximizing consumers attempt to improve their lot.

 Short & Long Run Equilibrium

 In short run equilibrium, price=MC. In long run equilibrium, price=MC=LRMC=minimum ATC=minimum LRAC. But long run equilibrium is rarely reached because of technological change, change in consumer preferences, etc.

Cyclical Patterns in Markets

 Producers determine production quantities in response to market conditions, but there is often a lag between when production decisions get made and when output is ready for sale. As a result, cyclical patterns can appear where markets oscillate around an equilibrium point. The “cobweb model” analyzes this pattern by dividing market activity into discrete periods and assuming that the quantity produced in each period is the quantity that would have been profit-maximizing in the previous period. The process goes like this:

 -          Suppliers bring some quantity Q1 to market.

-          Based on the demand curve, consumers are willing to pay a price P1 for this quantity.

-          Suppliers relate price P1 to their supply curve, and determine the quantity Q2 they will bring to the next market.

-          Repeat.

 This model assumes that producers always believe that the current market price will remain in effect, and are always surprised when it doesn’t. In the real world, producers would be more sophisticated in their analysis. In the real world, there may also be speculators, who buy quantities of the good at low prices and then re-sell at high prices, which will affect the stability of the market.

 Price and quantity are expected to move towards the equilibrium level. However, they can also diverge from equilibrium. This occurs when the supply curve is steeper than the demand curve. For each adjustment that suppliers make, purchasers make a much larger adjustment, throwing the next period further and further from equilibrium.

Taxes and Subsidies

 Taxes and subsidies have an effect on market supply and demand curves. If a tax is paid per output by suppliers, then the supply curve will shift upwards by an amount equal to the tax per unit. Given an upward sloping demand curve, this will result in an increase in price and a decrease in output. The burden of the tax will be allocated between consumers and producers depending on the price elasticity of the demand curve. If the demand curve is relatively inelastic, the price paid by consumers will rise by a relatively large amount and the quantity produced will not fall much. Consumers will bear a relatively high proportion of the total tax, as represented by the increased price per unit. If the demand curve is relatively elastic, the price paid by consumers will not rise much but the quantity produced will drop substantially. Since producer revenue is the price paid by consumers less the tax per unit sold, producer revenue will fall by a relatively high amount (the loss of revenue due to the tax will not be offset very much by the small price increase) and producers will bear a high proportion of the total tax.

 

Market Intervention, Price Ceilings, Price Floors

 Market Intervention

 Intervention (or regulation) occurs when a non-market force causes the price and quantity of a good bought and sold in a competitive market to be different from the price/quantity combination that would occur if the market were allowed to operate freely. Tickets to the World Series are sold for a price much lower than would prevail if market forces were allowed to set prices. Minimum wage laws force labor prices to be higher for certain jobs than they would be in a free market.

 Price Ceilings

 When the price of a good is fixed below the equilibrium level, a price ceiling is said to exist in the market for the good. Price alone will be an inadequate mechanism for allocating the available supply of the good among potential buyers, and some other allocative mechanism such as first come-first served, reliance on supplier’s preferences, or rationing, may be employed.

 Black markets (perhaps illegal) can exist in the presence of price ceilings. If one individual is prepared to pay the set price but no more (i.e. would prefer any amount of cash over the set price to the good), and another individual is willing to pay more than the set price, the two can engage in mutually beneficial trade.

 Price Floors

 When the price of a good is fixed above the equilibrium level, a price floor is said to exist in the market for the good. At the fixed price, there would be an excess supply of the good and some method other than price would have to be found for disposing of the excess. For example, the prices of many agricultural goods are subject to price floors. The surplus exists because producers are prepared to produce more at the fixed price than consumers are prepared to buy. The regulating agency has to determine how to deal with this problem.

 ·         The surplus can be produced and destroyed, which would be an obviously inefficient use of society’s scarce resources but might be justifiable, say in the case where prices below the floor would cause farmers to go bankrupt and this would in turn cause socially unacceptable levels of food scarcity.

·         The regulating agency could also stockpile the surplus and release it to the market in the event of poor production (crop failure or whatever) in the future; this would tend to even out price fluctuations over time.

·         Another option is to sell the surplus abroad.

·         Yet another option is to pay producers not to produce. This is no more wasteful of resources than producing and destroying the surplus, and may be less wasteful if there are costs associated with destroying the goods.

 The minimum wage is another example of a price floor. The effect of a minimum wage is to create excess supply of labor. Those who keep their jobs are better off at the expense of those who lose their job. Again the regulating agency is presented with the problem of what to do with this excess supply.

Changes in Market Equilibrium

 If a market is in equilibrium and any of the conditions determining demand or supply change, then market forces will establish a different equilibrium price and/or equilibrium quantity. This would be reflected by a shift in the supply or demand curve and a resulting change in the point at which the two curves intersect.

 If supply rises and demand rises, then the equilibrium quantity will rise but the equlilibrium price is indeterminate.

If supply rises and demand falls, then the equilibrium price will fall but the equilibrium quantity is indeterminate.

If supply falls and demand rises, then the equilibrium price will rise but the equilibrium quantity is indeterminate.

If supply falls and demand falls, then the equilibrium quantity will fall but the equlilibrium price is indeterminate.

Market Supply & Demand, The Operation of Markets

 Market Supply & Demand

 For exchange to take place, a market supply curve and a market demand curve must exist and there must be at least one common price at which suppliers are willing to sell some quantity of the good and at which buyers are willing to buy some quantity of the good.

 If at all positive prices in a market the quantity of a good supplied exceeds the quantity supplied, the price of the good will be zero (“free good”). Fresh air is an example. A certain amount of fresh air exists at a price of zero. For more than this quantity to be produced, the price has to be greater than zero. However, there is a certain maximum demand that exists even at a price of zero: If everyone has as much fresh air as they need, they do not want any more even if there is no cost. If the quantity of fresh air that can be supplied at a price of zero exceeds the maximum amount demanded, then fresh air is a free good. If the supply curve shifts to the left due to air pollution, fresh air may cease to be a free good.

 Excess supply exists when, at a given price, the quantity of a good firms are prepared to supply exceeds the quantity consumers are prepared to buy. Excess demand exists when the quantity consumers are prepared to buy exceeds the quantity firms are prepared to supply. The price where the quantity firms are prepaded supply equals the quantity consumers are prepared to buy, or in other words the price at which neither excess supply nor excess demand exists, is called the equilibrium price. At the equilibrium price, every supplier willing to sell at that price is able to and every consumer willint to buy at that price is able to.

 The Operation of Markets

 If a price causes excess demand or excess supply in a market, forces in the market will change the price of the good and the quantity bought and sold. These forces will eventually eliminate any excess demand or excess supply.

 If excess supply exists in a market, suppliers desire to sell more than they are able to at the prevailing price. It is to their advantage to offer to sell more goods at a lower price. Therefore competition among suppliers will force down the price of the good. These price reductions will also decrease the quantity of goods sold, reducing and eventually eliminating the excess supply.

 If excess demand exists in a market, buyers desire to purchase more than suppliers are willing to provide at the prevailing price. Buyers will therefore offer to pay a higher price to induce suppliers to produce more of the good. The increased price will result in less and eventually zero excess demand.

 Producer and Consumer Surplus

 In a market at equilibrium, all consumers who wish to purchase at the prevailing price are able to do so and all suppliers who wish to sell at the prevailing price are also able to do so. However, most of the consumers and suppliers would have been willing to trade at less favorable prices. For a consumer who purchases a good at the equilibrium price of $40 but would have been willing to pay up to $70, a consumer surplus of $30 exists. For a supplier who sells a good at $40 but would have been willing to sell at $20, a producer surplus of $20 exists. The market consumer and producer surpluses are the sum of all individual surpluses and are graphically represented by the area measured between the supply or demand curve, a horizontal line at the equilibrium price, and the price axis (ie a vertical line at zero quantity). These surpluses provide the motivation for the market to achieve equlibrium.

 

Factor Returns & Scale Returns

 Return to variable factor input is the relationship between changes in a particular variable factor input and total output, with all other factors held constant. Increasing returns occur where DQ/Q > DL/L where L is the variable factor input. In other words, a change in variable factor input returns a greater than proportional change in total output. Diminishing returns occur where DQ/Q < DL/L and constant returns where DQ/Q = DL/L. Return to factor input is a short term relationship because in the long run the “other factors” (like fixed costs) cannot be held constant.

 Return to scale is the relationship between changes in all factors put together and total output. Increasing returns to scale occur where DQ/Q > D(L,C)/(L,C), where (L,C) is the total variable and fixed factors of production. Because all factors are lumped together as if they were variable costs, this is a long term relationship.

 Factor and scale returns can be classified as increasing, diminishing or constant only over a particular range. Over the entire range of possible outputs, all three types of returns will most likely be evident. There is no relationship between factor and scale returns.

 

Labor Productivity

 Labor productivity equals the amount of output produced per unit of labor (ie, man-hour or man-month). If labor productivity differs between two plants of equal capital input, firms are likely to favor the conditions (such as location) of the more productive plant. However, these decisions can cause considerable controversy.

 In competitive labor markets, the wage rate is equated to the marginal product of labor. Different workers have different marginal products, depending on their capability of contributing to output (ie, their skills). However, some people have zero or near-zero marginal products. These people will not have jobs. Economics bails out on answering questions like “is this right” or “is this fair” because these problmens cannot be analyzed economically.