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.

Monopoly, Monopoly Structure, Monopolistic Behavior, Profit Maximization, Oligopolies, Monopolistic Competition, Production differentiation

    Monopoly

I.       Monopoly Structure

Market Power is when “a company [has the] ability to manipulate price by influencing an item's supply, demand or both. A company with market power would be able to affect price to its benefit. Firms with market power are said to be "price makers" as they are able to set the price for an item while maintaining market share.

Generally, market power refers to the amount of influence that a firm has on the industry in which it operates.”[1]

Market demand is the total quantities of good or service people are willing and able to buy at alternative prices in a given time period; the sum of individual demands.

Monopoly = industry

Monopolies arise when:

1.      No Close Substitute

a.      If a good has a close substitute, even though only one firm produces it, that firm effectively faces competition from the producer of substitutes.

2.      Barriers to Entry

a.       Barrier to entry – It’s a natural or legal constraint that protects a firm from competitors.

b.      Patent is a government grant of exclusive ownership of an innovation.

When we are faced with a monopoly, the firms demand is equal to the market demand for that given product

 Price vs. marginal revenue

Marginal revenue is the change in total revenue that results from a one-unit increase in quantity sold.

 Therefore the MR is equal to change in total revenue.

Q₁ = 1  P₁ = 10            TR₁ = 10

Q₂ = 2  P₂ = 9              TR₂ = 18                      MR = 8

This process continues and when the MR stops increasing it means that we have derived the price at which a firm obtains maximum TR.

MR = 0

The marginal revenue curve lies below the demand curve at every point but the first.  The MR is less than P because when the P is lowered to sell one more unit two opposing forces affect TR:

1.      The lower P results in revenue loss.

2.      The increase in Q sold results in a revenue gain.

 

II.     Monopolistic Behavior

 A monopolist is a price setter not a price taker.  A Price setter “[establishes] the price of a product or service, rather than allowing it to be determined naturally through free market forces.  A monopoly does this by first establishing its profit maximizing quantity.” [2]

 Profit Maximization

Profit maximization rule stats that one will produce at the rate of output where marginal revenue is equal to marginal cost

MR = MC

Monopolists do not use P = MC, only perfectly competitive markets use it.  This is what monopolists do.

Production Decision

Production decision is the selection of the short run rate of output (with existing plant and equipment).

A monopoly finds its Q _m by making MR = MC.  Then using this Q _m it goes to the demand curve and obtains the P _m.

 The monopoly price

Below is how we determine price and quantity supplied in a monopoly:

·         The intersection of the MR = MC curves establishes the profit maximizing rate of output.

·         The demand curve tells is the highest price consumers are willing to pay for that specific quantity of output.

·         Only one price is compatible with the profit-maximizing rate of output.

 Monopoly profit

They are higher than competitive market.

 III.    Barrier to entry

 Threat to entry

·         All they have to do is increase quantity and price will drop.

·         This will reduce the profits available in the market giving an economic discouragement.

Barriers to entry are obstacles that make it difficult or impossible for would be producers to enter a particular market.

·         Patent is a government grant of exclusive ownership of an innovation.

·         Copyright is an exclusive right granted to the author or composer.

Other entry barriers

There are two types of barrier to entry:

Natural monopoly – It’s a monopoly that arises when technology for producing a G or S enables one firm to meet the entire market demand at a lower price than two or more firms could.

Legal monopoly – It’s a market in which competition and entry are restricted by the concentration of ownership of a natural resource or by the granting of a public franchise, government license patent, or copyright.

·         Legal Harassment – Some companies will harass smaller companies by suing them.  This makes the cost of entrance higher (think Russia on everything and Apple computers’ OS system).

·         Exclusive licensing – Some companies will not allow for compatibility on the factors of production.  As with legal harassment, this makes the cost of entrance higher and prices of the product artificially high (think AT&T with the iPhone)

·         Bundled Products – Some companies force consumers to purchase complementary products (the largest offender that I can think of was Microsoft and their internet explorer).

·         Public Franchise is an exclusive right granted by the government to a firm so they can supply G or S (think USPS).

·         Government license controls entry into particular occupations, profession, and industries (Think commercial driver’s license, and emission or tag agencies).

 

IV.    Comparative Outcomes

Competition vs. Monopolies

Perfectly competitive	Monopoly
Higher prices signal the need for more supply	Higher prices signal the need for more supply
Higher profits attracts new suppliers	Barriers to entry are erected to exclude potential competition
P = MC	MR = MC
More efficient	Less efficient
Lower prices	Higher prices
Higher quantities	Lower quantities

 

Near Monopolies

Duopoly – It is a market with only two players (or firms)

Oligopolies

The characteristics of Oligopolies are:

1.      Small Number of Firms – An oligopoly consists of a small number of firms.  Each firm has a large share of the market, the firms are independent, and they face temptation to collude.

2.      Interdependence – With a small number of firms in the market, each firm’s actions influence the profits of the other firms.

a.       Example: if i^th player reduces his prices, all other players in the market will loose market share to him. This occurs if we assume the competitors do not change their prices as well.

3.      Temptation to Collude – When a small number of firms share a market, the can increase their profits by forming a cartel and acting like a monopoly.

Cartel – It is a group of firms acting together to limit output; it raises prices and increase economic profit.

4.      Barriers to Entry – Either natural or legal barriers to entry can create oligopoly.

How many firms are in the market depends on how many firms it takes to supply the demand for the given good.

A legal oligopoly arises when a legal barrier to entry protects the small number of firms in a market. 

When barriers to entry create an oligopoly, firms cam make an economic profit in the LR without fear of triggering the entry of additional firms.

 Monopolistic Competition

The characteristics of Monopolistic Competition are:

1.      Large Number of Firms – The presence of a large number of firms has three implications for the firms in the industries:

2.      Small Market Share – While each firm can influence the price of its own product, it has little power to influence the MKT P.

3.      No Market Dominance – Each firm is sensitive to the avg. MKT P, but it does not pay attention to any one individual competitor.  Since they are all relatively small not one firm can dictate the market.

4.      Collusion Impossible – Firms try to profit from illegal agreements with other firms to fix prices and not undercut each other, and this is impossible due to the share number of players in the market.

5.      Product Differentiation – This implies that the product has close substitutes, but not a perfect substitute.

Production differentiation – It’s making a product that is slightly different for the products of competing firms.

6.      Competing on Quality, Price and Marketing – Product differentiation enables a firm to compete with other firms in three areas:

a.      Quality – the quality of a product is the physical attributes that make it different from the products of the others. It runs on a spectrum between high and low.

b.      Price – because of product differentiation, a firm in monopolistic competition faces a downward-sloping demand curve.  So like a monopoly, the firm can set both its P and Q.  But there is a tradeoff between P and quality.

c.       Marketing – because of product differentiation, a firm in monopolistic competition must market its product. 

 What Gets Produced

Marginal cost pricing rule – It is the offer of goods at prices equal to their MC.

The marginal cost pricing rule is efficient, but it leaves the natural monopoly incurring an economic loss; therefore, it is seldom used.

 Average cost pricing rule – It is a price rule for a natural monopoly that sets the price equal to average cost and enables the firm to cover its costs and earn a normal profit.

 V.      Any Redeeming Qualities?

The main reason why monopoly exists is that it has the potential advantages over a competitive alternative.  These advantages arise from:

 Research and development

Invention leads to a wave of innovation as new knowledge is applied to the production process.  If a firm invents in something that obtains a patent, the monopoly will hold monopoly power for a period of time. 

This does not imply that productivity will grow.

 Economies of Scale

Economies of scale can lead to natural monopoly.

Economies of scale – A condition in which, when a firm increases its plant size and labor employed by the same percentage, its output increase by a larger percentage and its average total cost decreases.

Where significant economies of scale exist, it would be wasteful not to have a monopoly.  Usually they exist where the cost of providing a G or S is cheaper at higher quantities produced.

 Contestable Market

Contestable market is an imperfect competitive industry subject to potential entry if prices or profits increase.

 How contestable a market is dependant on entry barriers and not structure.

·         If entry is insurmountable competitors will be locked out of the market.