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The Power of Microeconomics: Economic Principles in the Real World


30 April 2014 - 14 June 2014


Lecturer: Professor Peter Navarro




Foreword




This document contains course notes of the course The Power of Microeconomics: Economic Principles in the Real World by Peter Navarro, Professor of Economics and Public Policy at the Paul Merage School of Business, University of California, Irvine in the United States that is available on Coursera.org. This course focuses on basic microeconomic concepts and uses a historical perspective to explain the schools of thought.




Contents



Foreword

Contents

1. An Overview of Modern Microeconomics
1.1. A short introduction into modern microeconomics
1.2. Microeconomics defined and three questions every economist must answer
1.2.1. Microeconomics versus macroeconomics
1.2.2. Economic order
1.2.3. Three questions
1.3. The production possibility frontier and opportunity costs
1.4. The fundamental concepts of microeconomics and course overview
1.5. Other reasons for government regulation
1.6. An overview of land, labour, and capital markets; externalities and public goods

2. Supply, Demand and Equilibrium
2.1. The law of demand, income and substitution effects, and shift factors
2.2. Change in demand versus change in quantity demanded; The market demand and supply curves; Supply curve shift factors
2.3. Equilibrium; price effects of supply and demand curve shifts; price controls and floors
2.4. The market allocates goods and resources; What, for whom, and how; Some examples
2.4.1. The market allocates goods and resources
2.4.2. What, for whom, and how
2.4.3. Some examples

3. Demand and Consumer Behaviour
3.1. Consumer choice and utility theory
3.2. Consumer optimisation and equimarginal principle; Income and substitution effects
3.3. Demand price elasticity and its determinants
3.4. Price elasticity and total revenue

4. Supply and Production Theory
4.1. Overview of production theory and the production function
4.2. Average, marginal, variable and total costs; The marginal product and law of diminishing returns
4.3. Marginal cost and marginal cost pricing; The AFC, ATC, and AVC curves
4.4. Long run cost analysis and economies of scale
4.5. Diseconomies of scale, minimum efficient scale and natural monopoly
4.6. Accounting versus economic profits; The price elasticity of supply

5. Perfect Competition
5.1. Overview of industry structure, conduct, and performance
5.2. Assumptions of Perfect Competition; The P=MR condition
5.3. Market failures that lead to imperfect competition; Externalities and the public goods problem
5.4. Pricing and production rules; P=MR=MC; The shutdown rule
5.4.1. P=MR=MC
5.4.2. The shutdown rule
5.5. Long run equilibrium; Normal or zero economic profits
5.6. Allocative versus productive efficiency; Pareto optimality; Consumer and producer surplus and deadweight loss
5.6.1. Allocative versus productive efficiency
5.6.2. Best possible allocation of a society's resources
5.6.3. Consumer and producer surplus
5.6.4. Deadweight loss
5.6.5. Market failures
5.6.6. Equity or fairness

6. Monopoly and Monopolistic Competition
6.1. Why study imperfect competition; Monopoly's pricing rule
6.2. Regulating monopolies and the P=AC rule; X-efficiency under cost-plus pricing; Schumpeter's argument for monopoly
6.2.1. Regulating monopolies and the P = AC rule
6.2.2. X-inefficiency under cost-plus pricing
6.2.3. Schumpeter's argument for monopoly
6.3. Monopolistic competition; Concentration ratios; Mutual dependence recognised and collusion
6.3.1. Monopolistic competition
6.3.2. Concentration ratios
6.3.3. Strategic interaction and collusion
6.4. Comparing monopolistic and perfect competition; Non-price competition and product differentiation

7. Oligopoly and Strategic Behaviour
7.1. Oligopoly defined and sources of oligopoly
7.1.1. Introduction
7.1.2. Economies of scale
7.1.3. Capital requirements
7.1.4. Absolute cost
7.1.5. Product differentiation
7.1.6. The bottom line
7.2. Market power and strategic interaction; Cooperative versus non-cooperative behaviour; Explicit collusion
7.3. Tacit versus explicit collusion; Forms of tacit collusion; Models of oligopoly conduct
7.4. Joint profit maximisation model; Why cartels can fail
7.5. The price leadership model; The kinked demand curve model
7.5.1. The price leadership model
7.5.2. The kinked demand curve
7.6. Game theory and the prisoner's dilemma; The Nash equilibrium
7.6.1. Game theory
7.6.2. Prisoner's Dilemma
7.6.3. Prisoner's Dilemma in oligopoly
7.6.4. Nash Equilibrium

8. Land and Rent
8.1. Introduction to land and rent; Factor prices
8.2. How land is priced; Rent versus economic rent
8.3. The Corn Wars and theory of Ricardian rents; Property rights
8.3.1. The Corn Wars
8.3.2. Theory of Ricardian rents
8.3.3. Property rights
8.4. Henry George's single tax movement; Efficiency of a land tax
8.5. Determinants of the price of land and rents; Rent seeking
8.5.1. Factors determining rent
8.5.2. Economic function of rent
8.5.3. Quasi rent
8.5.4. Rent seeking

9. The Labour Market and Wage Determination
9.1. What determines the wage Rate? Unions and “company towns”
9.2. The derived demand for labour; The marginal productivity theory of resource demand; The profit maximising rule; MRC=W
9.2.1. The derived demand for labour
9.2.2. The marginal productivity theory of resource demand
9.2.3. The profit maximising rule
9.2.4. MRC=W
9.3. Productivity, wages and product prices
9.4. Issues in labour force participation; Substitution and income effects and the backward bending curve; Immigration
9.4.1. Issues in labour force participation
9.4.2. Substitution and income effects and the backward bending curve
9.4.3. Immigration
9.5. Wages under differing market structures; Monopoly, monopsony, and labour unions; Labour immobility; Role of unions
9.5.1. Wages under differing market structures
9.5.2. Monopoly, monopsony, and labour unions
9.5.3. Role of unions
9.6. Factors affecting wage Differentials; Compensating differentials; Quasi-rents; Human capital; Immobilities; Non-competing groups
9.6.1. Compensating differentials
9.6.2. Quasi-rents
9.6.3. Human capital
9.6.4. Immobilities
9.6.5. Non-competing groups

10. The Capital Market, Interest, and Profits
10.1. Capital analysis in the real world; Three categories of capital goods; Interest rate defined; Rate of return
10.2. Depreciation; Theory of loanable funds; Two interest rate functions
10.2.1. Depreciation
10.2.2. Theory of loanable funds
10.2.3. Two interest rate functions
10.3. How shifts in demand and supply affect interest rates; Investment analysis over time; Net present value; Perpetuities
10.3.1. How shifts in demand and supply affect interest rates
10.3.2. Investment analysis over time and net present value
10.3.3. Perpetuities
10.4. NPV in the real world; NPV equation
10.5. Real world applications of NPV
10.6. Interest rates in the real world; Factors determining interest rates

11. Public Goods and Externalities
11.1. Why markets fail and the government’s role
11.2. Public versus private goods; Non-rival consumption; Non-excludability; Free rider problem
11.2.1. Public versus private goods
11.2.2. Non-rival consumption
11.2.3. Non-excludability
11.2.4. Free rider problem
11.3. Economic efficiency and public goods; Market demand for public goods
11.4. Benefit-cost analysis and the decision rule
11.5. Negative and positive externalities
11.6. Graphical analysis of externalities; Coase theorem and property rights; Tort system
11.6.1. Graphical analysis of externalities
11.6.2. Coase theorem and property rights
11.6.3. Tort system
11.7. Direct government intervention; Pigouvian taxes and subsidies; Internalising externalities
11.7.1. Direct government intervention
11.7.2. Pigouvian taxes and subsidies
11.7.3. Internalising externalities

References




1. An Overview of Modern microeconomics




1.1. A short introduction into modern microeconomics


At a business and professional level, microeconomics can help answer questions like the following. How can my firm minimise its costs and increase its profits? What prices should I charge for my products? Should I invest in a new plant and equipment? How should I respond to an aggressive strategic move by one of my competitors? At a personal level, microeconomics can help answer questions like the following. How can I maximise my grade point average given my time constraints? Will I really be better off financially if I quit my job now and go back for an MBA degree? What kind of career should I be preparing myself for? And what about that new refrigerator or automobile I want to buy? Should I get the new energy-efficient one with a higher price tag or settle for a cheaper model?

Microeconomics can explain why the government is so involved in the economic lives of individuals. It can do so by answering questions like the following. Why does the government regulate prices in some industries like electricity and gas but not in others? Why are there laws requiring seat belts and motorcycle helmets? Why do we have a federal environmental protection agency and thousands of rules about workplace safety? And why does the government provide some goods, like our national defence and lighthouses, and let the free market provide other goods, like hot dogs and computers? Microeconomics can help answer questions like these because it arms us with a powerful set of conceptual and problem-solving tools.

These concepts can be powerful and helpful these as several stories about some fictional people in real situations demonstrate. Priscilla Sanchez wants to buy a new refrigerator and her choice is between an energy-efficient model that cost $750 or the identical refrigerator without the energy saving features for only $500. Since Priscilla just finished her course of microeconomics, she knows about the time value of money. So, after calculating the net present value of the energy savings on an electricity bill over the life of the investment, she realises that the seemingly more expensive refrigerator is actually much cheaper.

Priscilla helped her husband Phil come to a similar conclusion on a completely different topic. Phil was thinking about entering an executive MBA programme, but the tuition is expensive, over $100,000 for the two-year programme. Phil's problem in thinking through his decision was that he didn't know how to compare his up front cost of going to school with the future benefits that would come in the form of a higher salary and better promotional opportunities. So Priscilla once again got out her hand calculator and made some assumptions about Phil's future stream of income after he got his MBA. And it became pretty clear to both of them that the family would be better off financially over the long run with Phil in school now. And that is where Phil is.

He sits right next to Stuart Applegate in his Microeconomics class. Before losing his job and going back to school, Stuart was the chief executive officer of a high-flying computer software company. However, when his company started to lose money, Stuart's solution was to raise prices in the hopes of boosting revenues and profits. Unfortunately, Stuart came from an engineering background, and as he hadn't studied microeconomics, Stuart didn't understand that the demand for his company's product was what economists call highly elastic. In such a case, raising prices actually reduces both total revenue and profits. The result was that Stuart's pricing strategy bankrupted the company.

Forunately, Jean Twilley was a lot smarter when confronted with a similar situation in her job as a financial analyst in the operations department for the transit authority in Paradise California. Facing a revenue shortfall, Jean ordered an analysis of the elasticity of demand for bus services. When she found that bus demand was also highly elastic, she recommended to her supervisor that the transit authority lower bus fares. This pricing strategy did indeed increase ridership and boost total revenues. It also earned Jean a nice promotion.

It was a totally different set of microeconomic tools that helped Jong Chan get a different kind of promotion - one into medical school. Jong's problem was that at the end of his freshman year in college, his grade point average was only 2.9. However after taking a course in microecononics Jong used the concept of opportunity costs and the tool of the possibilities frontier to more efficiently allocate his studying time across various subjects. The result? By the end of his senior year Jong had raised his grade point average to 3.8.

It's too bad that Jong's father, Nai-fu, didn't receive the same training in microeconomics as his son. Which isn't to say that Nai-fu Chan isn't a success himself. After all, he's a newly elected member of Congress from the Los Angeles area. However, in his first term last year, Congressman Chan tries to pass some legislation that would have forever eliminated any kind of price regulation in the entire transportation industry. While such price deregulation makes a lot of sense in an industry like trucking which is highly competitive, it makes little sense for the railroad industry, which is in essence a natural monopoly that will gouge consumers with high prices in the absence of government regulations. Fortunately, Congressman Chan's bill didn't pass.



1.2. Microeconomics defined and three questions every economist must answer


1.2.1. Microeconomics versus macroeconomics

Microeconomics focuses on the behaviour of individual markets and the smaller individual units that make up the broader economy, which are businesses, consumers, investors, and workers. Microeconomics is distinguished from macroeconomics which focuses on problems in the broader economy like inflation and unemployment and the rate of economic growth. Adam Smith is usually considered the intellectual forefather of microeconomics. In his classic book, The Wealth of Nations, published in 1776, Smith considered how individual prices are set, studied the determination of prices for land, labour, and capital and examined the strengths and weaknesses of the free market mechanism. Most importantly he identified the remarkable efficiency properties of perfectly competitive markets.


1.2.2. Economic order


Using his now famous invisible hand analogy, Smith argued that the self interested actions of individuals actually guide market outcomes to yield great economic benefits for the broader society. While Adam Smith's keen insights will provide an important foundation for many discussions in the study of microeconomics, it is also true that in the United States, as well as virtually all other nations of the world, few sectors of the economy fulfill Adam Smith's vision of a perfectly competitive marketplace delivering goods and services at the lowest price and the highest quality. In fact, the US as well as most other modern industrialised nations, has what is called a mixed economy.

At one end of this mixed economy are industries like farming and mining that are characterised by many buyers and sellers. They come closest to Adam Smith's model of perfect competition. At the other end there pure monopolies like the Post Office, characterised by one seller, and often run by the government. In between there are numerous oligopolies, from the tobacco and chewing gum industries to automobiles and oil. Oligopolies are industries which typically have a small number of large firms. Many of America's largest industries are oligopolies. They are much more likely to engage in collusive practices such as price fixing than the type of fierce competition envisioned by Adam Smith and his invisible hand.

In contrast to Adam Smith's free market economy and America's mixed economy, a command economy is one in which the government makes all the important decisions about production and distribution. In a command economy such as the one which operated in the Soviet Union, the government owns most of the means of production, land and capital. It also owns and directs the operations of enterprises in most industries. It is the employer of most workers and tells them how to do their jobs. It also decides how the output of society is to be divided among different goods and services.

 
Three questions and three facets
 

1.2.3. Three questions

Regardless of whether a country has a command or mixed economy it still must answer three basic questions. What shall be produced, how shall it be produced, and for whom shall it be produced for? In answering these three basic questions, a country must address three basic facets of economic and political life, scarcity, efficiency, and equity.

Scarcity is the first issue. If infinite quantities of every good could be produced, there would not be economic goods, that is goods that are scarce or limited in supply. All goods would be free like sand in the desert or seawater at the beach. In such an Eden of affluence, people wouldn't have to worry about stretching out their limited incomes to fulfill their wants. Businesses wouldn't worry about costs and profits when they produce their products. Governments wouldn't have to tax their citizens to build things like roads and bridges. And there would be no distinction or political and economic conflict between rich and poor because everyone would have everything they needed and wanted. Prices in markets would be irrelevant and economics would not be a useful subject.

Clearly no society has reached such a utopia of limitless possibilities. Instead, while goods are limited, wants are seemingly limitless. Indeed after two centuries of rapid economic growth, production in the United States is still not high enough to meet everyone's desires. Outside the United States, particularly in Africa and Asia, hundreds of millions of people suffer from hunger and material deprivation every day.

Faced with the undeniable fact that goods are scarce relative to wants, an economy must decide how to cope with limited resources. It must choose among different potential bundles of goods, the what, select from differing techniques of production, the how, and, decide in the end who will consume the goods, the for whom. In a real sense then the essence of economics is to acknowledge the reality of scarcity and then figure out how to organise society in a way that produces the most efficient use of resources. Efficiency denotes the most effective use of a society's resources in satisfying people's wants and needs.

Allocating resources efficiently is all the more complicated because in pursuing efficiency there is almost always a thorny trade-off between what is efficient from an economic point of view and what may be viewed as fair or equitable from a social and political point of view. In fact grappling with the trade-off between efficiency and equity is one of the most difficult tasks of economists and the political and business leaders they serve.

For example, from a microeconomic view, the most efficient way to regulate electricity prices would be to charge individual consumers much more than businesses for the same unit of electricity. Such a pricing creates enormous political problems because it is people rather than businesses that vote in a democratic system. Moreover, many would argue that it simply would not be fair to charge people, and especially the poor and elderly more than big corporations for the same product. In a similar vein, almost any time the government tries to raise taxes to redistribute income from the rich to the poor through mechanisms like food stamps or Medicare, those taxes tend to interfere with the efficiency of the free market.



1.3. The production possibility frontier and opportunity costs


 
Production possibilities
 
To illustrate the concepts of scarcity, efficiency and equity, the production possibilities frontier (PPF) can be used. The PPF shows the maximum amounts of production that can be obtained by an economy given its technological knowledge and quantity of inputs or resources available. It represents the menu of goods and services available to society. If a country is operating on its PPF, it is allocating resources efficiently. The important idea behind the PPF is that societies cannot have everything they want. They are limited, not just by their resources, but also by the technology available to them.

Therefore, societies must choose between goods, and one of the broadest choices that virtually every country is forced to make is between producing guns versus butter. How much of a country's resources should go to the military, the guns, and how much should go to civilian uses like education and health care and the production of consumer goods like computers and automobiles, the butter. This choice can be illustrated using PPF diagram for the mythical country of Tough Choice. Butter production is represented on the horizontal axis and guns production is represented on the vertical axis.

 
Opportunity costs
 
If the leaders of tough choice were to use all the country's resources to produce butter, it would produce five million pounds. And be at point F in the figure given its current technology. Alternatively, if Tough Choice were to produce only guns, it would be at point A, or 15,000 guns. Between these two extremes of only butter and only guns, Tough Choice also can produce many combinations of guns and butter, as illustrated by points B, C, D, and E. For example, by foregoing one million pounds of butter production, Tough Choice can increase its guns from 9,000 at point D to 12,000 at point C.

Such a movement along the PPF illustrates one of the most important concepts in microeconomics, which is opportunity costs. On the most fundamental level, the opportunity cost of moving from D to C is the butter given up to produce the extra guns. In this example, the opportunity cost of the 3,000 extra guns is one million pounds of butter forgone. In a world of scarcity choosing one thing means giving up something else. The opportunity cost of a decision is the value of the good or service forgone. Because resources are scarce, we must always consider how to spend our limited incomes or time.

 
Public versus private goods for frontier society
 
This concept can be used on other choices as well. Voters can choose between private goods like autos and houses, bought at a price, and public goods like roads and bridges, paid for by taxes. A frontier society is likely to be at point A because the society lives from hand to mouth with little left over for public goods like super highways or public health.

 
Public versus private goods for urban society
 
However, with economic growth and technological change, a modern urbanised and more prosperous economy will have a PPF shifted significantly outward relevant to the frontier society. In this case, this society may choose to be at point B, spending more of its higher income on public goods and services, like education, environmental protection, and roads.

 
Investment versus consumption
 
It's not just what a society chooses to consume that matters, it's also when it chooses to consume it. There is a choice between consuming goods like autos and watches and tennis rackets now, or investing in machinery and factories. Three countries can start out even with the same PPF. However, the Kingdom of Jiminy Cricket, as indicated by A1, does no investment for the future, while the Aristotle Republic invests modestly at A2, while Thriftyland sacrifices a great deal of current consumption to invest heavily at A3.

 
Growth by investment
 
After some time, the PPF of Thriftyland has shifted significantly outwards, allowing the sons and daughters of Thriftyland's investors to live a more prosperous life. Meanwhile the Kingdom of Jiminy Cricket remains mired at the same standard of living on its original PPF. The important point here is that by sacrificing current consumption and producing more capital goods, a nation's economy can grow more rapidly.

 
Growth by investment
 
The PPF can be used to shed further light on the concept of economic efficiency. There is a trade off between guns and butter. Point D is unattainable given the society's available technology, resources, and labour force. Point A is an inefficient point, because there is a way to produce more of guns or butter without having to give up any of the other. For a society, the idea that is to stay on the PPF at points like C and B.



1.4. The fundamental concepts of microeconomics and course overview


In lectures 2, 3 and 4, it is investigated how the forces of supply and demand reach equilibrium in the product markets, for example the market for consumer goods like autos and shoes and computers. Such an equilibrium can be illustrated using a figure. The price of the good, in this case corn flakes, is on the vertical axis. The quantity of the corn flakes is on the horizontal axis. The demand curve slopes downward. This reflects the idea that the lower the price, the more corn flakes the consumers want to buy. Similarly, the supply curve slopes upward indicating that as prices rise, businesses are willing to provide more corn flakes. The powerful idea behind this figure, is that the price in the market tends to be set where the supply and demand curves cross.

 
Market equilibrium
 
In order to understand exactly why this equilibrium happens, each of the components of these curves are studied. To understand the downward slope and the shape of the demand curve, and indeed why that curve may also shift, the theory of consumer of household behaviour is researched. By the same token, to figure out why the supply curve slopes upward, production theory, which examines why firms price and produce products the way they do, is treated.

After investigating these demand and supply curves, it will become apparent why prices tend towards an equilibrium where the two curves cross. Lectures 5, 6 and 7 discuss the broader issue of how markets are organised and structured. In this stage it will be shown that when a market meets Adam Smith's test of being perfectly competitive, its invisible hand allocates resources in the most efficient way possible without any help or interference of the government.

It will also be shown that markets are prone to various kinds of market failures that may require the government to intervene to correct them. The three most important market failures involve imperfect competition, such as monopolies, externalities, such as pollution, and public goods, such as national defence. In each case, the market failure leads to inefficient production or consumption, and the government can play a role in solving or reducing the problem.

For example, when there is only one seller in the marketplace, that seller tends to set prices too high so that consumption is too low relative to the most efficient outcome that would occur in a market with numerous buyers and sellers. In such a case, government intervention into the market may be appropriate. And such intervention may involve regulating prices and profits or prohibiting actions such as price fixing.

A second type of market failure involves negative externalities and positive externalities. In the case of a negative externality, a company may produce steel and sell it for the market price. In manufacturing the steel, the company will incur costs for its machinery and raw materials and labour. Those direct costs to the firm will be subtracted from its revenues to calculate its profits. In a free market, the company does not take into consideration the broader external costs it may impose on society in the process of making the steel.

Such costs arise, for example, when a company pollutes the river adjacent to its plant or the air basin over the nearby town. In the presence of negative externalities, like pollution and congestion, the free market produces too much of the good at too low a price, in this case steel. In such a case the government may want to regulate or tax the polluters. While in the presence of positive externalities associated with goods like education and vaccinations, government subsidies may be appropriate to internalise the externality.

A third market failure involves so-called public goods like national defence and lighthouses. Public goods are non-rival in consumption, meaning that my use of a lighthouse doesn't interfere with your use of that same lighthouse. This is different from goods that are rival in consumption, like hamburgers and shoes. If someone eats the burger, or wears the shoes, someone else cannot. The typical solution to the public goods problem is for the government to step in and provide them. That is why it is the government that is in charge in providing many public goods, from national defence, and the criminal justice system, to parks, roads and bridges.

The concept of market failure helps us better understand the many reasons why the government may get involved in the affairs of businesses and the lives of people. It is especially important for people in business to understand the economic role of government, because government rules and regulations have as much or more to do with the bottom line profits of most companies than any competitor's actions.



1.5. Other reasons for government regulation


Even if there are no failures in the market, there may be a political or ethical problem with how wealth and income are distributed, that triggers government intervention into the free market. To see this, assume for the moment that the economy is functioning with complete efficiency, always on the production-possibility frontier and never inside it, always choosing the right amount of public versus private goods and so forth. Even if the market system works perfectly, it might still lead to a flawed outcome. This may happen because incomes are determined by a wide variety of factors including effort, education, inheritance, factor prices, and luck.

The resulting income distribution may not correspond to a fair outcome. A rich man's cat may drink the milk that a poor boy needs to remain healthy. This is not happening because the market is failing. The market mechanism is doing its job, which is putting goods in the hands of those who have the dollar votes. To put it another way, if a country spends more fertilising its lawns than feeding poor children, that is a defect of income distribution, not of the market. Even the most efficient market system may generate great inequality. In this regard, if a democratic society does not like the distribution of dollar votes under a free market or laissez-faire market system, it can take steps to change the distribution of income.

 
Reasons for government interventions
 
For example, it can engage in progressive taxation, taxing large incomes at a higher rate than small incomes, or impose heavy taxes on large inheritances to break the chain of privileges. Because low tax rates cannot help those who have no income at all, governments can make transfer payments which are money payments to people. Such transfers today include aid for the elderly, blind and disabled and for those with dependent children, as well as unemployment insurance for the jobless and food stamps and housing subsidies for the poor. This system of transfer payments provides a safety net to protect the unfortunate from privation, and they are paid for from taxes levied on the more privileged.

It is usual to ask, at this point, what can economics contribute to debates about equality? Economics as a science cannot answer such normative or prescriptive questions about how much of our market incomes, if any, should be transferred to poor families. This is a political question that can be answered only at the ballot box, or in some countries, at the point of a gun. There are various reasons for, and ways that the government can intervene in the private marketplace. Those reasons are issues in macroeconomics or inefficiency and inequality that are the focus in microeconomics.



1.6. An overview of land, labour, and capital markets; externalities and public goods


Lectures 8, 9, and 10 delve further into the business side of the supply and demand equation by studying how firms use the three so called factors of production, land, labour and capital. These factors are the three major inputs into the production process, where the final goods and services that are produced are called the outputs. A study of the labour market will help to understand how wages are determined, while an analysis of the capital markets will help to better understand how to evaluate the profitability of investments, such as those in new planned equipment. Studying land economics gives a better grasp of how rents are set in real estate markets.

Along the way, a number of important analytical tools are treated, such as concepts like net present value and rate of return, that will be of enormous use in business and personal lives. Lecture 11 looks much more closely at two particular market failures, which are externalities and public goods, both of which provide important rationales for large scale government intervention into the private marketplace.




2. Supply, Demand and Equilibrium




2.1. The law of demand, income and substitution effects, and shift factors


 
The computer market
 
The British philosopher Thomas Carlyle once said: "Teach a parrot the words supply and demand and you got an economist." Economics is hardly that simple but Carlyle's raw observation does hit on a basic truth of economics, namely that the concept of supply and demand rests at the core of any study of how the market system works. This lecture is about some basic elements of supply and demand. The figure is a typical supply and demand diagram for a popular product in the consumer market, computers. Price will always be labeled on the vertical axis and quantity will always be labeled on the horizontal axis in these diagrams. The demand curve slopes downward and the supply curve slopes upward. The market equilibrium is where these two curves cross.

 
Demand schedule
 
In order to build a demand curve, there must be some data on price and quantity. This data is often available in the form of a table that provides a demand schedule. Using this data it is possible to draw a demand curve from this data. In this figure, the consumer will buy 20 boxes of cornflakes at point E if the price is 1, but only 9 boxes at point A if the price is 5. The implication of this downward sloping demand curve is that the lower the price, ceteris paribus, the more units the consumer will demand, and the higher the price, ceteris paribus, the less the consumer will demand. This is not just common sense. It is also a principle based on careful scientific observation. This is called the law of demand.

 
Demand curve
 
Quantity demanded tends to fall as price rises for two reasons. First there is the substitution effect. When the price of a good rises, people will substitute other similar goods for it. For example, as the price of beef rises, people eat more chicken. The second reason why the quantity demanded falls as price rises is the income effect. This is because when the price of beef rises, purchasing power declines. That portion of the increase of purchases of chicken due to a reduction in purchasing power is the income effect.

The concept of ceteris paribus is really critical to understanding economic analysis. The words ceteris paribus are Latin for other things being constant. Economists usually use this ceteris paribus assumption to both draw their diagrams as well as to isolate the effects of specific changes in a market. For example, in order to draw the demand curve in a two-dimensional price and quantity space, all other things that affect the demand curve, like incomes, tastes and the prices of other products, must remain constant. These other factors are called shift factors because if one of these factors changes, the demand curve will shift inwards or outwards.

 
Demand curve
 
For example, suppose the average income of consumers rises. With more money in their pockets consumers tend to buy more of everything. The demand curve will shift outward just as a fallen income will shift the demand curve inwards.

 
The beef market
 
Suppose the price of chicken rises then the beef demand will rise and the beef demand curve will shift out. This is because beef and chicken are substitutes for each other in the broader market for meat. So, if the price of one goes up, the demand for the other goes up or shifts. Other similar examples would include corn flakes and oatmeal, pens and pencils and oil versus natural gas.

A third shift factor has to do with consumer tastes. Suppose that tomorrow, the American Medical Association publishes a report that says that people who eat prunes regularly live on average several years longer, while people who eat onion rings every day tend on average to live several fewer years. Then the demand curve for prunes will shift outward and the demand curve for onion rings will shift inwards.



2.2. Change in demand versus change in quantity demanded; The market demand and supply curves; Supply curve shift factors


 
Change in quantity demanded
 
With regard to demand curves, there an important distinction between a movement along curves versus a shift of curves. There may be a movement along the demand curve for pizzas from point A to point B because the price of pizza has fallen from $3.50 per slice to $2.00. In this case there has been a change in the quantity demanded.

 
Change in demand
 
In contrast there can be a change in demand. This might happen if incomes rise or in the much more unlikely case that pizza is proven to be a miracle health food. For a given price, such as $3.50, demand increases, in this case from three to five slices.

 
Supply schedule
 
Making this distinction between the quantity demanded and a change in demand is important because it helps to pinpoint the source of a change in the market. The market demand curve is the horizontal sum of the individual demand curves. It is useful, particularly from a marketing point of view, to understand how a single market demand curve comes from the many different tastes and preferences of individual consumers.

 
Supply curve
 
The supply curve depends on the ability of firms to produce. They transform factors of production like raw materials and labour and capital into consumable goods. Supply also depends on the individual's decisions to supply the factors of production. This is a reason to study how wages and rents and interest rates are set in the labour, land, and capital markets.

 
Supply curve outward shift
 
There is a business analog to the law of demand on the consumer side, which is called the law of supply. It can be illustrated using a supply schedule for corn flakes.

Firms will produce no corn flakes at all if the price is only one but they will produce 18 million boxes if the price is five. The implication then of an upward sloping supply curve is that the lower the price, ceteris paribus, less units firms will produce, and the higher the price, holding other things constant, the more firms will produce. This is the law of supply.

As with demand curves, there likewise are shift factors that influence the supply curve. One of the most important is technology. Suppose a company comes up with a new cost-saving computerised process for making cornflakes. The supply curve would shift outwards, meaning that for a given price, say at point B, supply increases. This is a change in supply, which is different from a movement along the supply curve from a change in price.

 
Supply shift factors automobile industry
 
If the price of labour or raw materials increases for corn flakes manufacturers then the supply curve shifts inward so they supply less at a given price. Still a third important shift factor is government policy. This can be a big cost factor for businesses.

For example if the government imposes stricter environmental regulations, manufacturers will see their cost rise and the supply curve will shift inwards. While such regulations will improve the quality of the air and water, they will also make goods more expensive.

Such regulations as well as others for health and safety, may even put domestic producers at a disadvantage to foreign competitors. Adversely, if Congress removes tariffs and quotas on the auto industry, the supply curve will shift outward as auto imports increase. This table summarises the major shift factors using the automobile industry as an example. Each of these shift factors will cause a shift in supply, whereas a change in price causes a movement along the supply curve.



2.3. Equilibrium; price effects of supply and demand curve shifts; price controls and floors


 
Market equilibrium
 
It is possible to show how the forces of supply and demand lead to an equilibrium in the market and thereby set the market price. To say something is in equilibrium is to say that the dynamic forces pushing on it cancel each other out. In supply and demand analysis, equilibrium means that the upward pressure on price is exactly offset by the downward pressure on price. The equilibrium price is the price towards which the invisible hand drives the market.
 
Surplus
 

The supply and demand curves of corn flakes cross where the price is 3 and the quantity is 12. Through the forces of supply and demand, this is where the equilibrium price is going to be.

Suppose that the price is 5 instead of 3. In this case, firms are willing to supply 18 million boxes of corn flakes, but consumers demand only 9 million at that price. At this price there is a surplus in the market, an excess of quantity supplied over quantity demanded. This surplus is equal to point B in the curve minus point A, or 9 million boxes. With all those extra boxes of corn flakes piling up in their warehouses, firms will start lowering their price, and they will keep lowering it right up until a point where the surplus disappears at point C.

 
Shortage
 
If instead of the price being too high, it starts out too low in the cornflakes market, for example at 2 instead of 3, then consumers will demand 15 million boxes, but firms will be willing to supply only 7 million boxes. In this case, there is a shortage of 8 million boxes, an excess of quantity demanded over quantity supplied.

With consumers clamoring for their product, the best guess is that firms will raise the price and they will keep on raising the price right up until it reaches the point where demand and supply are in balance, and the market clears. The apparatus of supply and demand is powerful in helping to predict changes in the market system.

 
Supply shift after bad harvest
 
Suppose a drought in the Midwest severely damages the wheat harvest. Since wheat is a key ingredient of bread, this will shift the supply curve for bread to the left. The bread supply curve has shifted from S to S'. The demand curve has not shifted because people have the same desire for their daily sandwich whether the harvest is good or bad. The bad harvest causes bakers to produce less bread at the old price, so quantity demanded exceeds quantity supplied.

The price of bread therefore rises encouraging production and thereby raising quantity supplied. This simultaneously discourages consumption and lowers quantity demanded. The price continues to rise until at the new equilibrium price, the amounts demanded and supplied are once again equal. This new equilibrium is founded E''. The intersection of the new supply curve, S' and the original demand curve. Thus a bad harvest or any leftward shift at the supply curve, raises prices and by the law of downward slope in demand, lowers quantity demanded.

In contrast, suppose that a new baking technology lowers costs and therefore increases supply. This means the supply curve shifts down in to the right. The equilibrium price is lower and the equilibrium quantity higher.



2.4. The market allocates goods and resources; What, for whom, and how; Some examples


 
Price floor
 

2.4.1. The market allocates goods and resources

Now let's go back to our bread example to shed further light on how to interpret changes in price and quantity. Suppose you go to the store and see that the price of bread has doubled. Has the demand for bread risen? Or has bread become more expensive to produce? The correct answer is that without more information, you simply don't know. It could be either one, or even both. In fact, economists deal with these sorts of questions all the time. When prices of quantities change in a market, does the situation reflect a change in demand or supply? Sometimes in simple situations, looking at price and quantity simultaneously will give you a clue. For example, a rise in the price of bread accompanied by a decrease in quantity suggests that the supply curve has shifted to the left. However, a rise in price company by an increase in quantity indicates that the demand curve for bread has probably shifted to the right.

The supply and demand framework can be used to illustrate some of the implications of introducing artificial price controls into the free market. At different times in the history of the United States, different types of price controls have been imposed either on specific products or on the entire economy. For example, during the 1930s America's farmers experienced great hardships from drought, pests, and crop failures as well as the side effects of the Great Depression. In response, President Franklin Delano Roosevelt's New Deal began a programme of price supports for many of America's agricultural products, from milk, corn, and wheat to peanuts and sugar.

 
Price ceiling
 
These price support programmes set a price floor for the farmers' crops and commodities. If the market price fell below this floor, the government would make up the difference to the farmer, in essence, by buying up any surplus. For example, the market price can be $1.30 per gallon, but the price floor can be $1.50 per gallon. The end result cab be a surplus of 10 million gallons of milk.

It is also possible to have a price ceiling. During World War II, as part of the war effort, the U.S government instituted price controls on most consumer goods. For example, assume that the market for bread may have had market price of $0.35 a loaf but there was a price ceiling of $0.25. There was a shortage in the market equal to the difference between point A and B. The way that the government addressed the shortage was to ration bread supplies. In other words, rather than simply take their money to them marketplace and buy bread, people had to first get a ration card giving them the right to the purchase.

In the presence of price controls and shortages, there can be a different distribution of bread supplies. In a free market, it is the product price that rations supplies, so-called rationing by the purse. With price controls, it is the government that can control the for whom goods are produced. In this regard, in 1974, the U.S. experienced a different kind of rationing. When the government put a ceiling on prices at the gas pump in response to the Arab oil embargo. People had to wait in long lines to buy gasoline. In this case, no ration card was necessary to buy gas, all people had to have was time, lots of time.

 
Demand shift heating oil
 

2.4.2. What, for whom, and how

By determining the equilibrium prices and quantities of all inputs and outputs, the market and not the government allocates or rations out the scarce goods of the society among the possible uses:
- What goods are produced? This question is answered by the signals of the market prices. High oil prices stimulate oil production, whereas low food prices drive resources out of agriculture. Those who have the most dollar votes have the greatest influence on what goods are produced.
- For whom are goods produced? The power of the purse dictates the distribution of income and consumption. Those with higher incomes end up with larger houses, more clothing, and longer vacations. Backed up by cash, the most urgently felt needs get fulfilled through the demand curve.
- How goods are produced? Even this question is decided by supply and demand. When corn prices are low, it is not profitable for farmers to use expensive tractors and irrigation systems, and only the best land is cultivated. When oil prices are high, oil companies drill in deep offshore waters and employ novel seismic techniques to find oil.

 
Demand shift allergy medicines
 

2.4.3. Some examples

The supply and demand framework can help people to save or make money in their professional or personal life. Suppose then in your daily reading of the newspaper, there is a small story on the back pages about the possibility in the coming year of another El Niño condition. During the last El Niño, winter temperatures were unusually warm, while rainfall fell at record levels and flooding plagued much of the country. A highly respected Australian meteorologist contends that the chance of El Niño happening in the coming year is quite high.

How may people use all this information? It depends on who they are. For example, the chief executive officer of a home heating oil company in Boston may see such news as a first alert that, because of a warm winter, the demand curve for heating oil may shift dramatically inward like this. So, in response, she might stock lower inventories of oil and plan for a leaner work force.

A stock broker in Florida, managing several billion dollars of pension fund money might decide to sell the heating oil stocks and move some of those investment funds in the companies that provide things like pest-control and allergy medicines. This is because where there's unusually high rainfall, the flowering plants that cause allergies increase their growth dramatically. This shifts out the demand curve for allergy medicines. By the same token, this increased plan growth provides fodder for the food chain, with one of the byproducts more pest likes rats and fleas, thereby increasing the demand for pest control.

 
Coffee CEO decision
 
A homeowner in Los Angeles may take some precautions regarding his leaky roof. If he waits too long to call a roofer to fix it, he may find himself in a long line paying higher prices as the demand for roofing skyrockets in response to torrential rains. So he bites the bullet and gets the roof fixed now at a much cheaper price than he might have to pay a few months later.

Finally, there may be a more perplexing situation where both the supply and demand curves are likely to shift. In such cases supply and demand analysis can be especially helpful in figuring out the net effect of such changes on price, and thereby help dictate business plans. For example, a CEO of a large chain of coffee shops in the Pacific Northwest may face the following situation. On the one hand, El Niño may drive up the cost of cappuchino, because it is likely to lead to a bad coffee crop. On the other hand, during unusually wet weather, people drink a lot more coffee.

So what is she going to do? She might go into the coffee futures market and lock into a lower coffee price early, essentially betting that prices will rise later. However, El Niño might fizzle and she might be wrong. At the same time, if she decides that any demand effect will overpower a change in supply, she might decide to accelerate the construction of the 50 or so more coffee shops that are on the drawing boards. In business, it is all a gamble, but chance favours the prepared mind.




3. Demand and Consumer Behaviour




3.1. Consumer choice and utility theory


In the early days of automobile manufacturing, Henry Ford was reported to have said of his model T car: "Give them any color they want, so long as it's black." Much has changed since Ford's day, at least when it comes to consumer choice. Indeed, today's consumers can choose from a dizzying assortment of goods and services in the marketplace in virtually every industry, from autos and computers to sneakers and bikinis. The question is how do consumers go about making their choices? The concept of individual choice is one of the most important in economics. In fact, the great economist, Stanley Jevons once said, the theory of economics must begin with a correct theory of consumption.

So why do people do what they do? While psychologists and philosophers have many complex answers to that question, economists believe that for the most part we do what we do and we buy what we buy because it makes us feel good. Some may argue that this selfish mode lacks any of the milk of human kindness that sets humans apart from the apes, it is nonetheless hard to disagree with the idea that a lot of our behaviour is indeed driven by self interest. Using this simple method of self interest, consumer choice boils down to three things. The pleasure people get from consuming a good, the price they have to pay for it and the income or budget available to them to exercise their choices.

 
Diminishing marginal utility
 
So how do you measure pleasure? This is a good question. The English philosopher Jeremy Bentham and his followers thought they had an answer back in the 1800s. Bentham proposed that society should be organised on the principle of utility, which he defined as the property in any object. To produce pleasure, good or happiness or to prevent pain, evil or unhappiness. To Bentham all legislation should be designed on utilitarian principles to promote the greatest happiness of the greatest number. Bentham's followers took him quite literally. They believed that scientists would eventually invent a machine that could measure pleasure by measruing brain waves.

They even developed a measure of pleasure they called the util. For example, a big, juicy sirloin steak for dinner might give a person 1,000 util while a plate of spam might yield only 100 utils. If economists were able to take such measurements with some utilometer, they'd have what is called a cardinal measure of utility. Meaning that utility could be measured in actual numbers. This would make it easy to explain consumer behaviour.

Nobody yet has come up with a utilometer. Instead, in their efforts to explain consumer choice, economists have settled for an ordinal measure of utility. An ordinal measure simply ranks goods relative to one another. Thus, people can say that they like peas better than broccoli and like ice cream better than both of those vegetables. But they do not really need to say by how much to rank their preferences for these goods.

 
Diminishing marginal utility
 
Now, having debunked the existence of a cardinal utility, it will be nonetheless convenient to assume that it exists. In fact, economists actually use numbers to measure utility. Economists often make a simplifying assumption to explain a complex point. In this case, it can be used to explain the difference between total utility and marginal utility and to show how the utility-maximising rule or equi-marginal principle makes is possible to derive the downward sloping demand curve. The use of actual numbers is only for simplicity.

Marginal utility steadily falls as consumption rises. This reflects the law of diminishing marginal utility. And it is one of the most important concepts in economics. Suppose you go to a restaurant and have duck orange with wild rice. It might taste pretty good and you might even be hungry after eating it. Even so, if the waiter brings a second serving of the duck, it probably won't taste as good as the first. A third serving probably would not taste good at all.

Utility can be plotted in a graph, for example the utility and marginal utility associated with eating pizza slices. The downward slope of the marginal utility curve is reflected in the total utility curve being bowed downward. This bowed shape in turn reflects the idea that total utility increases with consumption but does so at a decreasing rate. In other words, there is diminishing marginal utility.



3.2. Consumer optimisation and equimarginal principle; Income and substitution effects


Utility theory can be used to solve the consumer's optimisation problem. That means that given the money they have in their pockets, consumers are going to find the best way to spend it. That's optimising behaviour and all economic agents are assumed to optimise something as a way of explaining their behaviour. For example, firms typically are assumed to maximise profits. In the consumers case, economists assume that consumers maximise utility subject to a budget or income constraint. This means that consumers have a certain amount of income to spend. Subject to their budget constraint and given a menu of prices, they will choose a market basket of goods that will provide them with the greatest utility or satisfaction.

 
Marginal utility
 
The question is how do consumers do this? The answer lies in something called the utility maximising rule or equimarginal principle. A consumer with a fixed income facing market prices will achieve maximum satisfaction when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good. Let's take a few minutes now to prove this. By so doing, we can derive the downward sloping demand curve and gain further insight into market equilibrium on the consumer's side of the market.

Assume that fastfood nut Greg is trying to decide how many Big Macs and Dove Bars he should buy with his fixed daily income of $10. This table summarises the marginal utility that Greg will get from the consumption of the first, second, third and so on units of each of these goods. Note that for both products, marginal utility is declining. Now in order to make this table really work for us, we have to take into account the different prices of each of the two products. This can be done by converting the marginal utilities to a per dollar spent basis, simply by dividing each marginal utility by the product price. For Big Macs, a marginal utility of 18 converts to a marginal utility per dollar of 9 because its price is $2.

 
Purchase decision
 
There is a specific sequence of purchases that Greg will make to maximise his utility. With his first potential choice, he will start by buying one Big Mac which will yield him a marginal utility per dollar of 12 and leave him with a dollar less income. This is clearly superior to buying the first Dove Bar, which only yields an MU of 10 per dollar. Next, Greg will buy his first Dove Bar for $1.00 and a second Big Mac for $2.00, because both yield an MU per dollar of ten. In his third potential choice, Greg opts for a third Big Mac, and with his fourth potential choice, he spends his remaining income of $3 on a second Dove Bar and fourth Big Mac.

Greg runs out of money exactly where the marginal utility per dollar of the two goods are equal, in this case, equal to eight. This proves more generally that utility maximised when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good. This is the utility-maximising rule or the equimarginal principle. The equimarginal principle perfectly explains why demand curves slope downward.

This can be explained as follows. Suppose that at the equilibrium point in the example the marginal utility per dollar for the two goods would be constant and equal to eight. Now further suppose that the price of Dove Bars increases. The marginal utility per dollar of Dove Bars falls below the same ratio for Big Macs. Therefore, in order to maximise his utility, Greg will have to decrease his Dove Bar consumption and increase that of Big Macs. This clearly implies a downward sloping demand curve. As the price of Dove Bars rises, the quantity demanded falls.

This example can also help to understand the income and substitution effects. In this case, the substitution effect is that when the price of Dove Bars rises, Greg increases his consumption of Big Macs. This is because the last dollars spent on Dove Bars yields less utility than the last dollars spent Big Macs. To understand the income effect, the difference between nominal income and real income is important. Nominal income is the face value of what we have in our pocket or bank account. For Greg it is $10.

When inflation increases, in this case when the price of Dove Bars rises, it reduces Greg's actual purchasing power. Real income is nominal income adjusted for inflation. The portion of the increase in Greg's purchase of Big Macs due to his reduction in real income is the income effect. The algebra to generalise the utility-maximising or equimarginal principle to the case of many goods looks like this:

MU = MU1/P1 = MU2/P2 = MU3/P3 = ... = MUn/Pn

If MUx/Px > MUy/Py then one should consume more of good x to maximise utility. If MUx/Px < MUy/Py then one should consume more of good y to maximise utility.



3.3. Demand price elasticity and its determinants


 
Demand curves for crack cocaine and beef
 
The price elasticity of demand simply measures how much consumers will increase or decrease their quantity demanded in response to a price change. A big change means demand is elastic, and a small change means demand is inelastic. The demand curve for crack cocaine is steep, almost vertical. In contrast, the demand curve for beef is almost flat or horizontal. The demand for crack cocaine is the least elastic and the demand for beef is most elastic. If the price of crack cocaine rises by a dollar, the quantity demanded changes little. In contrast, a dollar increase in the price of beef results in a huge decrease in the quantity demanded. The general price elasticity formula is:

(ΔQ / Q) / (ΔP / P)

This is simply the percentage change in the quantity demanded divided by the percentage change in price. Percentages are used rather than absolute amounts in measuring consumer responsiveness for at least two reasons. First, the use of percentage changes for both price and quantity makes the calculation independent of the unit of measure for different goods, which can be pounds, bushels, tons, or something else as well as the measure is for price, which can be pennies or dollars. Using percentages resolves this choice of units problem.

For example, suppose that the price of cement falls from three dollars to two dollars and consumers increase their purchases from 60 to 100 pounds. It may appear that consumers are sensitive to price changes, and therefore, the demand is elastic. After all, a price change of 1 has caused a change in the amount demanded of 40. But now, let's change the monetary unit from dollars to pennies. In this case, we could just as easily say, that a price change of 100 pennies caused a quantity change of 40 pounds, giving the impression that demand is inelastic.

Second, the use of percentages allows us to solve the comparing products problem. For example, it makes little sense to compare the effects on the quantity demanded of a $1 increase in the price of a $10,000 car versus a $1 increase in the price of a $1 carton of milk. Here, the price of both products has risen by the same amount, but the price of milk has risen by 100%, while the price of the car has risen by a miniscule tenth of one percent. It is better to compare the price change of both products on the same percentage basis to determine how consumers will respond to the price change. That is what the elasticity formula allows us to do. The formula for calculating price elasticities is:

Ed = (ΔQ / (Q1 + Q2) / 2) / (ΔP / (P1 + P2) / 2)

The change in Q or ΔQ can be rewritten as the quantity demanded before the price change, minus the quantity demanded after the price change, or Q1 - Q2. The same can be done for the change in P or ΔP. It is simply P1 - P2. The two terms in the denominators are simply the averages of quantity and price. The formula is about dividing a change by an average. Since price and quantity demanded are inversely related, the price elasticity coefficient will always be a negative number. For simplicity, economists usually ignore the minus sign and present price elasticities as absolute values.

 
Demand curves for crack cocaine and beef
 
There are three major categories of elasticity. First, demand is elastic if a given percentage change in price results in a larger percentage change in quantity demanded. For example, if a two percent fall in price results in a four percent change in quantity demanded. In this case, the elasticity is greater than one, and the curve is flat, as in the beef example. If the curve were horizontal, demand would be said to be perfectly elastic.

Second, demand is inelastic if the price elasticity is less than 1. For example, if a 3% decline in price leads to just a 1% increase in quantity demanded. In this case, the percentage change in price is accompanied by a relatively smaller change in the quantity demanded, and the curve is steep as in the crack cocaine example. If the curve were perfectly vertical, demand would be perfectly inelastic. Finally, demand is said to be unit elastic if the price elasticity equals 1. For example, if a 1% drop in price causes a 1% increase in quantity demanded, elasticity is exactly 1.

Necessities like housing, electricity and bread, are price-inelastic. On the other hand, goods that tend more towards being luxuries, like restaurant meals and glassware, are price-elastic. Besides luxuries versus necessities, other important factors that determine the elasticity of demand include substitutability, proportion of income, and time. The greater the number of substitutes for a good, the more elastic its demand will be. For example, beef has a lot of substitutes, such as poultry, fish, and soy products. In contrast, crack cocaine has little or no substitutes. That is why a drug addict's demand is much more inelastic than a beef eater's.

The elasticity of demand also depends on how narrowly the product is defined. For example, the demand for Chevron gas is much more elastic than the demand for gas because many brands, such as Shell and Texaco, can be substituted for Chevron, but there is no good substitute for gas. A third factor determining elasticities is the proportion of income. Other things equal, the higher the price of a good relative to someones budget, the greater will be his or her elasticity of demand for it. For example, a 10% increase in the price of pencils will amount to only a few pennies, with little response in the amount demanded, but a 10% increase in the price of housing would have a significant impact on the quantity people would purchase.

The fourth factor is time. In general, demand will tend to be more elastic in the longer run than in the short run. For example during the energy crisis of the 1970s the demand for oil was inelastic in the short run. However, over time, businesses invested in energy-saving technologies while people started driving more fuel-efficient cars, and the demand elasticity increased.



3.4. Price elasticity and total revenue


 
Total revenue
 
The price elasticity concept can be useful in both business and government applications. If the price of a product is raised, total revenues from selling that product can go up or down depending on the price elasticity of demand. Total revenues TR simply equal the price P times the quantity Q:

TR = P * Q

Suppose a business sells a product for which demand is relatively price elastic. If the goal is to raise total revenues, then the price should be lowered. This is because in the total revenue formula price P will go down by less than quantity Q will go up, so total revenues TR will rise. There are six pricing and total revenue possibilities.

It should be readily apparent from this figure just how powerful this concept can be. Just remember the case of Stuart Applegate. He was the Chief Executive Officer who tried to bail out his software company by raising prices, but demand was highly elastic so total revenues fell, and his company went out of business. Then there was Jennifer Twilly, a financial analyst in the operations department for the transit authority in Paradise, California. Facing a revenue shortfall, Jean ordered an analysis of the elasticity of demand for bus services. When she found that bus demand was also highly elastic, she recommended to her supervisor that the Transit Authority lower bus fares. This pricing strategy did indeed increase ridership, and boost total revenues. It also earned Jean a nice promotion.

It's not just pricing strategies that the concept of elasticity of demand can help with. It's also broader marketing strategies. For example, many airlines offer fare discounts to people who stay over on a Saturday night. This is because airlines are trying to sort out two different kinds of customers, business people with more inelastic demands who want to fly home on the weekends and perhaps be with their families, versus pleasure travelers who do not mind staying over on a Saturday night. By making this separation, the airlines can effectively charge two prices, a higher one to business travelers and a lower one to pleasure travelers. This means more total passengers, and more total revenue.

Most new cars do not sell at their sticker price? People have to go in and haggle when they buy a car whereas if they buy a gallon of milk, they pay the sticker price. Car salespeople are trained to sort out comparison shoppers with more elastic demands from impulse buyers who have inelastic demands. By not listing the selling price of cars, the car salespeople can charge the impulse buyers more.

 
Crack cocaine price elasticity
 
Finally, the concept of price elasticities can also help to think through a wide variety of public policy problems. The demand curve for a highly addictive drug like crack is almost perfectly inelastic. The supply curve crosses the demand curve at point E where the price is $10 a dose. When the US government escalates its war on drugs by interdicting large quantities of illegal cocaine shipments from Colombia, the supply curve shifts inward. The practical effect is to significantly raise the price, but because demand is inelastic, this has little impact on reducing crack consumption. There is a further problem. Crack addicts have to pay more for their fix so crime tends to increase, because it is through robberies and burglaries and prostitution that most addicts pay for their dope.

Given these observations, the logical thing to do, at least from an economic point of view, would seem to be to just legalise drugs. Beyond the obvious moral questions raised by that proposal, some economists have argued that while drug addicts are highly insensitive to price, the casual drug user is highly price sensitive. This suggests that even if the war on drugs has little effect on curbing consumption by drug addicts, it nonetheless may have a big effect on reducing consumption among casual users, who presumably respond to price hikes by substituting cheaper drugs like alcohol for more expensive drugs, like cocaine. The debate over the legalisation of drugs remains unresolved, but with the help of microeconomics, policy makers can better think through the problem.

A second policy issue involves agricultural price supports. The problem here is that demand for farm products is highly inelastic, perhaps only 0.20 or 0.25. This means, that during a year of bumper crops, the quantity demanded will change only a little bit, but food prices will plummet. The paradoxical result is that many farmers go bankrupt when crops are plentiful. One way to address this problem is to restrict farm output, and this has been regularly done with many farm products, from milk and oranges to corn and wheat. A third application involves the levying of so-called excise or sales taxes. If the government imposes a sales tax on a product that is highly elastic, total revenues fall. Most legislatures are smart enough to seek out products with more inelastic demands to tax, such as alcohol and tobacco.




4. Supply and Production Theory




4.1. Overview of production theory and the production function


This lecture is about the supply curve and production theory. This includes a number of important ideas, such as the difference between short run and long run costs and the concepts of marginal cost and the law of diminishing returns. The powerful concept known as economies of scale is discussed when the various possible shapes of cost curves are examined. The important difference between economic versus accounting profits is treated as well.

Suppose that tomorrow morning you wake up and find yourself as the main character in a Steven Spielberg movie called Back To The Business Future. You are a refugee from the new millennium and you find yourself smacked back to the middle of 1972, shortly before the OPEC oil cartel slapped an embargo on the American economy. Your only possessions besides the now quite out of style clothes on your back, are the design and engineering blueprints of a highly energy efficient automobile, blueprints that your mad scientist buddy stuffed in your hands just before he accidentally catapulted you back into one of the worst decades in American economic history.

 
Production function
 
Now to round out this plot let's assume that the only way you can save the planet from a rapacious foreign cartel, and also get back home to your family and friends, is to make a few million bucks producing these energy efficient cars. How do you do it? The first thing you have to settle upon is your recipe for producing the car. In economics, this is the production function. Algebraically, it looks like this:

Q = F(K,L,R)

In this equation Q is the output and K, L and R are the factor inputs. Specifically, Q is the quantity of cars you want to produce, K is the capital or plant and equipment needed for the production, L is the quantity of labour and, R is a catch-all term for things like raw materials and energy. The F term reflects the state of the current technology. The more advanced the technology, the more output can be produced with a given mix of labour, capital and resource inputs. In technical terms, the production function specifies the maximum output that can be produced with a given quantity of inputs, for a given state of engineering and technical knowledge.

In order to make your millions, what combination of inputs are you going to choose, and by implication, what would be the size of your automobile plant? Before answering this question, it is helpful to make a further distinction between the short run and the long run. To illustrate the short run suppose the factory for your energy efficient auto is already up and running and producing 10,000 cars a year. Further suppose that the Organisation of Petroleum Exporting Countries, the OPEC cartel slaps an embargo on the U.S. and quadruples the price of oil, just as it did in 1973 and 1974. At this point, demand starts to increase dramatically for your cars as consumers seek to substitute your gas miser for their gas guzzlers.

What do you do? In the short run, you add more shifts, hire more workers and use more energy and raw materials as you try to run your plant around the clock to meet increased demand. In the short run, this is your only option because it would take over a year to build a new factory. The short run is the period in which firms can adjust production only by changing variable factors such as materials and labour but cannot change fixed factors such as capital. The long run is a period sufficiently long enough so that all factors in the production function, including capital, can be adjusted. In this case, it is the time it would take to expand the existing factory or build a new one. This distinction between the short and long run is important in production theory because each period has its own kind of cost analysis.



4.2. Average, marginal, variable and total costs; The marginal product and law of diminishing returns


 
Cost table
 
The short run cost analysis can be made using table detailing auto production cost at the factory. The first column is the quantity of cars the factory can produce in thousands. The second column represents the firm's fixed costs. These fixed costs are sometimes called overhead or sunk costs. Fixed costs are those costs that do not change with the level of output. Examples of fixed costs include rent, interest on the bonds the firm issued to get money to build the factory, insurance premiums and, the salaries of top management.

Variable costs are those costs that change with the level of output. For example, when production is increased to meet demand, the firm has to pay for more raw materials and fuel. The firm also has to pay more in wages to cover the increased overtime and additional workers. Total cost is variable cost plus fixed cost. Marginal cost is the additional cost incurred in producing one extra unit of output. Thus, when the firm increases from say 10 to 11, the total cost increase is from 150 to 156. In this case, the marginal cost of that additional unit of production is 6.

 
Marginal product
 
While fix costs stay the same, and both variable and total costs rise, marginal costs first fall and then rise. This is because of the Law of Diminishing Returns. In the context of production theory, capital is fixed in the short run, but factors like labour are variable. In such a situation, adding more workers means that each additional unit of labour has less capital to work with. At some point, the extra or marginal product of each additional worker begins to decrease.

The marginal product of an input such as labour is the extra output added by one extra unit of the input, holding other things such as capital constant. The marginal product cannot keep rising forever. For example, in the car factory, as more and more workers are added, the assembly line starts to get too crowded and workers have to wait in line to use the machines. Thus, at some point the total product or total output keeps increasing but begins to do so at a decreasing rate.

The total product that can be produced for different inputs of labour holding other things constant can be plotted in a graph. As total product rises, it does so at a decreasing rate, as indicated by the smaller and smaller incremenets in the dark gray squares in the left-hand corner. This translates to a falling marginal product curve. A rising marginal cost curve must follow directly from a falling marginal product curve. The shapes of both curves are attributable to the law of diminishing returns.



4.3. Marginal cost and marginal cost pricing; The AFC, ATC, and AVC curves


 
Supply curve
 
The concept of marginal cost is one of the most essential in microeconomics as competitive firms will produce at a level where the price of their product P equals their marginal cost MC or:

P = MC

The supply curve is actually that portion of the marginal cost curve above the average variable cost curve. Average fixed cost, average variable cost and average total cost are derived by calculating averages. The data can be used to draw the graph for marginal cost.

 
AFC, AVC and MC curves
 
The AFC curve slopes downward and approaches zero on the horizontal axis, while the AVC curve approaches the ATC curve. The AFC curve approaches zero because as a firm's output increases, it spreads its fixed costs over a larger number of units, so average fixed costs must fall. For the same reason the AVC curve must approach the ATC curve as output increases. These are important insights in business, because the name of the game is often to spread fixed costs over as many units as possible. The ATC, AVC, and MC curves first slope down and then up because of the law of diminishing returns.

 
AFC, AVC and MC areas
 
The MC curve intersects both the AVC and AC curves at their minimums. If MC is greater than ATC then the ATC must be rising. If the production of an additional unit has a marginal cost smaller than the average cost, then production of that unit must reduce the average. If the production of an additional unit has a marginal cost greater than the average cost, then production of that unit must drive the average up.

Only when MC equals ATC, the ATC is at its lowest point. This is a critical relationship. It means that a firm searching for the lowest average cost of production should look for the level of output at which marginal cost equals average cost. There is a small range, Area B, where average cost is falling and average variable cost is rising. When marginal cost is coupled with the concept of marginal revenue, the firm is able to determine if it is profitable to expand or contract its production level.



4.4. Long run cost analysis and economies of scale


The long run is when all factors, including capital, are variable. For example, the Back to the Business Future auto plant started off with a relatively small plant. As demand expanded, more plant capacity has been built. Now suppose that this pattern kept repeating itself and that the firm kept building larger and larger plants. What happens to the firm's average cost as plant scale increased? There are a number of possible answers. The long run average cost curve is the envelope of the short run average cost curves. For any given plant scale, two things are certain. Capital inputs are fixed in the short run and there is a point on the ATC curve where average cost is minimised.

 
Long run average cost curve
 
Now if you built a bigger plant output will increase and there will be another short run ATC curve created. which point on this bumpy planning curve, shows the least unit cost attainable for any output when the farm has had time to make all desired changes in plant size. Now if the number for possible plant sizes if large, the long run average cost curve approximates a smooth curve. This long run cost curve has a broad U shape. The U-shape of the long run average cost curve suggests that at least up until point Q* a larger plant size will mean a lower and lower unit cost. However, beyond Q* successively larger plants mean higher average total costs.

The reason for this is not the law of diminishing returns, which explained our U shaped short run average cost curves. In the long run, the law of diminishing returns does not apply, because all factors are variable. Instead, the explanation lies in economies of scale, diseconomies of scale and constant returns to scale. Economies of scale exist when the per unit output cost of all inputs decreases as output increases. Economies of scale to may be traced to labour specialisation, managerial specialisation, efficient capital, by products and other factors.

Increased labour specialisation means dividing and subdividing jobs as plant size increases. Instead of performing five or six jobs, a worker can focus on one. For example, in a small plant a skilled machinist might spend half the time performing unskilled tasks leading to higher production costs. Greater specialisation also eliminates the loss of time that occurs when workers shift between jobs. With managerial specialisation, a supervisor who can handle 20 workers will be under-used in a small plant, as well as a sales specialist who may have to divide his or her time between other managerial functions, such as marketing, personnel, and finance.

Larger plant size also facilitates the most efficient capital use. For example, in the auto industry, the most efficient production method involves robotics and sophisticated assembly line equipment, but effective use of such machinery and equipment requires an output of at least 200,000 cars. Larger scale production also allows better use of by-products. For example, a large meat packing plant will also make glue, fertiliser, and pharmaceuticals from animal remains which would otherwise be discarded by smaller producers. Finally, there are other factors such as design, development, and certain other start up costs that must be incurred irrespective of sales. These costs per unit decline as output increases.



4.5. Diseconomies of scale, minimum efficient scale and natural monopoly


 
Different long run average cost curves
 
An excellent example of how the concept of economies of scale enters into important policy debates, is offered by the case of the B2 or Stealth Bomber. The Pentagon originally wanted to build 132 of the planes at a cost of $580 million per plane, but the secretary of defence slashed the Pentagon's request to only 75 bombers. The cost per plane soared to over $800 million due to the loss of scale economies.

Just as a firm can benefit from economies of scale, so too can it be harmed by diseconomies of scale. Such diseconomies are characterised by higher unit costs as plant size increases beyond a certain point, represented by Q*. The main problem causing diseconomies of scale lies with managerial problems in efficiently controlling and coordinating a firm's operations as it becomes a large scale producer. At some point, a plant just gets too big for effective management. At the same, in massive production facilities, workers may begin to feel alienated from their jobs and efficiency may suffer.

There are four different possible long-run cost curves for a given industry. The first graph shows a broad U-shaped curve. The second graph has a much more pronounced U-shape. The third graph has a flat segment. The fourth graph has a downward slope.

The narrow and steep U-shape in the second graph indicates that economies of scale are exhausted quickly, so that minimum unit cost will be encountered with a relatively low output. Typical profile of an industry characterised by this kind of curve is that there are numerous sellers in s healthy competition. Examples include many retail trades and some types of farming, as well as certain types of light manufacturing, such as baking, clothing, and shoes. In such industries, a particular level of consumer demand will support a large number of relatively small producers.

 
Constant returns to scale
 
The third graph has a long flat spot in the middle of the curve where unit costs do not vary with size. This is the case of constant returns to scale and it characterises many American industries. For example, during the 1980s there were a lot mergers in the commercial banking industry. At the time most analysts thought that unit costs would fall dramatically. After all, banks could close some of their branches in overlapping markets and combine support services such as computer processing, advertising, auditing and legal work. However, studies found that the mergers did not significantly reduce costs. One possible explanation is constant returns to scale over a broad spectrum of output.

The fourth graph is the signature of a natural monopoly. Unit costs steadily fall so that there are increasing returns to scale over the relevant range of output. This means that over time bigger producers will drive out smaller producers until there is only one producer left, the infamous monopolist. The result of this market failure is that price will be set too high and output too low for market efficiency so that government regulation may be warranted. Examples of regulated natural monopolies include railroads, the local telephone service and cable TV as well as the distribution of electricity and gas.

Another important concept in production theory is minimum efficient scale. This is defined as the smallest level of output at which a firm can minimise long-run average costs. In the constant returns to scale figure, this point is reached at Q1. Because of the extended range of constant returns to scale, relatively large and relatively small firms can coexist and be equally viable. This is the case in industries such as apparel, food processing, furniture, wood products, and small appliances.

In contrast, in the case of natural monopolies, like the rail roads and utilities, small firms cannot realise the minimum efficiency scale (MES) so there is only one seller. A large minimum efficient scale can also give rise to another type of industry structure known as oligopoly that is characterised by a small number of large sellers. Examples include automobiles, aluminum, steel, and cigarettes. The shape of an industry's long run average cost curve has an enormous influence on the structure of that industry and determines that it will be competitive, oligopolistic or monopolistic. These different market structures determine the conduct of the firms and therefore the performance of the market.



4.6. Accounting versus economic profits; The price elasticity of supply


 
Elasticity of supply
 
The supply curve shares several common traits with the demand curve. Just as there is a law of demand, there is a law of supply. First, when the price of a good increases, the quantity of that good supplied will increase. This that the supply curve is upward sloping. Second, just as there is a price elasticity of demand, there is a price elasticity of supply. The price elasticity of supply is simply the percent change in quantity supplied divided by the percent change in price. The most important determinant of the elasticity of supply is the number of substitutes for the good. If substitution is easy, supply will be elastic. If substitution is difficult, supply will be inelastic.

An economist as opposed to an accountant, will count not only explicit but implicit cost as well. In business, explicit costs are monetary payments to outsiders for things like labour, materials, fuel, transportation and power. In contrast, implicit costs represent the money payments that could have been earned by employing the available resources in their best alternative use. This distinction sheds further light on the concept of opportunity costs. The opportunity costs of a decision include all of its consequences, whether they reflect explicitly monetary transactions or not. For example, the immediate dollar cost of going to a movie instead of reading your economics textbook is the price of the movie ticket. However, the opportunity cost also includes the possibility of gaining a better understanding of macroeconomics and therefore becoming more successful in business.

 
Example of income statement
 
Explicit, implicit and opportunity costs can be illustrated using an example. Suppose both you and your spouse earn after tax salaries of $45,000 a year as sales representatives for a hospital equipment distributor. You want to do better, so you both quit your jobs to open your own business, a health food juice bar called Juice Me Up Scotty. For your start-up capital, you borrowed $20,000 from the bank at 10% interest. You use another $30,000 of your own savings that had been earning you $1,500 annually in interest income from your portfolio bond investments. You also kick out the tenant of the storefront that you own so you can use it for the business. The tenant was paying $800 in rent per month.

Now take a look at this income statement that your accountant has prepared for your business after a year of operation. Items two, three and four represent the cost of goods sold, which are basically the variable costs. These total 97,000 dollars and include employee compensation, operating costs such as utilities, and materials like the 400 pounds of carrots and 1,000 bushels of oranges that have beem juiced. Items six, seven, and eight represent the fixed costs since, in the short-run, these costs can't be changed. Those costs total $18,000 and include things like selling and administrative costs, rent, which in this case is zero because you own the building, and appreciation. When your company buys, say a cash register for your store, it may have an estimated useful life of ten years. Each year, in effect, you use up a portion of that machine. Appreciation is a way of measuring the annual cost of the each capital input that your company owns.

 
Example of opportunity cost
 
Subtracting net sales form operating expenses yields a net operating income of a $140,000. From this you have to subtract the taxes you pay to the government as well as the interest payments on the loan. This yields an accounting profit or net income before taxes of $135,000 and an after tax accounting profit of $90,450, which you could either pay out as dividends if you had shareholders, or count is retained earnings for the firm. That looks pretty good for a year's work. Implicit costs have to be subtracted from the accounting profit to get the true economic profit.

The calculation of economic costs shows that, at least in this case, you wound up actually being worse off by going into business for yourself. By providing your own financial capital you gave up $1,500 in forgone interest. By kicking out your tenant you gave up $9,600 in annual rent. And then there is the $90,000 in after tax salaries that you and your spouse gave up to work for yourselves. Subtracting all these implicit costs from the accounting profit you wind up for all your blood, sweat and carrot juice with a negative economic profit of $10,650. That's not good. Ppeople make mistakes like this all the time in both their personal and professional lives because they base important decisions on accounting rather than economic profits. So please be careful and always consider your opportunity cost when you make a decision.




5. Perfect Competition




5.1. Overview of industry structure, conduct, and performance


Industries and markets are organised in different ways. An important part of microeconomics is to understand how industries are structured and why different industries exhibit different kinds of market conduct and performance. Industry structure refers to how many firms are in an industry, whether the firms are big or small, what the firms cost structure looks like and, how market share is divided among the firms. The four major types of industry structure include, perfect competition as well as three forms of imperfect competition, which are monopoly, monopolistic competition, and oligopoly.

 
Structure-conduct-performance paradigm
 
Perfect competition is the market structure by which economists measure all other market structures. It is important to understand the implications of each of the major assumptions of perfect competition. These assumptions range from numerous buyers and sellers, and free entry and exit, to perfect information and homogeneous products. These assumptions can be used to explain why the perfectly competitive market is efficient and how markets in the real world can fail when one or more of the restrictive assumptions of perfect competition fail. The concept of market failure is key to understanding why government may sometimes intervene in the free market.

The goal is to understand how industries are structured and why different industries exhibit different kinds of market conduct and performance. Industry structure refers to how many firms are in an industry, whether the firms are big or small, what the firms cost structure looks like, and how market share is divided amongst the firms. When studying perfect and imperfect competition, the structure-conduct-performance paradigm can be useful. It is one of the key conceptual tools of traditional microeconomics. The central concept driving this paradigm is that industry structure determines market conduct, and market conduct in turn helps determine market performance.

Market conduct embodies the various pricing and marketing tactics and strategies of businesses. Such conduct includes at what level a firm or industry sets its price and output. It also includes whether that firm or industry engages in various kinds of non-price competition through product differentiation and advertising. These different kinds of market conduct in turn drive market performance. Where performance is measured by yardsticks, such as allocative and productive efficiency. These yardsticks can tell us how well or poorly a society's resources are being used.



5.2. Assumptions of Perfect Competition; The P=MR condition


In a perfectly competitive market numerous buyers and sellers meet, consumers pay the lowest price for goods and services and all resources are allocated efficiently. It is the market structure by which economists measure all other market structures. This is because beginning with Adam Smith, many economists have shown that perfect competition is the most efficient type of market structure. There are few if any industries, which can meet the restrictive assumptions of perfect competition. Each of these restrictive assumptions has specific implications.

 
Market and individual demand curves in perfect competition
 
The most important requirement of perfect competition is numerous buyers and sellers. When this assumption is met, any one firm's output is minuscule compared to the market output. Therefore what one firm does has no influence on what other firms do. This condition is important because it is one of the primary reasons why perfectly competitive firms are price takers rather than price makers. For example, in a perfectly competitive market for widgets equilibrium will occur where supply-demand cross at P* and Q*. Because there are numerous buyers and sellers in this perfectly competitive industry, so if one firm tries to rise it price above P*, customers will simply by their widgets from any one of thousands of other firms, and quantity demanded falls to zero.

From the perspective of the firm, the individual firm's demand curve is not downward sloping at all. Rather, the demand curve is perfectly horizontal. The firm's demand is perfectly elastic. Marginal revenue is the additional revenue earned by the firm from the sale of one additional unit. In a perfectly competitive industry, price equals marginal revenue. This is the P = MR condition. This follows directly from the price taker assumption and a perfectly elastic demand curve.

Another assumption of perfect competition is that of homogeneous products. A homogenous product is a product such that each firm's output is indistinguishable from any other firm's output. Examples include commodities such as wheat and coal. In contrast, you can buy 30 different brands of many different kinds of differentiated products. Soda is not soda, its 7-Up or Coke. Cars are not cars, they are Fords and Volvos and so on. The homogeneous product assumption is important because it means that every firm in the industry is selling exactly the same product, so that the only thing that first can compete on is price and not on other things such as product design and product quality. A key difference between perfect competition and monopolistic competition is that with monopolistically competitive firms, products are differentiated and non-price competition is common.

Reentry and exit means that additional firms may freely enter an industry when prices and profits rise and just as easily exit the industry in the presence of losses. In order for this free entry condition to hold there must be no barriers to entry. Such barriers range from exclusive patents and the large capital requirements symptomatic of natural monopolies to the ownership of valuable resources, such as the bauxite reserves owned by Alcoa, the world's largest aluminum producer. The free entry and exit assumption is important because it helps ensure an efficient allocation of resources over the longer run.

Perfect or complete information means that both consumers and producers will be fully informed instantaneously of market prices and any changes in prices. This condition ensures that consumers will always pay the lowest price available because they will always know what that price is. It also ensures that if any one producer makes a technological breakthrough and is able to produce a product more cheaply, all other firms will be able to reuse the same technology instantaneously.



5.3. Market failures that lead to imperfect competition; Externalities and the public goods problem


 
Perfect competition externalities
 
The four major assumptions of perfect competition are important because the failure of one or more of them to hold, leads to imperfect competition. Imperfect competition is a catch all term that includes all three of the other major market structures, monopoly, oligopoly and monopolistic competition. Imperfect competition is not the only possible market failure, associated with the failure of the assumptions of perfect competition to hold. There are two other perfect competition assumptions.

The first assumption is that the demand curve accurately measures the benefits of consumption to society, while the supply curve accurately measures the cost of production to society. If the demand curve measures social benefits, and the supply curve measures social costs, then it must be true, that where the demand and supply curves cross, at market equilibrium, social benefits, must equal social costs. This is an efficient outcome for society's resources. When this assumption fails, there is an externalities problem. Externalities include things like pollution, and congestion. In the presence of externalities, government intervention may be warranted.

The second assumption is that the market demand curve is the horizontal sum of the individual demand curves. When this assumption fails, there is a public goods problem. Public goods include things like national defence and roads. In the presence of the public goods market failure, the government may have to step in and provide the goods. The concept of market failure is the theoretical foundation upon which much of the economic rationale for modern government rests. This concept helps to explain a wide range of government activities, and agencies, from the Pentagon, and the Federal Trade Commission, to the Environmental Protection Agency, and the National Institute of Health.



5.4. Pricing and production rules; P=MR=MC; The shutdown rule


 
cost table
 

5.4.1. P=MR=MC

Given a market structure of perfect competition, the expected conduct with respect to pricing is captured in the equation price equals marginal revenue, equals marginal cost or:

P = MR = MC

Showing that price equals marginal revenue is not difficult. A profit maximising perfectly competetive firm is a price taker in the marketplace. The firm faces a horizontal or a perfectly elastic demand curve, so the firm's marginal revenue must be equal to price.

It is a harder task to show that profits are maximised when the firm sets marginal revenue to marginal cost. This is the profit maximising rule, MR = MC. This can be demonstrate with the help of a table and with a graph. By applying the MR = MC rule, it is possible to calculate the price and quantity at which profits will be maximised. An increase output from seven to eight has a marginal cost of $30, which is less than $35, so it makes sense to do so. Increasing output from eight to nine has a marginal cost of $40, which is more than $35, so it does not make sense to do so. Therefore, eight units is the profit maximising output, just like the MR = MC rule indicated it would be.

 
Profit situation
 
The MR = MC rule is an accurate guide to profit maximisation for all firms, not just perfectly competitive ones. The other portion of the equation, P = MC is a special case of the MR = MC profit maximising rule for perfect competition. If the profit maximising firm always sets its output at a level where marginal cost equals marginal revenue, then a firm's marginal cost curve must also be it's supply curve.

Profits are measured by ABCD. Total revenue is price times quantity or the rectangle ADGF. Total cost then is the average total cost or ATC times the quantity sold. This yields the rectangle BCGF. Subtracting it from ADGF gives the green profit box ABCD. Suppose that the firm's ATC is actually a lot higher and is $45. This could happen, for example, if it had to pay higher wages or more for its raw materials. In that case the firm suffers a loss of ABED.

 
Loss situation
 

5.4.2. The shutdown rule

Given the firm's loss, the question is whether or not it should close its doors and go out of business. At least in the short run, the firm should remain in business, even in the face of negative profits. This is because of the shutdown rule, the shutdown condition, or the close-down case. The shutdown point comes where revenues just cover variable costs, or where losses are equal to fixed costs. When the price falls below the level where revenues are equal to variable costs, the firm will minimise its losses by shutting down.

 
Marginal cost
 
A firm must still cover its contractual commitments even when it produces nothing. That means in the short run, the firm must still pay fixed costs such as rent, interest on bank loans, and salaries to key management personnel. Suppose the firm in the example has fixed costs of $40, then the rectangle of loss only equals $20. It is better off to continue to operate in the short run because losses are minimised. After shutdown the loss would be $40.

The shutdown rule affects the definition of the firm's supply curve. The firm's marginal cost curve is still at supply curve, but only for that portion of the marginal cost curve that lies above the AVC. There are lots of industries that go through cycles of large short run losses without shutting down. Capital intensive industries with high fixed costs like automobiles and the airlines are more likely to experience such losses than industries with low fixed costs like coffee shops and dry cleaners. The higher the firm's fixed cost the more it has to lose by shutting down.



5.5. Long run equilibrium; Normal or zero economic profits


 
Long run equilibrium
 
While a firm can lose money in the short run, no firm can keep doing it forever. In the long run a perfectly competitive industry will be in equilibrium where price equals average total cost. At this point, firms will earn what economists call alternatively either normal profits or zero economic profits. Zero or normal economic profits means that accounting profits just cover opportunity costs.

The conventional wisdom in economics is that if money is invested in the stock market, over time the inflation adjusted real rate of return on the investment will be roughly three percentage points above the return of risk free government bonds. After adjusting for risk, any investment yielding that return would be considered a normal profit or zero economic profits.

 
Firm and industry supply
 
In the long run, a perfectly competitive industry will produce where price equals average total cost at its minimum and earn zero economic profits. The question is how does the industry wind up at the particual point?

The answer lies in one of the original assumptions of perfect competition, which is free entry and exit into the market. This can be illustrated using an example. Assume that there is a market for widgets. The equilibrium market price is $50. Equilibrium quantity in the industry is 100,000 units and economic profits are zero.

 
Market for widgets
 
Assume that a report comes out in the American Medical Journal showing that widgets can reduce the incidence of Alzheimer's disease among senior citizens. The demand curve will shift outward, reflecting an increase in demand.

This will in turn increase the firm's prices and marginal revenue and lead to an increase of profit above the zero level. Because of the lure of high profits, additional firms will enter the industry. Entry by new firms shifts the supply curve out and returns the industry to long run equilibrium. This drives the price back down to $50 and economic profits back to zero.

 
Normal profit
 
Suppose that instead of extolling the virtues of widgets as a cure for Alzheimer's, the American Medical Journal had warned that widgets significantly increase the risk of breast cancer. Demand shifts in, the price goes down and so do profits. In the short run firms can incur losses, but over the long run they exit the industry. This shifts the supply curve in, driving up price and driving economic profits back to zero.

Thus, the process always stop at zero economic profits. In the long run, perfectly competitive firms earn a normal profit, no more and no less. The importance of this conclusion about long run equilibrium lies in its implications for the efficiency of the perfectly competitive market. This efficiency can be seen in at least two dimensions of market performance: allocative efficiency and productive efficiency.



5.6. Allocative versus productive efficiency; Pareto optimality; Consumer and producer surplus and deadweight loss


 
Productions possibilities frontier
 

5.6.1. Allocative versus productive efficiency

Productive efficiency occurs when price equals minimum average total cost, the condition of market conduct that holds when a competitive industry is in long-run equilibrium. Productive efficiency means that the firm is using the minimum amount of resources to produce any particular output. The firm is also using the best available least cost technology. If it does not, it will not survive.

Allocative efficiency is a slightly more difficult concept and in economics there are several different definitions of allocative efficiency. One of the most cumbersome is Pareto optimality, the condition first identified by the economist Alfredo Pareto. An allocation of resources is pareto optimal when no possible reorganisation of production can make anyone better off without making someone else worse off.

 
Consumer surplus
 
This concept of allocative efficiency goes beyond the productive efficiency illustrated by the production possibility frontier An economy is clearly inefficient if it operates inside the PPF and no one needs suffer or decline in utility by moving to the PPF frontier. Therefore, at a minimum, an efficient economy is on its PPF. Nonetheless, allocative efficiency goes one step further and requires not only that the right mix of goods be produced, but also that these goods be allocated among consumers to maximise consumer satisfaction.

 
Producer surplus
 

5.6.2. Best possible allocation of a society's resources

Perfect competition yields the best possible allocation of a society's resources. The demand curve reflects the willingness of a consumer to pay for the product. Under the assumptions of perfect competition, it must reflect the social benefits of that product. At the same time, the supply curve reflects the costs of production and therefore must reflect the social costs of producing the product. It follows that in a perfectly competitive market equilibrium occurs where supply intersects demand so that social benefits equal social costs.

Moreover, at this point of equilibrium, the marginal cost of production exactly equals the marginal benefit, or utility of consumption. This is true because consumer theory states that consumers choose purchases up to the point where price equals marginal utility. Furthermore, in a competitive market price will equal marginal costs. Therefore, marginal utility must equal marginal cost.

 
Producer and consumer surplus
 

5.6.3. Consumer and producer surplus

There is another way of looking at allocative efficiency. In economics, the area under the demand curve is called the consumer surplus. The shaded triangle A provides a dollar measure of the difference between what consumers would have been willing to pay and what they actually pay. By the same token, there is a producer surplus that is depicted by the shaded triangle B above the supply curve. It measures the difference between the price at which producers would have been willing to supply a good and the price they actually receive. The concepts of producer and consumer surplus can be used to measure both the efficiency loss of a deviation from the perfect competition equilibrium, as well as its distributional implications.

 
Distributional impact of a monopoly
 
For example, there is a market for ice cream cones. In a perfectly competitive equilibrium, at a price of Pe and the quantity of Qe, the consumer surplus is the triangle C and the producer surplus is the triangle E.

Now suppose a monopolist corners the market for ice cream cones and raises the price to Pm so quantity falls to Qm. The distributional of impact of this monopoly pricing on consumers is that consumers have to pay more for less quantity. The rectangle B is transferred to the monopolist. That means consumers are poorer and the monopolist is richer.


5.6.4. Deadweight loss

Another question is what portions of consumer and producer surplus represent the loss of allocative efficiency from monopoly pricing? The efficiency loss on the consumer side comes from the consumption of ice cream that is forgone under monopoly pricing. By the same token, the loss of efficiency on the producer's side comes about by a reduction in output and an under supply of resources to the ice cream market. The loss of consumer surplus is measured by the triangle C while the loss of producer surplus is measured by the triangle E. Together, the triangles C and E measure the loss in allocative efficiency from the monopoly pricing. Economists call this lost the deadweight loss.

 
Loss allocative efficiency by a monopoly
 

5.6.5. Market failures

Monopoly not only transfers income from the many to the few, it also creates an efficiency loss in the process. A perfectly competitive market yields the most efficient use and allocation of resources, as embodied in productive and allocative efficiency. Yet there are several problems.

First, perfect competition is rarely, if indeed ever, totally mirrored in reality. There are just too many restrictive assumptions to be met. When one or more of these assumptions fail, the consequence is any one of a number of market failures ranging from imperfect competition and externalities to the public goods problem.

Perfect competition is studied because it gives a benchmark against which to measure how the other three market structures, monopoly, oligopoly, and monopolistic competition, perform. It also gives appropriate guidance as to when and how to intervene in the market to correct market failures, as well as how to measure success or failure at doing so.


5.6.6. Equity or fairness

The other major problem with perfect competition is that, while its results maybe efficient, they are not necessarily fair. The efficient allocation of resources achieved by perfect competition is contingent on the initial distribution of income. That means if the distribution of income is changed, a different efficient allocation of resources may ensue, and by implication, a different consumption pattern. For example, in a country like Guatemala were less than 5% of the people control over 90% of the wealth, the patterns of consumption between the rich few and the many poor are likely to be starkly different. While the rich few can afford huge villas and fancy clothes and fleets of limousines and eat steak every night, many of the poor peasants live in rags and shacks, eat beans and rice, and can't even afford to buy bicycles.

In a world of perfect competition, that can be a perfectly efficient outcome. Yet, it is also true that if income were distributed more evenly in Guatemala, there could be an equally efficient allocation of resources, but one with a different structure of demand. A lot more people could afford to buy more housing, refrigerators, air conditioners, motor scooters and small cars, while the consumption of villas and limos and steaks would go down. Assessing which of these two efficient outcomes is more fair is a normative or prescriptive question about what should be.

Economists cannot answer such normative questions. Deciding normative questions are more properly the domain of politicians and philosophers and votes at the ballot box or revolutionaries in the jungle. In contrast, the more proper role of the economist is positive or descriptive analysis, describing what is, rather than what should be. Having said that, positive economics, nonetheless, can offer great insights about how different types of government policies can affect the distribution of income and consumption. Therefore, positive economic analysis is essential in many normative policy debates.




6. Monopoly and Monopolistic Competition




6.1. Why study imperfect competition; Monopoly's pricing rule


 
Cost and revenue table monopoly
 
Prices are generally higher and outputs are lower under imperfect competition than under perfect competition. There may be benefits to imperfect competition as well, including the exploitation of economies of scale to lower cost, and the acceleration of technological change in long term growth. Understanding how imperfectly competitive markets work, helps to understand how an economy functions.

Monopoly is the purest form of imperfect competition. Between 1870 and 1914, the so-called gilded age of America, monopolists pretty much ran amuck. Legendary and often unscrupulous figures like John D Rockefeller, J Gould, Cornelius Vanderbilt, Andrew Carnegie, and J.P Morgan were able to corner the markets in everything from oil, steel and the railroads to kerosene, sugar and salt.

No one epitomised the gilded age monopolist better than Rockefeller, who saw visions of riches in the fledgling oil industry and began to organise oil refineries. Using a combination of shrewd management, secret deals with the railroads, and an utter ruthlessness in crushing his competitors. Rockefeller was able to gain control of 95% of all the pipelines and refineries in America, after which he promptly raised prices.

Rockefeller did not stop there. He devised an ingenious new device to maintain control, the so called trust in which shareholders turned their shares over to trustees who would then manage the industry to maximise its profits. These trusts were essentially cartels. A cartel is simply an organisation of independent firms, producing similar products that work together to raise prices and restrict output. This trust device worked so well that other industries soon imitated Rockefeller's standard oil trust to consolidate their monopoly power.

 
Cost and revenue graph monopoly
 
This practice so insensed the American public that in 1910 Congress passed so called Antitrust Law to break up the trust band cartels and regulate the prices of many industries. Today, the unregulated monopolies of the century past are rare, while the monopolies that do exist tend to be subject to a special form of price regulation. Monopoly has some unique characteristics.

Monopoly exists when there is only one seller in the market selling a product for which there are no close substitutes. In such a case, the monopolist is not a price taker like a perfectly competitive firm. Rather, it is a price maker. This means that it exerts considerable control over what the market price will be. The monopolist has this power because it also controls quantity supplied in the market. Under the assumption that the monopolist wants to maximise profits, the monopolist will set the market price where the marginal revenue from an additional unit sold equals its marginal cost. This is also true in the case of monopoly.

 
Monopoly pricing
 
For example, the table can be used to calculate a firm's profit or loss by calculating total revenues minus total cost. At the price and quantity at which profits are maximised, marginal revenue equals marginal cost. At this point, price equals 120 and quantity equals 4. The data can be used to draw the curves for demand, marginal revenue, average cost, and marginal cost. At point E marginal revenue equals to marginal cost. Moving up to point G on the demand curve, the monopolist will set the price at 120, where the economic profit is measured by the rust shaded rectangle.

The price set is not the highest possible price the monopolist could charge but the monopolist charges a price higher than the perfectly competitive outcome. The loss in allocative efficiency, or dead weight loss, equals C plus E. A rectangle of consumer surplus B is transferred to the monopolist. Monopoly is both inefficient and redistributes income in a way that many would describe as unfair.

 
Natural monopoly
 
A question for public policy is what to do about monopoly. The answer is not so easy. For example, a natural monopoly is characterised by increasing returns to scale over the relevant range of output. This is the case in varying degrees in a number important industries, including electricity, gas, water, as well as perhaps cable TV. If there are increasing returns to scale, over time, one firm will emerge as the low cost producer and capture the entire market, the natural monopolist.

Now suppose some irate congressmen decides to launch a crusade against monopoly and sponsors antitrust legislation to break up every monopoly into many small firms. Is this a good idea? Well, breaking up some monopolies might be a good idea indeed. However, breaking a natural monopoly up into many small firms is likely to be a bad idea. This is because each of the smaller firms will produce at a significantly higher unit cost than the monopolist.

This in turn is because each of the smaller firms will be unable to achieve the same minimum efficient scale as the monopolist. Thus, while this artificially created competitive market may indeed yield a competitive price, where price equals marginal cost, it may also be the case that this price is well above the natural monopolist one.



6.2. Regulating monopolies and the P=AC rule; X-efficiency under cost-plus pricing; Schumpeter's argument for monopoly


 
Regulated monopoly
 

6.2.1. Regulating monopolies and the P = AC rule

Another approach is price regulation. But again, this should be done with great care. For example, a public utility commissioner in the regulated market for the distribution of electricity, would set price equal to average cost. This might seem counter intuitive as it may seem that the best place to set price is where price equals marginal cost. At this point, price regulation would effectively simulate the outcome in a perfectly competitive market and therefore be allocatively efficient.

The problem is that the monopolist would be forced to lose money equal to the shaded rectangle, which is simply price times average cost minus revenues. Therefore, at this point the only way the monopolist could really stay in business over time would be to receive a subsidy from the government equal to its loss. Since this is likely to be a politically unattractive option, a more feasible option is point C, where price equals average cost. Under this scenario the monopolist earns zero economic profits, enough to stay in business, but does so without gouging consumers.

 
Regulated monopoly
 
At the same time, the dead weight loss is considerably smaller than under pure monopoly. This price equals average cost rule has been used for decades to regulate prices in natural monopoly industries ranging from electricity, gas, and water, to the rail roads, telephone and even cable TV. There is never any free lunch in economics, only hard choices. Even though the P = AC rule seems to solve a lot of problems with monopoly, it can also create additional problems such as X-inefficiency, a concept first introduced by a Harvard economist Harvey Liebenstein.


6.2.2. X-inefficiency under cost-plus pricing

Suppose that a regulated electric utility has its price set by the P = AC rule. What does this do to the incentive to maximise profits? Well think about this. Under the P = AC rule, the firm has a guaranteed recovery of any cost that it incurs. This type of regulation is known as cost plus pricing. The problem is that under cost plus pricing, regulated industries no longer have the incentive to minimise cost and therefore maximise profits. Instead, there is a perverse incentive to increase cost for the benefit of the executives operating the firm. The X-inefficiency theory predicts that executives in regulated industries will tend to hire more staff, buy thicker carpets, build larger offices and engage in more business travel than they otherwise would under strict profit maximisation.

 
X-inefficiency
 
This would raise the average cost curve and lead to a higher regulated price. The shaded rectangle is precisely the measure of X-inefficiency. It just means that firms are operating well above their potential ATC. In some cases, it may well be that any increase in allocative efficiency achieved by regulating monopolist, might be more than offset by an increase in X-inefficiency due to cost-plus pricing. Monopoly and the appropriate public policy response raise many thorny issues.


6.2.3. Schumpeter's argument for monopoly

Industry structure also affects another key measure of market performance known as dynamic efficiency. Dynamic efficiency measures the rate of technological change and innovation in an industry. The faster this rate, the better the industry will perform, and the faster the economy will grow. The question then, first raised by another Harvard economist, named Joseph Schumpeter, is whether monopolies are likely to outperform competitive industries in the dynamic efficiency dimension. The implication is profound. If the answer is yes, then perhaps it is better to just leave monopolies alone.

Joseph Shumpeter's argument was that, since monopolists are likely to earn a much higher level of economic profit than competitive industries, they will have much deeper pockets to engage in longer term strategic activities such as research and development. At the same time, they will also have a much bigger cash fund with which to make investments to speed the diffusion of the technology.

The counterargument to Schumpeter is likewise interesting. While the monopolist may have deep pockets to spend on developing new technologies, the monopolist has little incentive in the absence of competitors to introduce the technology, so technological progress is actually slowed. For example, the phone monopoly AT&T did indeed invent the touch tone phone in its research arm of Bell Labouratories, but nonetheless it waited years before introducing it because it faced no competition. This debate provides yet an additional layer of complexity to thinking through the public policy implications of economic theory.



6.3. Monopolistic competition; Concentration ratios; Mutual dependence recognised and collusion


 
Forms of competition
 

6.3.1. Monopolistic competition

Pure monopoly together with a polar case of pure competition are the exceptions, not the rule. The market structures of most industries fall somewhere in between these two extremes and can be classified either by monopolistic competition or oligopoly. Based on the number of firms in the industry, there is a continuum of market structures. The defining characteristics of monopolistic competition are a relatively large number of sellers, easy entry to and exit from the industry and product differentiation. The first and second characteristics provide that competitive aspect of monopolistic competition While the third characteristic contributes to the monopolistic aspect.

Monopolistic competition is one of the most prevalent market structures. From mattresses to men's suits, from book publishing to paperboard boxes, and from upholstered furniture to fur goods, all these industries are monopolistically competitive just as are the industries producing the several hundred magazines on a newsstand rack, the 50 or so competing brands of personal computers. And then, there are the numerous brands of gasoline that can be found at the four corners of many intersections and, the several grocery stores in a neighborhood, all carrying the same products, but competing on the basis of location and brand name.

Perhaps the best way to understand monopolistic competition is to focus on the differences between monopolistic competition and oligopoly on the one hand and monopolistic competition and perfect competition on the other hand. There are three key differences between oligopoly and monopolistic competition. First, a monopolistically competitive industry is relatively unconcentrated. Each firm in a monopolistically competitive industry has a comparatively small percentage of the total market so that each has limited control over market price. In contrast, market concentration in an oligopoly is relatively high and so too is the oligopolous price making power. This is because there are only a small number of firms in concentrated oligopoly so that each has a relatively large share of the market.

 
Concentration ratios per industry
 

6.3.2. Concentration ratios

In economics, there are a number of different measures of market concentration, such as the concentration ratio. The four firm concentration ratio is the percentage of total industry output accounted for by the four largest firms. The industries listed in black are generally considered oligopolies, while those in red are generally characterised as monopolistic competition. In oligopolies such as chewing gum, cigarettes, cereals, and greeting cards, four firms have over 85% of the market. In contrast, market concentration is quite low for monopolistically competitive industries such as metal doors, fur goods, paper board boxes, and wood furniture.


6.3.3. Strategic interaction and collusion

The reason why concentration ratios are so important in studying market structure is that they help serve as an indicator of the degree of strategic interaction that might occur in an industry. Strategic interaction is a term that describes who each firm's business strategy depends on their rivals strategy. Put simply, as the number of firms in an industry shrinks, and industry concentration grows. Each firm is more likely to base his or her pricing and output decisions on how other firms in the industry are likely to respond.

At the same time, with this mutual interdependence recognised, each firm is more likely to want to collude with the others when setting price and quantity. Where collusion may be defined as the concerted action by firms to restrict output and fix price. This observation leads to two additional important distinctions between what oligopoly and monopolistic competition. Because of the fall small number of firms in an oligopoly, collusion is possible. However, the relatively large number of firms in a monopolisticly competitive industry ensures that collusion is all but impossible.

At the same time with numerous firms in the industry, there is no feeling of mutual interdependence among them. That means that each firm determines its policies without considering possible reactions of its rivals. This is a reasonable way to act in a market in which there are numerous rivals. For example, the 10 or 15% increase in sales which a firm may realise by cutting prices will be spread so thinly over its 20, 40, or 100 rivals. That for all practical purposes the impact on their sales will be imperceptible. That means that rivals reactions can be ignored because the impact of one firms actions on each of its many rivals is so small that these rivals will have no reason to react. This is certainly not the case with oligopoly.



6.4. Comparing monopolistic and perfect competition; Non-price competition and product differentiation


Monopolistic competition resembles perfect competition in three ways. There are numerous buyers and sellers, entry and exit are easy, and firms are price takers. A big difference is that with monopolistic competition there is product differentiation. Purely competitive firms produce a standardised or homogeneous product. This means that consumers, will have no basis, other than price for preferring one firm's product over another's, so price competition is the norm.

In contrast, monopolistically competitive producers turn out many variations of a particular product. Because of such product differentiation, consumers have reasons other than price to prefer one product over another, so that economic rivalry, typically takes the form of non priced competition. Competition comes primarily in the way that firms differentiate their products, and such differentiation, can be accomplished in many ways from product quality, conditions of sale, and service, to location, and advertising, and packaging.

For starters, product differentiation may take the form of differences in actual product quality, due to engineering, processing or styling differences. For example, personal computers differ in terms of hardware capacity, software, graphics and how user friendly they are. That big burger served up at any one of a number of fast food restaurants may differ on the leanness of the beef, the size of the bun, and whether it is broiled or fried. In a similar vein, plain old aspirin may be enhanced by buffered compounds to prevent stomach aches, or caffeine to keep you awake. When it comes to durable goods like automobiles, different brands can differ in 100's if not 1000's of ways from styling and horsepower to airbags, gas mileage and stereo systems.

 
Product differentiation to increase demand
 
Beyond physical characteristics and product quality, products may also be differentiated in other ways such as the amount of service and the conditions of sale. For example, one auto dealer might offer low interest financing and free service, while another might feature multi year warranties. One grocery store may stress the helpfulness of the clerks that bag your groceries, while a warehouse, may leave the bagging and carrying to you, but offer lower prices. One pizza restaurant may tout its fast delivery, while another touts its fat mushrooms and thick crust.

A third source of product differentiation is location and accessibility. For example, small mini groceries or convenience stores successfully compete with big supermarkets even though they offer much less choice and much higher prices. They can do so because they are often closer to customers and stay open for 24 hours. By the same token, a gas station's proximity to a freeway or busy intersection gives it a locational advantage which may allow it to sell gas at a higher price then a gas station, several miles away.

Product quality, conditions of sale and location are all important sources of product differentiation, based on real differences between products. Such is not always the case with the fourth major source of product differentiation, advertising, packaging, brand names and trademarks. For example, while there are many aspirin type products, promotion and advertising may convince, headache sufferers that Bayer or Anacin are superior and worth a higher price than a generic substitute. Similarly a celebrity associated with jeans or perfume may enhance those products in the minds of buyers, while a tobacco or auto company that can successfully associate their product with greater sex appeal may get ahead on its competitors.

 
Product differentiation to make demand less price elastistic
 
From the economists point of view, product differentiation in general, and advertising in particular, have two goals. The first goal is to increase consumer demand, and thereby shift the firm's demand curve outwards and increase the firm's market share. By increasing its market share, a monopolistically competitive firm can also increase its profits. The second goal is to increase the in elasticity of the demand curve for its product. One of the ways this goal can be achieved is by creating brand loyalty among consumers through advertising, thereby creating a stronger preference for the firm's product.

This increased inelasticity increases the strategic opportunities of the firm. For starters, rather than being a price taker the monopolistically competitive firm becomes a price maker, albeit it with less flexibility than a pure monopolist. At the same time, because the firm can now react to changing market conditions by changing the traits of its product, it can also engage in non price competition.

So how do monopolistically competitive firms behave? There is no prospect of any collusion among firms in the industry to fix prices. This is for two reasons. First, by definition there is a large number of firms in the industry so collusion is difficult. Second, even if the large number of the firms in an industry were to successfully collude, they would not be able to stop a flood of new firms from entering the market to take advantage of any collusive monopoly pricing. This is because, again by definition, with monopolistic competition, entry is easy. For these two reasons monopolistic competition is sometimes called non collusive oligopoly.

Market conduct is different in the presence versus the absence of collusion. In the case of non collusive monopolistic oligopoly, in terms of market conduct or market performance, monopolistic competitors may well earn monopoly profits under certain circumstances in the short run. However, in long run equilibrium, economic profits in the industry will be driven to zero, just as in perfect competition.

 
Monopolistic competition before entry
 
Nonetheless, there is an important difference between perfect competition and monopolistic competition in the long run. Under monopolistic competition prices will be above marginal cost, indicating the dead weight efficiency loss. It is possible to illustrate the short and long run implications of monopolistic competition for market performance, with an example from the personal computer industry.

Steve Jobs and Steve Wozniak started off in their garage, making what turned out to be the Apple One computer, and they grew fabulously wealthy doing it. In the early years of the personal computer industry there were numerous sellers but lucrative profits were still to be had. So what's the price, in quantity in this industry, and what are the economic profits. That's right, in the figure the firm, uses the profit maximising rule, to set prices, where marginal revenue, equals marginal cost, so as to maximise profits, and economic profits are equal to the grey box P1P2GB.
 
Monopolistic competition after entry
 

The lure of large economic profits makes firms rapidly enter the industry. This causes the typical sellers' original profitable DD curves to shift downward and leftward by the entry of new firms and price falls. Entry will cease only when each seller has been forced into a long run, no profit tangency such as at G'. Now here's something even more interesting. Note that at this long run, equilibrium price remains, above marginal cost, and each producer is on the left hand, declining branch of it's long running average cost curve.

 
Monopolistic competition after entry
 
For market performance this means is that, in the long run, monopolistic competition is neither allocatively or productively efficient. In particular, an under allocation of resources occurs in the industry because the product price exceeds marginal cost. At the same time, productive efficiency is not realised because production occurs at point G' where the average total cost exceeds the minimum attainable cost at point A.

The fact that monopolistic competition, is both allocatively, and productively inefficient relative to the perfect competition result, is not the only problem with market performance. At least some economists argue that monopolistic competition leads to both excessive advertising and needless brand proliferation. This possibility follows directly from the fact that, in the long run economic profits are zero. Therefore, in order to improve upon this position, firms will engage in additional product differentiation and development, and rely upon advertising to create real, or perceived differences in their product with consumers.

While it is true that these efforts will cost money, they also increase demand and reduce demand elasticity so that in some circumstances, a firm can improve its profit position. Nonetheless, such market conduct is not always graded as a plus by economists. To support this view, these economists usually have to point no further than the cereal aisle at their local supermarket where a dizzying array of brands proliferate, from Apple, Cinnamon, Cheerios, Honey Nut Cheerios, and Whole Grain Cheerios, to Count Chocula, Captain Crunch, and Frosted Flakes.

From a societal point of view it is hard to argue that being able to choose over 50 ways to eat sugared grain adds significantly to societal welfare. However, there remains a strong logic to the incredible variety of options. Reducing the number of monopolistic competitors, while cutting costs, might well end up lowering consumer welfare because it would reduce the diversity of available goods and services. To bolster this argument, an economist need point no further then the centrally planned socialist and communist economies that have tried to standardise output on a small number of varieties, but left consumers highly unsatisfied.




7. Oligopoly and Strategic Behaviour




7.1. Oligopoly defined and sources of oligopoly


7.1.1. Introduction

Oligopoly exists when a small number of typically larger firms dominate an industry. Oligopolistic industries include everything from disposable diapers, chewing gum, and cigarettes to electric razors, car rentals, batteries, soft drinks, credit cards, razor blades, toothpaste, beer, soap, coffee, canned soup, canned tuna, and spaghetti sauce. A central feature of oligopoly is strategic interaction. Given the small number of firms, each firm must take into account the expected reaction of the other firms. This means that oligopolistic firms engage in strategic decision making when setting things like price, quantity and product quality.

The other thing that is really important about oligopoly from an anti-trust perspective is that, given the small number of firms, oligopolistic firms have a much better chance of colluding on price than suppliers in either perfect competition or monopolistic competition. It is the strategic decision-making and the possibility of collusive behaviour that makes oligopoly so interesting and sometimes dangerous for society. In analysing oligopoly, the following questions are important. What gives rise to the market structure of oligopoly? What kind of market conduct is likely to characterise oligopoly? What does this market conduct imply for market performance?


7.1.2. Economies of scale

 
Minimum efficient scale in oligopoly
 
The same barriers to entry that give rise to pure monopoly that are important in explaining oligopoly. First, there are scale economy barriers to entry to consider. With monopoly average costs decreased throughout the relevant range of production so that one firm is eventually able to drive out all other firms by producing at lowest cost. With oligopoly, it is a few firms, not just one, that drive everyone else out. The figure shows the average total cost curve for an oligopolistic industry. The relevant range of output extends to point D, since this reflects total industry output total sales. At the same time, between points C and D there are constant returns to scale, whereas between points A and C, there are decreasing returns to scale.

This clearly implies that the minimum efficient scale for a firm in this industry is a plant size of AC, which in this example, equals one third of the total output AD. By the way you may recall from lecture four, that the minimum efficient scale is defined as the smallest level of output at which a firm can minimise long run average cost. In the case of natural monopolies like the rail roads and utilities, small firms cannot realise the MES, the minimum efficient scale. So there is only one seller at the same time as I indicated in lecture four and this this example illustrates a a large minimum efficient scale can also give rise to oligopoly. Now let's assume that there are three big firms in this industry all produce an output of AC at their MES with an equal share of the market. Or market share is defined as the percentage of market output produced by a single firm. Can you see the dilemma for a new firm trying to enter this industry?

If a new firm tries to enter the industry at a plant size less than the MES Say at output AB it will be a higher cost producer than its rivals and will be highly vulnerable to being driven out of the industry by its competitors. In fact, all its rivals need to do is set price below the new firm's costs for a while, cause it to incur heavy losses. And eventually it will withdraw. Alternatively, if the firm builds a plant size at the MES to be competitive, it will have to seize a sizeable market share from its rivals to achieve efficient production. In particular, in this example, it would have to cut each of its rivals back from a third to a fourth of the national market, and the likely result would be losses for everyone. Given this dilemma, it is perhaps not surprising that scale economy barriers data entry into the industry and preserve the oligopolistic structures.


7.1.3. Capital requirements

A closely related barrier to entry is the large capital requirements that characterise the industries like cigarettes, autos, steel, and petroleum refining. In each of these industries, it simply requires a lot of capital investment to set up the elabourate plant and equipment necessary to produce. In this case, the broader problem is that established firms with a track record may have better access to lower cost capital than new entrance. For example, a large existing firm with an established reputation will likely be able to borrow money at a significantly lower interest rate than a new firm without a track record.


7.1.4. Absolute cost

 
Absolute cost advantage
 
Still the third important barrier to entry has to do with absolute cost. Absolute cost barriers to entry are illustrated in this figure. One source of such barriers is that established firms may possess valuable know how in production or so called trade secrets. For example one of the best kept secrets in the industrial world is the secret ingredient in Coca Cola. Only a few executives in the company know what it is. In a similar vein an existing firm may have patents granting it exclusive rights to certain product features or production processes.

In fact, that's how Polaroid got such a strong initial foothold in the instant camera market decades ago. Then there is the issue of who owns or controls the basic raw materials for a product. This type of absolute cost barrier explains, for example, the historic dominance of Alcoa in the production of aluminum ingots. This is because Alcoa owns much of the high-grade bauxite reserves used in aluminum production.


7.1.5. Product differentiation

Finally, product differentiation, which we discussed at length within the context of monopolistic competition, can be an important barrier to entry in and industry. In particular to the extent that a firm has an established brand name with consumers it has a distinct cost advantage over any other new firms entering the market. This is because any new firm entering the market would have to incur substantial advertising costs Just to enjoy the same size and any elasticity of demand for it's product.


7.1.6. The bottom line

The bottom line here is that barriers to entry play a important role in creating and sustaining oligopolistic industries. The question is, why should we worry about this particular market structure? And the answer lies in better understanding the concepts of market power and market concentration.



7.2. Market power and strategic interaction; Cooperative versus non-cooperative behaviour; Explicit collusion


Market power signifies the degree of control that a firm or a small number of firms has over the price and production decisions in an industry. The most common measure of market power is the four-firm concentration ratio. Concentration ratios are important because they help serve as an indicator of the degree of strategic interaction that might occur in an industry. Strategic interaction is a term that describes how each firm's business strategy depends on their rival's strategy. As the number of firms in an industry shrink and industry concentration grows, each firm is more likely to base his or her pricing and output decisions on how other firms in the industry are likely to respond.

Moreover, once this mutual interdependence is recognised, firms have a choice between pursuing cooperative and noncooperative behaviour. On the one hand firms act noncooperatively when they act on their own without any explicit or implicit agreements with other firms. This kind of market conduct typically characterises monopolistic competition. On the other hand, firms operate in a cooperative mode when they try to minimise competition by agreeing explicitly, or tacitly, on price and output and other market issues. The clear danger of oligopoly is that it is fertile ground for cooperative behaviour. When firms in an oligopoly act cooperatively they must engage in some form of collusion.

Collusion occurs when one or more firms jointly set prices or outputs, divide the market among themselves, or make other business decisions jointly. Such collusion can be either explicit or tacit. One example of explicit collusion would be that of the Gilded Age oligopolists in the early years of American capitalism. These oligopolists formed trusts or cartels to set prices. After the American public rose up and demanded the passage of tough antitrust laws in 1910, cartels and explicit collusion became illegal in the United States. These laws have not always worked.

The lure of lavish profits has tempted many a business executive to skirt the law, and many have wound up in a small prison cell rather than in a big mansion for their efforts. Perhaps the most famous historical example of explicit collusion is the so called Phases of the Moon Conspiracy. In 1960, some executives at General Electric, Westinghouse, and Allis-Chalmers, among others, cooked up a scheme to fix prices in the market for heavy electrical equipment such as transformers, turbines, and circuit breakers. Each of the various companies would submit sealed competitive bids, but it was arranged beforehand that the work would be allocated to a particular company based on which phase the moon was in.

This allowed all the companies to submit bids higher than would have prevailed without this collusion. It also allowed the prearranged winner to submit an only slightly lower bid, one well above the competitive outcome. The eventual outcome of this conspiracy is that 29 manufacturers and 46 company officially were eventually indicted, substantial fines were levied and many of the executives went to jail.

After this highly publicised event American executives have not learned their lesson and have not refrained from explicit collusive behaviour. For example, in 1993, Borden Incorporated paid $8 million in fines for fixing bids on milk sold to schools, while Bristol-Meyers Squibb and American Home Products paid $5 million in 1992 to settle charges that they had fixed prices on baby formulas. In a cola war meltdown, local executives for both Coca Cola and PepsiCo went to prison for conspiring to fix soft-drink prices in Virginia, while Mitsubishi plead guilty and paid a $1.8 million fine for conspiring to raise the price of fax paper.

A recent study found that about 9% of major corporations have admitted to or have been convicted of illegal price fixing. The alleged perpetrators range from the makers of scouring pads and Kosher Passover products, to universities, art dealers, the airlines, and the telephone industry. The lure of economic profits is often irresistible and drives many a firm and too many executives to bend an often break antitrust laws.



7.3. Tacit versus explicit collusion; Forms of tacit collusion; Models of oligopoly conduct


It is not just explicit collusion that is the only problem with oligopoly. The broader problem is with implicit or tacit collusion that arises precisely because explicit collusion is illegal. The word tacit means to express or carry on without words or speech. Tacit collusion is said to occur when firms in an industry refrain from competition without explicit agreements. Executives may tacitly collude and communicate with one another without surreptitious phone calls or secret meetings.

One common vehicle is public speeches given by leading executives. In some of those speeches, when executives are talking about, say, how costs are rising in an industry and why it might be time to raise prices, they are not just talking to who is in the room. They are talking through the media to the other top executives in the industry, and its all quite legal.

 
Three models of oligopoly
 
Similarly industry trade associatons can play an important role in tacit collusion because they can act as a conduit and clearing house for information about prices and costs in an industry. From such information, executives can better glean what their rivals are doing and, in some cases, then coordinate their activities.

When firms tacitly collude, they often quote identical high prices, which pushes up profits and decreases the risk of doing business. To better understand how both explicit and tacit collusion can shape oligopoly conduct, a more systematic discussion of the various models of oligopoly behaviour is needed. This is an important sub-field in economics known as industrial organisation and the related discipline of game theory.

There is no unified theory of oligopoly, but rather many different models, each of which may have some application to specific industries. It is only possible to scratch the surface of industrial organisation and game theory. Three basic models of oligopoly behaviour appear prominently in traditional industrial organisation literature.

The cartel model provides insight into the price and quantity that oligopolists are likely to set when they can successfully collude. The price leadership model provides insight into how firms in an industry might tacitly collude as well as how firms in that industry who refuse to collude might be punished for failing to follow the leader. The third model, the kinked demand theory, offers an explanation other than collusion as to why prices in an oligopoly might be set higher than the perfectly competitive outcome.



7.4. Joint profit maximisation model; Why cartels can fail


The simplest model of oligopoly is known as the lucrative oligopoly or joint profit maximisation. The cartel model provides insight into the price and quantity that oligopolists are likely to set when they can collude successfully. Consider a four-firm industry, in which each firm had grown tired of ruinous price wars. During the annual trade show in Las Vegas, the chief executive officers of all four companies ignore anti-trust laws against explicit collusion, and risk a possible jail sentence, as they slip off to a secret rendezvous. They then negotiate what price should be charged for the product. As part of their secret cartel agreement each firm will also have to agree to restrict its output to maintain the price in the market.

If the oligopolists can truly coordinate their activities, the obvious price to set is the same as that which would be set by a monopolist. That means that price will be set by the profit maximising rule of marginal revenue equals marginal cost. If the price is set at that point, the oligopolists will jointly maximise their profits, which is why this model is often called the joint profit maximisation model.

In order for the monopoly price to hold in the marketplace, total industry output must equal the monopoly output. This is where problems with the cartel are likely to emerge. Because, if any one firm in the oligopoly decides to cheat by producing more than its agreed upon share of output, it can make higher profits than if it adheres to the cartel agreement. It is precisely such cheating that has made the international oil cartel OPEC so unsuccessful over the past several decades at propping up oil prices. In the dark days of 1973 and 1974, when the members of OPEC banded together and slapped an oil embargo on the U.S for its support of Israel, prices more than quadrupled. The result was long lines at gas stations and a strong negative shock to the American economy.

Under international law, OPEC's cartel behaviour was legal, even when cartels are illegal within the U.S. In the ensuing years the OPEC cartel has been unable to keep the price of oil high, and at least part of the problem has been on the demand side. After the 1970s oil price shocks, motorists started driving smaller, more fuel-efficient cars. Home owners more fully insulated their homes. Businesses adopted new technologies to dramatically cut energy use, and the world in general adopted wide-ranging energy conservation measures. At the same time, on the supply side, higher oil prices stimulated the search for new oil reserves. Many non-OPEC members like Norway and Mexico also entered the global oil market.

Nonetheless the biggest problem was wide scale cheating within the ranks of OPEC. This is due largely to the economic and political diversity of members as well as the large number of members in the cartel. On the one hand, this sparsely populated and fabulously wealthy members of the cartel like Saudi Arabia, Kuwait and Qatar have been perfectly content with restrict output and enjoy monopoly profits. On the other hand, other much more populous and poorer nations, like Venezuela and Nigeria, were not able to resist the urge to cheat because of large external debts and growing needs for cash. The broader problem has been that OPEC has no effective enforcement mechanism to police its agreements.



7.5. The price leadership model; The kinked demand curve model


7.5.1. The price leadership model

A second model of oligopoly, the price leadership model, provides insight into how firms in an industry might tacitly collude, as well as how firms which refuse to collude might be punished. In the price leadership model, the policing or enforcement mechanism used is often punishment by the price leader, usually the biggest or dominant firm in the industry. With price leadership, executives within the industry do not have to slip off to a secret rendezvous in Vegas to set prices. Rather, a practice evolves where the dominant firm, usually the largest firm, initiates a price change. All other firms more or less automatically follow that price change. If one or more firms refuse to follow suit, the price leader may choose to back down.

Alternatively, it can punish the non-cooperative firms by significantly lowering prices for a while, forcing the followers to incur losses. In the way, the oligopoly can maintain price discipline. A classic case of such price leadership involves the cigarette industry. The big three firms Reynolds, American, and Liggett and Meyer, evolved a highly profitable practice of price leadership which resulted in virtually identical prices between 1923 and 1941. During that period, the companies averaged a whopping 18% rate of return after taxes, roughly double the rate earned by American manufacturing as a whole. In more recent time, other industries such as farm machinery, anthracite coal, cement, copper, gasoline, newsprint, tin cans, lead, sulfur, rayon, fertiliser, glass containers, steel, automobiles, and nonferrous metals have practiced some type of price leadership.

 
Raise price with kinked demand curve
 

7.5.2. The kinked demand curve

A third model of oligopoly involves the kinked demand curve. This model helps to explain why prices are sticky in oligopolistic industries, that is, why prices don't rapidly adjust to changes in supply and demand. In doing so, the model also helps explain why prices may be high relative to the perfect competition outcome, even if there is no collusion. Imagine then an oligopolistic industry with three firms A, B and C, each of which have one third of the total market. Further assume that each firm sets its price independently, meaning that there is no collusion. he question is what does the firm's demand curve look like? What makes this an interesting question is their mutual independent of the three firms, coupled with the uncertainty of each rival's reaction to the pricing moves of the other.

 
Kinked demand curve
 
If Firm A raises its price, and the firm believes that the other firms will not go along, its perceived demand curve for increasing price will be elastic because of its fear of losing business to its rivals. Firm A's demand curve looks like D1, while the relevant portions of the demand curve and its marginal revenue curve are shown in blue. Alternatively, if firm A decides to lower its price, the most logical response of form A's rivals to a price decrease would be for the firms to match that decrease, otherwise they will lose market share to firm A. Under this strategic assumption, a large drop in price by firm A would yield only a small, if any, increase in sales, so demand under this scenario is inelastic. This is represented by the curve D2.

The firm's perceived demand curve has a kink in it. The relevant marginal revenue curve for this kinked demand curve has a gap in it. Therefore the relatively large shifts in marginal costs between points c and d as indicated by the shaded area will not change the price or the output that maximises profits since they do not change the intersection of marginal cost and marginal revenue. Hence, in this industry, prices will tend to be sticky. If prices are set high to begin with, they will tend to remain high, even in the absence of collusion.



7.6. Game theory and the prisoner's dilemma; The Nash equilibrium


7.6.1. Game theory

Game theory is about picking a stategy by asking what makes most sense assuming that rivals are analysing your strategy and acting in their best interest. Game theory is important for two reasons. First, the many different possible games articulated by the theory help to capture the essence and complexity of oligopoly conduct. This is because with mutual interdependence recognised between firms, oligopoly conduct becomes a game of strategy such as poker, chess or bridge. The best way to play your hand in a poker game depends on the way rivals play theirs. Second, game theory sheds a light on the importance of collusion in driving socially undesirable economic outcomes. The insights of game theory help to underscore why such collusion is often made illegal in a given economic system.

 
Duopoly example
 

7.6.2. Prisoner's Dilemma

The Prisoner's Dilemma is a well-known game that demonstrates the difficulty of cooperative behaviour in certain circumstances. Suppose that two suspects in a bank robbery, Bonnie and Clyde, are arrested and interrogated in separate rooms. Each of the prisoners is offered the following options. First, if one prisoner confesses and the other does not, the one who confesses will go free and the other will be given a 20 year sentence. Second, if both confess each will receive a five year sentence. Finally, if neither confesses, each will be given a six month sentence on a minor charge. So which strategy would they choose?

Assume that they do no trust each other. Their best strategy is likely to confess and take a five year sentence. That makes this prisoner's dilemma interesting. It is clear that if both prisoners could talk to one another after they are arrested, they could collusively agree not to confess, and both would get light sentences if they kept the bargain. In the absence of collusion, there is great pressure on each prisoner to confess, because he or she knows that if he or she does not confess and the partner does, he or she will get a long sentence. In the absence of collusion, the typical result is that both prisoners confess, and get medium sentences. This is because the only other way out of the Prisoner's Dilemma without collusion, is trust, but trust is something that is hard to come by unless there is an explicit enforcement mechanism.

 
Duopoly without collusion
 

7.6.3. Prisoner's Dilemma in oligopoly

The Prisoner's Dilemma has its simplest application to oligopoly when the oligopoly is a duopoly. That is, when the industry consists of only two firms. A duopoly might emerge in an industry when the minimum efficient scale of production is about half that of the total industry sales. Assume that there is a duopoly in packaging materials. The left hand figure shows the average total cost and marginal cost curves for one of the firms. The minimum efficient scale occurs at point A, where the ATC is at a minimum, and production is 4,000 tons. Assuming that both firms in the duopoly have identical cost curves, it is possible to draw supply, demand, and several possible equilibria in the packaging materials market.
 
Duopoly example
 

Suppose that, just like in the prisoner's dilemna, the two firms are unable to communicate with one another and therefore are unable to collude in any way, either explicitly or tacitly. In the absence of collusion, the two duopolists are likely to behave like perfect competitors. The market price will be $500 per ton, output will be 8,000 tons, or twice that of the minimum efficient scale of production, and economic profits will be zero.

Suppose on the other hand, the two duopolists are able to fully collude, and each keeps the bargain that they strike. In that case they will act together, just like a monopolist, and jointly maximise their profits. The price will be $600, output will be 3000 tons per firm and economic profits will equal $75,000.

 
Duopoly with cheating
 
It is also possible that, while the two duopolists fully collude and shake hands on the monopoly deal, one of the duopolists decides to cheat on the agreement. The cheating duopolist may refuse to limit his share of production to 3,000 tons and instead produce 4,000 tons. Price falls to $550 per ton, and will stay there, as long as the non-cheating firm does not increase its production. Industry output increases to 7000 tons.

As for the profits of each firm, note in the figure that the non-cheating firm receives $550 per ton, but because it does not produce at its minimum efficient scale, it incurs costs of $575 per ton. This leads to a loss of $75,000 as indicated by the shaded arrow. In contrast, the cheating firm produces at its MES where costs are $500 per ton. Its profit is the shaded area in the figure, or $200,000. This example demonstrates clearly the often huge incentive to cheat that colluding oligopolists face. In this case the successful cheater can more than double his profits from $75,000 to $200,000.

 
Payoff matrix
 


7.6.4. Nash Equilibrium

Game theory was developed to provide insight into this type of strategic situation. It does so by analysing the strategies of both firms under all circumstances and placing the combinations in a so-called payoff matrix or payoff table. In this matrix, each box shows the payoff from a pair of decisions listed in the columns and rows. The blue triangles show firm A's profit, while the gold triangles show firm B's profit. The upper left box represents the outcome for successful collusion. The lower left and upper right hand boxes are the cheating outcomes and the box in the lower right hand corner is the non cooperative outcome.

If it is impossible to detect cheating, both firms face a dilemma. If they each believes the other is maximising profit, than each must expect the other to cheat. Just as in the prisoner's dilemma, each prisoner must expect the other to confess. In this case, the optimal strategy for both firms is to cheat. However, when both firms cheat, they both wind up in the lower right-hand box with the zero profit competitive outcome.

The non-collusive outcome in box D is called the Nash Equilibrium in Game Theory. A Nash Equilibrium describes a situation in which no player can improve his or her payoff given the other player's strategy. The concept of the Nash Equilibrium is important, because it often describes a non-cooperative equilibrium. This is because in the absence of collusion, each party chooses that strategy which is best for itself without collusion and without regard for the welfare of society or any other party.




8. Land and Rent




8.1. Introduction to land and rent; Factor prices


A nation's gross domestic product or GDP is the most common measure of its productive output. One way economists have of measuring the GDP is to add up all the income that people receive each year from producing years output using the three major factors of production, land, labour and capital. Together with raw materials, land, labour, and capital are the major resource inputs or factors that businesses need to produce goods and services. Each of these factor inputs has a price. The price of labour is the wage rate. The price of capital is related to both the interest rate and the profits earned on capital. The price of land is rent, although economists have a narrow definition of rent. GDP roughly equals wages earned by workers plus rents earned by property owners plus interest received by lenders plus profits earned by firms:

GDP = wages (for workers) + rents (for property owners) + interest (for lenders) + profits (for firms)

The distribution of income is determined in large part by the price for which each of the major factors of production can be sold or rented. That means factor prices will be a major determinant of annual personal income of individuals. Their future income will depend, not just on the wages they earn at their job, but also upon the interest and profits derived from any stocks and bonds or other capital that they hold, and from the rents from any land that they might own.

Factor pricing also guides resource allocations. Just as product prices ration finished goods and services to consumers, so do resources prices allocate scarce resources among industries and firms. An understanding of how resource prices affect resource allocation is particularly significant since, in a dynamic economy, the efficient allocation of resources over time calls for continuing shifts in resources among alternative uses. At the same time factor pricing illustrates the flip side of profit maximisation, namely cost minimisation. To maximise profits a firm must produce the profit maximising output with the least costly combination of factor resources. Given technology, resource prices will play the major role in determining the quantities of land, labour, capital, and entrepreneurial ability, that will be used in the production process.

Finally, there are a myriad of ethical questions and public policy issues surrounding the factor resource market. Should the Robin Hood of old have stolen from the rich to give to the poor, and in today's modern society, should the government use tax policy to redistribute income from the upper and middle classes to the poor? By the same token should the government tax the excess profits of corporations, put a cap or ceiling on the sometimes exorbitant interest rates charged by credit card companies, or provide workers with a wage floor in the form of a minimum wage. Do labour unions actually raise the wages of workers, and, if so, do unions do so at the expense of jobs?



8.2. How land is priced; Rent versus economic rent


Suppose someone wants to build a dream house. It is a 6,000-square foot mansion with five bedrooms, four baths, three tennis courts, two swimming pools, and an entertainment centre that would make Walt Disney blush. The only problem is that he needs an acre of land to build it on. If he wants to build your dream house where Clint Eastwood hangs out in Carmel, California, that one-acre lot might cost you over $3 million. If he decides that this is not quite in his budget, he could settle for an acre of land in rural Mississippi for about $500.

What accounts for this big difference in price for an acre of dirt? More fundamentally, how is land priced in the real estate market? To answer this question, it is important to understand what makes land different from most other factors of production. The essential feature of land is that its quantity is fixed and completely unresponsive to price. This essential feature leads us to our first definition. Pure economic rent is the price used to pay for land and other natural resources which are completely fixed in supply.

 
Supply and demand for land
 
It is the fixed nature of the supply of land that makes the rental payments clearly distinguishable from the prices paid to the other factors of production. Pure economic rent, as defined by economists, is not the same thing as the rent people pay for their homes or apartments. The rental payment they make to their landlord typically includes compensation for the use of capital such as the building structure, or labour, including building maintenance and management, and for the use of utility services such as water, electricity and gas. In most cases, only a small fraction of rental payment represent pure economic rent.

Given that the supply of land is fixed, the supply curve is vertical and therefore completely inelastic. The demand and supply curves cross at the equilibrium point E. It is towards this fact of price that the rent for the land must tend. If rent were above the equilibrium price, the amount of land demanded by all firms would be less than the existing amount that would be supplied. Some property owners would be unable to rent their land at all, so they would have to offer their land for less and thus the rent would be bid down. By similar reasoning, the rent could not remain below the equilibrium intersection for long. If it did, the bidding of under supplied firms would force the factor price back up towards the equilibrium level. only at a competitive price where the total amount of land demanded exactly equals the fixed supply will the market be at equillibrium.



8.3. The Corn Wars and theory of Ricardian rents; Property rights


 
Populist view on relation between land and corn prices
 

8.3.1. The Corn Wars

To really understand what distinguishes land from most other factors of production, can be illustrated by two controversies in 19th century history, the Corn Wars in England and the single tax movement in America. In 19th century England, English consumers became increasingly concerned about the rapid escalation in the price of various cereal grains that they called corn. The question is, why was the price of corn rising so rapidly? The most common explanation was that, landlords were raising the rent they were charging farmers for the use of their land, thereby forcing farmers to pass on the increase in land cost to consumers. In this scenario, landlords were the clear villains.

However, one of the great classical economists, David Ricardo, had a different explaination. Ricardo said that the price of corn is not high because a rent is paid. Rather, rent is high because the price of corn is high. In this scenario the root cause of the problem was, increased demand for corn, which in turn was driving up rent for corn land. The corn controversy was based on the assumption that rising land rents would in turn lead to an upward shift of the corn supply curve, making landlords to blame for high food prices. But something is wrong with this picture. As David Ricardo pointed out, supply decisions are based on marginal cost, not fixed costs, such as the cost of land.

 
Ricardo's view on relation between land and corn prices
 

8.3.2. Theory of Ricardian rents

Instead Ricardo envisioned the following chain of causality. In the corn market there might be an increase in demand as the English population grew. As demand shifts upward from D1 to D2, price increases from p1 to p2 and quantity increases from q1 to q2. This in turn would increase the demand for land, from D1 to D2 and rents would rise from R1 to R2. This illustrates that an increase in price in the product market, in this case corn, results in an increase in the price of the factor of production, in this case land. This is the case for all factors of production.

One might still conclude that landlords were unfairly benefiting from the situation. After all, these landlords would be just as willing to rent all of their land at a rent of R1 as they are at R2. However, at the higher rent they appear to be enjoying an unearned profit or windfall profit. In fact, that is precisely the conclusion reached by someone a continent away in a similar situation. That person was the journalist Henry George. The time and place was 19th century America and the debate was over the so-called single tax movement. At the time, America's population was expanding rapidly, as people migrated to the United States from all over the world.

With this growth of the population, and the expansion of the rail roads into the American West, land rents soared, creating handsome profits for those who were lucky or far-sighted enough to buy land early. During this time, it was up to Henry George to formally the question that was on many people's minds at the time. If land is a free gift of nature, if it costs nothing to produce, and if it would be available even without rental payments, why should rent especially exorbitant rent, be unfairly paid to those who, by historical accident, by inheritance, or by luck happened to be landowners?


8.3.3. Property rights

Indeed, socialists like Henry George have long argued that since all land rents are unearned incomes, land should be nationalised. That is, it should be owned by the state, so that any payments for its use can be used by the government to further the well being of the entire population, rather than simply enriching a small minority of landowners. At this point it is perhaps useful to digress for a moment and discuss one of the most important concepts in both economics and the law, namely property rights. Property rights are the rights given to people to use specific property as they see fit. In modern societies such rights are protected by a complex set of laws. That is why you can own your own home and the parcel it resides on and that is why you do not have to share your home, your car, or your shoes with anyone not of your own choosing.

In many earlier societies there was no such thing as property rights. For example, in Feudal times in Europe much of the land was held communally, that is the land belonged to everyone or at least to all the peasants in that time that used it. In the language of the times it was common land, a communally held resource. As the economy evolved into a market economy, the land was appropriated by individuals. These individuals became landowners who could determine the use of land and who could receive rent for allowing the other individuals to use that land. Today, there is not only a well-defined system of property rights and a contractual legal system to enforce these rights. There are also complex mechanisms, such as zoning laws, that limit or modify property rights.



8.4. Henry George's single tax movement; Efficiency of a land tax


In his important, and best selling book, Poverty and Progress, published in 1879, Henry George called for financing the government principally through property taxes on land. George's idea was to use this single tax to cut or eliminate all other taxes on capital, labour, and improvements on the land. George argued that such a tax would not only be more fair, it would also be more efficient. Modern economists have demonstrated that George was right that such a tax could improve the distribution of income without harming the productivity of the economy. It is possible to demonstrate the Georgist argument, and in doing so, prove this point. A tax on pure economic rent will result in no distortions of allocative inefficiencies.

 
Effects of the land tax
 
Suppose then that the government introduces a 50% tax on all land rent paid by farmers to landowners. It is a pure tax on land alone. In particular, this is not a tax on the buildings on the land, nor is it a tax on building improvements. This clarification is an important one. The reason is that while the supply curve for land is vertical, the supply curve for buildings and building improvements is upward sloping. This is because the price of such improvements affects their supply.

The 50% tax does not affect the quantity of land supplied and demanded. The initial equillibrium is at point E. After the tax is imposed, both the quantity of land supplied and demanded remains the same. The landlords actually wind up bearing the burden of paying this tax. The farmer pays the same at $200for the land but the landlord only keeps half that amount. The landlord bears the burden of the tax. This is an exercise in what economists call tax incidence analysis.

A tax on pure economic rent leads to no allocative inefficiency or dead weight loss. The reason is that a tax on pure economic rent does not change anyone's behaviour. Consumers are clearly unaffected by the tax because price has not changed. At the same time, the behaviour of landlords is unaffected because the supply of land is fixed and therefore cannot react. Hence the economy operates after the tax exactly as it did before the tax, with no distortion our inefficiencies arising as a result of the land tax. The argument offered by Henry George in defence of a single tax on land are so strong, from both an economic and equity perspective.

Despite that such a tax has never really been implemented. One obvious problem is that current levels of government spending are such that, a land tax alone would not bring in enough revenues. A second problem is that land is typically improved in some manner by productive effort. And economic rent cannot be readily disentangled from payments for capital improvements. Still a third problem is that, historically, a piece of land is likely to have changed ownership many times. Thus, while former owners may have been the beneficiaries of past increases in land rent, it would hardly be fair to tax current owners who paid the competitive market price for land.



8.5. Determinants of the price of land and rents; Rent seeking


8.5.1. Factors determining rent

There are reasons why an acre of land to build a house in rural Mississippi costs so much less than an acre of land in Carmel, California. And why an acre of farmland in Iowa costs so much more than an acre of farmland in New Mexico. Thus far, it was assumed that all units of land are of the same grade. This is clearly not so. Different acres of land vary greatly in productivity. These productivity differences stem primarily from differences in soil fertility, and such climatic factors as rainfall and temperature. These factors explain why Iowa soil is well-suited to corn production, while the desert wasteland of New Mexico is incapable of corn production. These productivity differences will be reflected in resource demand.

 
Land grades
 
An example can illustrate the rent differentials that might arise from differences in the quality of land and its productivity. Suppose that only corn can be produced on four grades of land, each of which is available in the same fixed amount. When combined with identical amounts of capital, labour, and other cooperating resources, the productivity. Or more specifically the marginal revenue productivity, of each grade of land, is reflected in the demand curves D1, D2, D3 and D4, with D1 being the most productive and D4 being the least productive.

The resulting economic rents for grades one, two and three land will be R1, R2 and R3 respectively, while grade four land is so poor in quality that it would not pay farmers to bring it fully into production. Just as productivity is important in explaining differences in land rent, so too is location. Other things equal, business renters will pay more for a unit of land which is strategically located with respect to materials, labour, and customers than for a unit of land that is remote from the markets, witness the extremely higher land rents in large metropolitan areas, and witness the difference in the cost of a scenic house lot in Carmel, California, which is close to heavily populated. San Francisco, versus a similar parcel in hot, muggy and remote rural Mississippi.


8.5.2. Economic function of rent

Although rising economic rents do not increase the quantity of land supply, rents do have a certain economic function. In particular, rents serve to allocate a scarce factor among competing uses. More importantly, the most valuable use will determine the market rent. For example, did you know that much of land in New York city was once used for pasture crops? However, over time, the rising price of land drove the fixed costs of farming so high that farmers could no longer make a profit in Manhattan. These farmers were initially replaced by modest homes, rooming houses, and factories, and ultimately by sky-scraping office buildings. Each step in this evolutionary process was propelled, in part, by increasing rents. Farms and individuals with more valuable uses for the scarce land offered increasingly high prices for its use. In turn, the high rents forced others to move their farms or households to other locations. Accordingly, the most valuable use of land will be determined by the market rent.

 
Quasi rents
 

8.5.3. Quasi rent

The concept of rents has been extended by economists to include any payment to a factor resource above its opportunity cost. That is, above the amount it would receive in its next best use. For example, an individual represented by point A on the supply curve would be willing to supply the good at S0, but the market equilibrium is P0. The difference P0 and S0 is his or her quasi rent. In fact, this quasi-rent situation looks a lot like the market for superstars. The demand for these performers is high because they can generate substantial revenues for their musical, comedic, and athletic talents. However, the salaries these superstars command are significantly above the salaries they might earn in their next best job. For example, when Michael Jordan tried to play baseball, he earned a small fraction of his basketball salary.


8.5.4. Rent seeking

The broadened definition of rent has led economists to the insight that if individuals could somehow restrict the supply of a factor, the rent they could receive for the factor would be higher. Rent seeking is the name given to the restricting of supply in order to increase the price suppliers receive. Put another way, rent seeking is an attempt to create either ownership rights or institutional structures for personal gain. Suppose the chairman of General Motors is facing stiff competition from Toyota of Japan. One solution is to become a more efficient producer. However, an alternative solution is to use the company's political clout to lobby the congress to impose a tariff or quota on Japanese auto imports. This would be an example of rent seeking by a special-interest group in the economy.




9. The Labour Market and Wage Determination




9.1. What determines the wage Rate? Unions and “company towns”


 
Union monopoly
 
President Jimmy Carter long ago soberly observed that life isn't fair, and nowhere is this more evident than in the labour market. While sports stars and Hollywood starlets earn millions of dollars a year, everyone from nurses and teachers, to fast food clerks and garbage disposal workers earn far less. The question is why do some people earn so much more than others? Why do doctors earn 15 to 20 times more than lifeguards even though both are saving lives? And why does a college graduate likewise earn substantially more than a high school drop-out. These questions are all the more important, because the wages a person will earn in his or her lifetime, will likely be the single most important determinant of his or her economic welfare.

In a perfectly competitive labour market the demand for labour slopes downward and the supply of labour slopes upward. Assume that the equilibrium wage rate in this market will be W*, where supply equals demand. How might this wage rate rise or fall? The demand curve might shift out. And as we shall see, this might occur if either worker productivity increases, or the prices of the good the workers are making increases. In this case, wages will rise.

 
Company town monopsony
 
Alternatively, labour supply might increase, for example due to an increase in immigration or labour force participation. This would shift the supply curve of labour out and wages would fall.

At the same time, the wage rate might be affected by the market structure. For example, workers might organise into unions. In this case, they would exert monopoly power in the market, and wages might rise to W**. But note that the number of people actually working is shown by a fall in the quantity of labour, actually falls.

Alternatively, workers might be unorganised and there might be only one employer in the market. This is the so called company town situation. An example might be the Anaconda Mining Company, the major employer in Butte, Montana. In economics, we refer to this situation as monopsony, only one buyer. In this situation, the wage rate will not only be below W*, but also the number of workers employed will be less than the competitive outcome.



9.2. The derived demand for labour; The marginal productivity theory of resource demand; The profit maximising rule; MRC=W


 
Resource cost benefit
 

9.2.1. The derived demand for labour

The demand for factors in general and for labour in particular is a derived demand. Factor resources usually do not directly satisfy consumer wants but do so indirectly by producing goods and services. For example, no one wants to consume an acre of land, a John Deere tractor, or the labour services of a farmer. But households do want to consume the food and fiber products these resources help produce. Similarly, the demand for automobiles generates a demand for automobile workers, just as the demands for such services as income tax preparation, haircuts, and child care create derived demands for accountants, barbers, and child care workers.


9.2.2. The marginal productivity theory of resource demand

The derived nature of resource demand implies that the strength of the demand for a factor such as labour will depend on two things: one, the productivity of the factor helping to create the product, and two, the market price of the product that the factor is helping to produce. Assume that a firm adds one variable resource, labour, to its fixed plant. As the units of labour increase, the total product increases, but the marginal product of labour decreases because of the law of diminishing returns. For simplicity, it is assumed that diminishing marginal productivity, sets in with the first worker hired.

The derived demand for the resource also depends on the price of the commodity it produces. Assume that the product price is constant and $2, because it is a competitive product market. In such a case, the firm is a price taker in the product market, meaning that it can sell as few or as many units of output as it wants to at this price. By multiplying total product by product price, the total revenue data can be computed. From these total revenue data, the marginal revenue product, or MRP, can be computed. The marginal revenue product is the increase in total revenue resulting from the use of each additional variable input, in this case, labour. The MRP schedule in columns one and six, provides the firm's demand schedule for labour.


9.2.3. The profit maximising rule

To maximise profits, a firm should hire additional units of a given resource, labour, land, and capital. As long as each successive unit adds more to the firm's total revenues than it does to total costs. When a firm decides to hire an additional worker, it must evaluate how much that worker will increase the firm's profits. It will do so by comparing the extra revenue generated by the extra output produced by the additional worker to the cost of employing that worker. The firm's addition to total revenues is the marginal revenue product. The marginal resource cost is the amount that each additional unit of a factor resource adds to the firm's total resource cost.

The profit maximising rule states that it will be profitable for a firm to hire additional units of a factor resource, such as labour, up to the point at which that resource's MRP is equal to its MRC. If the number of workers currently employed by the firm is such that the MRC of the last worker is less than the MRP, the firm can clearly profit by hiring more workers. However, if the number of workers already hired is such that the MRC of the last worker exceeds the MRP, the firm is employing workers who are not paying their way, and it can increase its profits by laying off some workers.


9.2.4. MRC=W

Under the assumption that the labour market is perfectly competitive, the MRC will be equal to the wage rate under perfect competition in the labour market. Therefore, the complete rule for profit maximisation under perfect competition is this. The MRP will equal the MRC, will equal the wage rate:

MRP = MRC = W

Suppose that the wage rate in this market is $13.95 then the firm will only hire one worker. This is because the first worker adds $14 to total revenue, and slightly less, $13.95 to total cost. In other words, the MRP exceeds the MRC for the first worker, so it is profitable to hire that worker. If the wage rate is $9.95, the firm will hire three workers.

The MRP schedule constitutes the firm's demand for labour. This is because each point on this schedule or curve indicates the number of workers that the firm would hire for each possible wage rate that might exist. The location of the demand curve for labour depends on the marginal productivity of the resource and the price of the product. Under pure competition, product price is constant. Therefore, diminishing marginal productivity is the only reason why the resource demand curve is downward sloping.



9.3. Productivity, wages and product prices


Prices can change in the labour market. If the productivity of a labourer increases, so too, should his or her wage. By the same token, if the price of the product that the worker is helping to produce falls, he or she is likely to see wages fall as well. Productivity, and more precisely, a worker's marginal productivity might change and thereby change wages. The most important influences on productivity are, the amount of capital and natural resources that a person has to work with, the state of the technology, and the quality of the labour itself. In each of these cases, more is better.

From this list of productivity boosters, we it is possible to see why American workers are so much more productive, and earn higher wages than workers from many other nations. For example, the United States is richly endowed with natural resources, ranging from fertile farmland and mineral resources such as oil, coal and uranium, to sources of industrial power, such as hydroelectric dams. At the same time, American workers have large amounts of capital to work with, on average, over $50,000 of plant and equipment per person. It is not just that Americans have more capital equipment to work with than many of their counterparts, they also have more technologically superior machinery, as well as more advanced management and work methods.



9.4. Issues in labour force participation; Substitution and income effects and the backward bending curve; Immigration


 
Backward bending curve
 

9.4.1. Issues in labour force participation

One of the most dramatic developments in the labour force participation over the last half-century has been the sharp influx of women into the work force. In fact, that participation has roughly doubled since 1950, from 34% to about 60% today. At the same time, labour force participation by older men has fallen sharply, particularly for men over 65, a change probably due in large part to changes in programmes such as Medicare and Social Security which offer far more generous health and retirement benefits. The typical American works between 35 and 40 hours a week. Nonetheless, many workers work as much as 50 to 60 hours a week at the same, or a second job. There are a variety of incentives such as over-time pay that can greatly affect hours worked.


9.4.2. Substitution and income effects and the backward bending curve

In this regard, one of the most interesting analytical concepts in labour market economics has to do with something called the backward bending curve. The idea here is that, the higher the wage, the more people will be willing to work, but only to a point. After that point, people will actually work less. The reason is that at higher wages, workers can afford more leisure, even though each extra hour of leisure, costs more in wages foregone.

On the one hand, there's a substitution effect. The more people work, the more they will earn. So each hour of leisure becomes more expensive as the wage rate rises. The incentive is to substitute work for leisure. On the other hand, there is an income effect. The higher the wage, the higher the income, so people will be able to take that extra week of vacation to ski in Colorado or sun in Miami. The income effect dominates up to point C. Above point C, the income effect outweighs the substitution effect, and the amount of labour supply declines as wage rates climb higher.


9.4.3. Immigration

A final important determinant of labour supply is immigration. In recent years this become a potent political issue for many reasons. Not perhaps the least of which is that as immigration increases, everything else being equal, wages tend to decline. Since 1970, the percentage of the foreign-born United States population has more than doubled from only 5% to well over 10%. More importantly, the characteristics of the immigrants have changed.

During the 1950s Europe and Canada were the major sources of primarily high skilled workers. However, beginning in the 1980's, the biggest groups of now primarily less skilled and less educated immigrants have come from places like Mexico, the Philippines, and Vietnam, as well as from Central American and Caribbean countries like Nicaragua and Jamaica. The result has been a significant increase in the supply of low skilled workers and a sharp decline in the wages of less educated groups relative to the college educated.



9.5. Wages under differing market structures; Monopoly, monopsony, and labour unions; Labour immobility; Role of unions


 
Resource cost benefit with imperfect competition
 

9.5.1. Wages under differing market structures

There are different considerations for wage rates under differing market structures in both the labour and product markets. In an imperfectly competitive product market, the monopolist, the oligopolist, or the monopolistic competitor will face a demand curve for its product that is downward sloping. That in turn means that the firm must accept a lower price to increase its sales. The important point here is that the lower price that accompanies every increase in output applies in each case not only to the marginal product of each successive worker, but also to all prior units, which otherwise would be sold at a higher price. The product price must be lower to sell the marginal product of each successive worker.

For example, if the product price is $2.40, the firm will sell 13 units. However, in order to sell 27 units, it must lower it's price to $1.75. The MRP be for two units of labour is $13. This can be calculated as follows. The second worker's marginal product is six units. These six units can be sold for $2.40 each, or as a group for $14.40. But this is not the MRP of the second worker. To sell these six units the firm must take a $0.20 price cut on the seven units produced by the first worker, units which could have been sold or $2.60 each. Thus the MRP of the second worker is calculated by first multiplying the total number of units sold, seven, times the price drop of $.20. This equals $1.40, which is then subtracted from $14.40, yielding $13.

The MRP curve for the imperfectly competitive producer will be less elastic than that of a purely competitive producer. At a wage rate of $11.95 and therefore an MRC of $11.95 both the purely competitive and the imperfectly competitive seller will hire two workers. However at a wage rate of $9.95 the competitive firm will hire three workers while the imperfectly competitive firm will hire only two workers. This observation has an important implication. Other things equal, the imperfectly competitive producer will produce less of the product than the perfect competitor. In doing so, the imperfectly competitive producer will also employ fewer factors of production including workers.

Assume now that there is perfect competition in the product market and imperfect competition in the labour market itself. In this case, there are two polar possibilities, monopsony and monopoly. The typical example of monopsony is the so-called "company town". A monopsony has the following characteristics. First, the firm's employment is a large portion of the total employment of a particular kind of labour, such as coal mining or food processing. Second, the workers are relatively immobile, meaning that workers do not or cannot move easily from the area. This might happen if they have strong family ties to an area, it may also happen in the sense that if workers sought alternative employment, they would have to acquire new skills.

 
Monopsony
 

9.5.2. Monopoly, monopsony, and labour unions

In fact, monoposony type situations are not uncommon in the United States. From New England textile mills and Colorado silver mining towns to farm belt food processing communities and remote Montana mining areas, the economies of many towns and cities in America depend almost entirely on one major firm. In the monoposony the firm is wage maker, meaning that the wage rate it pays varies directly with the number of workers it employees.

Unlike a firm hiring workers in a perfectly competitive market, a monopsonist does not simply hire all the labour wants at the equilibrium market wage. Instead the monopsonist faces an upward sloping market supply curve. In this situation, if the monopsonist wants to increase the number of workers that it hires, it must increase the wage that it pays to all workers, including those currently on its payroll. Thus, the monopsonist's MRC is not equal to the wage paid to the additional worker as in perfect competition, but rather is equal to a higher amount.

The MRC is greater than the wage rate. One worker can be hired at $6, but hiring a second worker forces the firm to pay a higher wage of $7. That means the MRC is $8, the $7 paid to the second worker plus the $1 raise for the first worker. Thus, the total labour cost is $14. The point is, that the monopsonis MRC, exceeds the wage rate. This means the MRC curve lies above the supply curve of labour. Applying the MRP equals MRC profit maximising rule, shows that equilibrium occurs at a wage of Wm and a quantity of Qm. Both wages and the level of employment are less under monopsony than in a perfectly competitive labour market. From this result, it is clear why so called company towns have been accused of exploiting their work force.

 
Monopsony
 
The other side of the labour market coin is monopoly. Monopoly in the labour market occurs when workers are able to act collectively as a single bargaining unit. The most obvious way that this might happen is through the vehicle of a labour union. Using their monopoly power, unions can compel firms to provide wages, benefits and working conditions that are above the competitive outcome.

For example, if a non-union plumber earns $15 per hour in Alabama, a union might bargain with a large construction firm to set the wage at $25 per hour for that firm's plumbers. Such an agreement will only be valuable if the union can restrict the firm's access to alternative labour supplies. Hence, under a typical collective bargaining agreement, firms agree not to hire non-union plumbers, not to contract out plumbing services, and not to sub-contract work to non-union firms. Each of these provisions help prevent erosion of the union's monopoly lock on the supply of plumbers to the firm.

 
Union labour market
 

9.5.3. Role of unions

The equilibrium in a unionised labour market differs from a competitive market. In this case the wage rate, Wu, is above the wage rate at Wc under perfect competition and that is better for workers, than the monopsony outcome However, as with monopsony, employment is less than under perfect competition. In this case, the union workers with jobs are unquestionably better off. But those workers who are unemployed as a result of the union, clearly are not.

Economists have concluded that union workers receive on average wages that are 10 to 15% higher than those of nonunion workers. This difference ranges from a negligible amount for hotel workers and barbers to 25%-30% higher earnings for skilled construction workers or coal miners. Perhaps needless to say, the subject of unionism is controversial. And it is the focus of much debate among both economist and politicians.

Indeed the study of unions is an important part of understanding the dynamics of the US labour market. About one-seventh of the workforce still belongs to a union. In negotiating collective bargaining contracts, unions raise issues that are important to all workers, ranging from pensions, health care benefits, and working hours.



9.6. Factors affecting wage Differentials; Compensating differentials; Quasi-rents; Human capital; Immobilities; Non-competing groups


9.6.1. Compensating differentials

There are a number of other factors that may account for wage differentials among people in different occupations. One reason has to do with so-called compensating differentials that measure the relative attractiveness of jobs as well as the degree of risk. Think of it this way. A group of high school graduates may be equally capable of becoming either bank clerks or unskilled construction workers. But as a rule, the construction workers will receive higher wages than the bank clerks. This difference can be explained by the non-monetary aspects of the two jobs.

The construction job involves dirty hands, a sore back, potentially dangerous accidents, and irregular employment, both seasonally and cyclically. On the other hand, the banking job means a white shirt, pleasant air-conditioned surroundings, and little risk of injury or layoff. Other things equal, it is easy to see why workers would rather pick up a deposit slip than a shovel. That is why contractors pay higher wages than banks pay, to compensate for the unattractive, non-monetary aspects of construction jobs.

This idea of compensating differentials might lead to the conclusion that garbage collectors and soldiers make more money than university professors or doctors. However, we know this not to be the case. Indeed, we see countless examples of high-paying jobs that are far more pleasant than low-paid work. Accordingly, we have to look beyond compensating differentials for additional explanations of wage differentials.


9.6.2. Quasi-rents

A second explanation is the differences that people have in both their mental and physical capabilities. Take an athletic super star or a comedian like David Letterman or a pop novel writer like Stephen King. Each of these people are talented, and their skills are highly valued, but outside their special fields, they might earn but a small fraction of their incomes. Economists refer to the excess of these wages above those of the next-best available occupation as a pure economic rent, or, as we learned in the last lecture, more precisely a quasi-rent. In fact, these quasi-rents are logically equivalent to the rents earned by a fixed supply of land.


9.6.3. Human capital

A third explanation of wage differentials has to do with the different amounts that people invest in their own human capital. Where human capital refers to the stock of useful and valuable skills and knowledge that are accumulated by people in the process of their education and training. For example, unlike lifeguards, doctors, as well as lawyers, engineers, and professors, invest many years in their formal education and on the job training. They spend large sums on tuition and foregone wages, investing a $100,000 or more in college and graduate-level training. At least part of the high salaries of these professionals should be viewed simply as a return on their investment in human capital.


9.6.4. Immobilities

A final source of wage differentials takes the form of various immobilities, such as geographic immobilities. For example, workers take root geographically, and they are often reluctant to leave friends, relatives, and associates. Nor do they want to sell their homes, force their children to change schools and incur the costs and inconveniences of adjusting to a new job and a new community. Such reluctance or inability of workers to move, enables geographic wage differentials for the same occupation to persist.

These geographic immobilities may be reinforced by institutional immobilities. For example, a low-paid non-union carpenter in Colorado may be willing to move to heavily-unionised Chicago to find higher wages. But in Chicago, he may not be able to get a union card. Without card there is no union job. In fact, many professions impose similar restraints. For example, a professor could not teach at at a university without a doctorate degree. Finally there are sociological immobilities that take the form of discrimination. Indeed, despite legislation to the contrary, both women and blacks frequently receive less pay than white men on the same job.


9.6.5. Non-competing groups

One last important distinction in the labour market is that of non-competing groups. Wage differentials may reflect the attractiveness of certain occupations, differences in the amount of education and training, rewards or rents and, various immobilities. But even taking into account these factors, there may still be substantial wage differentials. The reason may be traced to the fact that labour markets are segmented into non-competing groups. Think about it this way. Instead of labour being a single factor of production, it is many different but closely related factors of production.

Doctors and mathematicians, for example, are not in competing groups, because it is difficult and costly for a member of one of these professions to enter into the other. And just as there are many different kinds of houses, each demanding a different price, so too, there are many different occupations and skills that compete in only a general way. The point is that once people specialise in a particular occupation, they become part of a particular labour sub-market. They are then subject to the supply and demand for that skill and will find that their own labour earnings will rise and fall depending upon events in that occupation and industry.




10. The Capital Market, Interest, and Profits




10.1. Capital analysis in the real world; Three categories of capital goods; Interest rate defined; Rate of return


The subject of capital is one of the most important and useful areas of microeconomics. By understanding the nature of capital markets, it is possible to answer questions that have enormous application to both people's personal and professional lives. On a personal level, it is possible to answer questions like should I rent or buy a home now? Should I quit my job to go back to school for a business or law degree? Should I buy that expensive energy efficient refrigerator, or go for the cheaper model? Should I invest in a portfolio of high risk, high technology stocks or settle for some safer tax free municipal bonds?

At a professional level, capital analysis is equally crucial, and can help business executives answer questions like, should a business invest in new plant and equipment? Should the firm be expanded? And how much inventory should the firm maintain? The analysis of capital markets can help answer these questions because it offers a framework for evaluating investment in new capital over time. There is a distinction between real capital, the bricks, mortar and machines, and financial capital, the stocks and bonds and other loanable funds used to finance real capital.

There are three major categories of real capital goods. The first is structures such as factories and homes. The second is equipment including consumer durable goods such as automobiles and producer durable equipment like machine tools and computers. The third category of capital goods is inventories and includes things like cars in dealers lots. All three categories of these capital goods are bought and sold in capital goods markets. For example, IBM sells computers to businesses, and these computers in turn are used by firms to help improve the efficiency of their payroll systems or production management.

One of the most important tasks of an economy, business or household is to allocate its capital across different possible investments. Should a country devote its investment resources to heavy manufacturing like steel, or to information technologies, like the Internet? Should Intel build a $4 billion dollar factory to produce the next generation of microprocesors? Should Farmer Jones, hoping to improve his record keeping, buy a customised accounting programme or make do with one of the popular varieties available for around $100?

This is where interest rates and the rate of return to capital comes in. When a person invests in capital, he or she is laying out money today to obtain a return in the future. In deciding upon the best investment to make, he or she needs to know how much the money is going to cost. That is the interest rate. He or she also needs to know how much the investment will earn. That is the rate of return. The interest rate is the price paid for the use of loanable funds, where the term loanable funds is used to describe funds that are available for borrowing.

In particular the interest rate is the amount of money that must be paid for the use of $1 of loanable funds for a year. Because it is paid in kind, interest is typically stated as a percentage of the amount of money borrowed rather than as an absolute amount. It is less clumsy to say that interest is 12% annually than that interest is $120 per year per $1000. Furthermore, stating interest as a percentage makes it easy to compare interest paid on loans of different absolute amounts. For example, by expressing interest as a percentage, we can immediately compare an interest payment of say $432 per year per $2880 and one of $1800 per year per $12,000. Both interest payments are 15%, which is not obvious from the absolute figures.

The rate of return on capital is the additional revenue that a firm can earn from its employment of new capital. This additional revenue is usually measured as a percentage rate per unit of time. Assume that the Ugly Duckling rental company buys a used Ford for $10,000 and then rents it out for $2,500 per year. After calculating all the expenses associated with owning the car, such as maintenance, insurance and appreciation, and ignoring any changing car prices, Ugly Duckling earns a net rental of $1200 each year. The rate of return is 12%. This can be calculated by dividing the net rental of $1,200 per year by the initial investment outlay for the Ford of $10,000. The rate of return is a pure number per unit of time.



10.2. Depreciation; Theory of loanable funds; Two interest rate functions


10.2.1. Depreciation

Depreciation is an estimate of the loss in the dollar value of a capital good, due to obsolescence or wear and tear during a period of time. And corporations are allowed to treat depreciation as an expense on their taxes, just like other expenses, like labour costs and raw materials. When depreciation over a period of time exceeds investment over the same period of time, the capital stock will decrease, whereas if investment exceeds depreciation, the capital stock will increase.

Both investment and depreciation are flow concepts, meaning that they are measured per unit of time. This is in contrast to capital, which is a stock concept, meaning that capital is measured at a given point in time. Suppose a firm ends its previous fiscal year with a capital stock of $1 million. If the firm, over the course of the current year, invests $100,000 in new plant equipment and incurs depreciation of 200,000 dollars, the capital stock at the end of the current year is 900,000 dollars.


10.2.2. Theory of loanable funds

 
Capital market
 
Both the interest rate and the rate of return determine investment decisions in a market economy. Firms will demand loanable funds to invest in new projects as long as the rate of return on capital is greater than or equal to the interest rate paid on funds borrowed. This can be demonstrated with the theory of loanable funds. In the example there is an upward sloping supply curve, a downward sloping demand curve, and an equilibrium interest rate of 8%, where the supply and demand curves cross.

The theory of loanable funds is based on the assumption that households supply funds for investment by abstaining from consumption and accumulating savings over time. The upward sloping supply curve of loanable funds, reflects the idea that households prefer present consumption to future consumption, and therefore must be paid an interest rate to induce them to save rather than consume. The higher the interest rate, the larger the amount households are willing to save. On the demand side, it is businesses that demand loanable funds to build new plants or warehouses, or to purchase machinery and equipment. This curve is downward sloping because, other things equal, there will be more potential investments that will be profitable at lower interest rates than at higher interest rates.


10.2.3. Two interest rate functions

This can be illustrated recalling the example of the Ugly Duckling car rental. In that example, the company bought a used Ford for $10,000, earned a net rental of $1,200, and wound up with a 12% rate of return on its investment. Suppose the company wants to borrow some money from the market for loanable funds to buy an identical used ford, and it projects an identical rate of return on its investment. If the interest rate is 10%, it will surely borrow the money, because the rate of return that it can earn using the funds exceeds that. However, if the interest rate is 15%, it will not borrow the money, and it therefore will not make the new investment.

This example not only shows why the demand curve for loanable funds is downward sloping, it also helps to explain equilibrium in the market, where the supply of funds equals the demand for funds. If equilibrium occurs at an interest rate of 8%, and the market rate of interest were instead 10%, the supply of funds would exceed the demand for funds because not enough businesses could find investments capable of generating at least a 10% rate of return. Because of this surplus of funds, lenders would have to lower the interest rate.

In contrast, if the interest rate were 6% in this market, there would be plenty of businesses demanding the funds. However, there would not be enough households willing to forego present consumption to meet that demand. The result is that excess demand would bid up the interest rate and drive that rate back to where the supply and demand curves cross. From this discussion, it is possible to see that the market interest rate serves two functions. It rations out society's scarce supply of capital goods for the uses that have the highest rates of return and it induces people to sacrifice current consumption in order to increase the stock of capital.



10.3. How shifts in demand and supply affect interest rates; Investment analysis over time; Net present value; Perpetuities


10.3.1. How shifts in demand and supply affect interest rates

How might events in the real world cause the demand and supply curve to shift and thereby change the interest rate and the economy's level of investment? First consider the supply side. Suppose that the federal government significantly expands the social security retirement programme to more fully cover the cost of hospitalisation and retirement. The most likely response to this new government policy would be for people to save less for their retirement. This would shift the supply of loanable funds inward and the market rate of interest would rise. Any Federal cut backs in Medicare or Social Security might shift the supply curve outward, and cause the interest rate to fall.

Now consider the demand side. Suppose the economy has been in a deep recession, but is now moving towards full employment. As the economy improves, more businesses are likely to increase their investment in new plant and equipment. This will shift out the demand curve and thereby increase the interest rate.


10.3.2. Investment analysis over time and net present value

In the example above, it was easy to evaluate the firm's investment decision because the investment horizon was limited to only one year. That means that there was an investment in something at the beginning of the year and a return at the end of the year. That is a pretty artificial example, because most investments last more than one year after the initial outlay of funds, from a few years for a new computer or some office furniture, to 30 to 40 years for an electric power plant, and more than 50 years for a big skyscraper.

The question is how to evaluate an investment when the capital outlay occurs today but the benefits from that investment come in the form of a revenue stream over many years. In order to answer this question, one of the most important concepts in economics is needed, which is net present value. Net present value goes by various other names, including present discounted value or just plain present value. The concept behind net present value is that it provides the time value of money, which is defined as the dollar value today of a stream income over time. It is measured by calculating how much money invested today would be needed, at the going interest rate, to generate the assets of future stream of receipts.

Suppose an apartment building generates rental payments of $10,000 per month from the tenants. Suppose further, that the tenants are always calling the owner up in the middle of the night to complain about a leaky faucet or a blocked toilet or a broken waste disposal. The owner decides to sell the building. But how much should he sell it for? What lump sum payment of money today would make the owner at least as well off as that stream of rental payments that he would get over the life of the building?

To start towards an answer to this question, it is better to start with a simple example for only a one year investment. Suppose that somebody offers to sell a bottle of wine that matures in exactly one year and that the wine can be sold for $11 at the end of the year. Assume that the market interest rate is 10% per year, the present value of the wine $10, because $10 invested today at the 10% market rate of interest would yield $11 at the end of the year. In other words, the present value of next year's $11 wine is $10.


10.3.3. Perpetuities

A perpetuity is an asset, like land, that lasts forever and pays a certain amount of dollars per year from now to eternity. There is a simple formula to valuate a perpetuity:

V = N / i

Here V equals the present value of the land, N is the permanent annual receipts from the land, and i is the interest rate in decimal terms. If the interest rate is 5% per year and the perpetuity yields a $100 a year, the net present value of the perpetuity is $2000 or simply $100 divided by 0.05. This formula for a perpetuity can be used to determine what the selling price of the apartment building should be. Assume that the prevailing interest rate is 5%. Further assume that after expenses, the monthly rental income of $10,000 is reduced to $5.000 or $60,000 for the year. Based on that net rental income, and assuming that the building will last forever, the selling price should be at least $1.2 million, which is found simply by dividing $60,000 by the interest rate. If the interest rate was 10%, the selling price would be only $600,000.



10.4. NPV in the real world; NPV equation


 
NPV equation
 
Suppose that instead of an asset generating the same amount of income each year, the asset generates a different amount of income each year. Further suppose, that instead of generating a stream of income from now to eternity, like the indestructible apartment building, the asset generates a stream of income over a fixed period of time, maybe five years, maybe ten years, maybe 50 years. Suppose a chief executive officer of a textile company is considering replacing the old mechanical looms with a set of highly computerised looms. These new machines are not cheap. The price tag is a cool $2 million. The chief economist forecasts that these new machines will increase revenues by $500,000 for each of the five years of the service life of the looms. At the end of five years, the machines will have a salvage value of another $500,000.

From this data, it may seem obvious that the company should make the investment. While the machines will cost $2 million, they will generate an even cooler $3 million in revenues and salvage value over the five-year period. It is important to consider the time value of money. There is a formula to calculate the net present value of this investment. In this equation, I0 is the initial investment at time period 0. The one period market interest rate is i and for this example, assume that this interest rate is constant at 15%. N1 is the net receipts from the investment in the first period or year and N2 is the net receipts in the second period during the year, and so on. Then, the sum of the initial investment and the stream of payments, N1, N2, and so on, will have the present value, NPV, given by the formula:

NPV = - I0 + N1/(1 + i) + N2/(1 + i)2 + ... + Nt/(1 + i)t + ...

 
NPV calculation
 
This formula can be used to calculate the net present value of the loom investment. Here's the math. It starts off with the initial $2 million investment, which has a negative sign because it is an outlay. Then, the income stream of $500,000 per year plus the $500,000 the company will receive at the end of the fifth year as salvage value, must be discounted. This gives a NPV of $1,924,664 for the income stream. It turns out that the actual NPV of the total investment is a negative sum, minus $75,336. Because the net present value of the investment is negative, the company should not make the investment. This is despite the fact that over the life of the investment the investment will generate an undiscounted sum a full half million dollars greater than the initial investment.

If the interest rate were 5%, the company would make the investment. This is because the value of that investment in net present value terms is positive at the prevailing cost of borrowed funds. Put another way, by making the investment, the company would increase its profits. The higher the interest rate, the more one has to discount the revenue stream. This, in turn, reduces the present value of the revenue stream, and vice versa.



10.5. Real world applications of NPV


These same formulas to solve several of the real world puzzles of the first lecture. The refrigerator problem is a choice between a new energy efficient refrigerator which costs $750 or a cheaper model at $500. The energy efficient refrigerator will produce an electricity bill that is $120 cheaper per year over the five-year life of the refrigerator. Assuming an interest rate of 8%, which refrigerator should be bought purely on economic grounds?

The net present value of the investment is calculated by first subtracting the purchase price of the cheaper refrigerator from the purchase price of the more expensive refrigerator. To get the net additional investment required to buy the more expensive model. This is $250, which must have a minus sign in front of it, because it is an investment outlay. Then the time value of the savings must be calculated, which turns out to be $479. Subtracting $250 from this, yields a positive NPV of $229. Clearly the seemingly more expensive refrigerator turns out to actually be cheaper from net present value perspective.

The next puzzle is the dilemma of Priscilla and Phil from the first lecture. As a family they are trying to decide whether Phil should quit his job in order to enter a two year programme for his MBA. Phil is 45 years old and is making good money at his job as a salesman at a medical equipment company, $50,000 a year. Nonetheless, Phil feels stuck in his job, knowing that he can never advance further in his company or his career without additional education. With an MBA degree, Phil could move into the corporate side of the company and make at least $85,000 a year, right up until retirement at age 55.

The MBA programme he wants to enroll in will cost him $80,000 or $40,000 a year. He will have to borrow money to do it, as well as quit his job. Fortunately, Priscilla brings home a decent salary, one big enough to support Phil and their two children over the next two years. So the only question they have is whether it makes financial sense for Phil to take this major step. Assuming that the interest rate is 6%? Phil's foregone salary is an opportunity cost of entering the programme? That is $50,000 per year for two years. That plus the $40,000 tuition for two years gives an annual cost of Phil's investment in human capital of $90,000.

Properly discounting this sum at a 6% interest rate over the two-year period yields a net investment cost of $165,903 in net present value terms. Phil's incremental income from getting his MBA will be $35,000 per year, which is the difference between his current and future salary. His new salary will not start until year three. Properly discounting this income flow through year ten, when Phil reaches retirement, yields $193,434. The NPV of Phil and Priscilla's investment is a positive $27,531, which is simply the difference between the NPV of the investment outlay and the NPV of the income stream. So, Phil should go get his MBA.



10.6. Interest rates in the real world; Factors determining interest rates


So far, it was assumed that there is only one interest rate in the economy and that it will stay stable over time. There is actually a cluster, or range, of interest rates. This range of rates is based on a variety of factors, including the degree of loan risk, the length or maturity of the loan, the size of the loan, and the taxability of the interest on the loan.

The first determinant is risk. Suppose ther is the choice of lending a $100 to either General Motors or the Fly By Knight corporation. If someone were to lend our money to Fly By Knight, she would probably want to charge them a higher interest rate to compensate for the risk of lending to a smaller much less known company that might not repay the loan. That higher rate for risk is known as the risk premium.

The longer the term of the loan the higher usually is the interest rate. This is to compensate the long-term lender for the inconvenience and possible financial sacrifice of foregoing alternative uses of the money for a greater length of time. As for loan size, given two loans that are equal in both length and risk, the interest rate usually will be somewhat higher on the smaller of the two loans because the administrative costs of a large and a small loan are about the same.

Taxability is another issue. Interest on certain state and municipial bonds is exempt from federal income taxation. Because lenders are interested in their after tax rate of interest, state and local governments can attract lenders even though they pay lower interest rates. To see this, suppose that a prospective bond buyer earns over $100,000 a year. This puts him in the top Federal marginal tax bracket, which for the purposes of this example is 28%. That means that for every additional dollar over $100,000 that she earns, she must pay $0.28 in taxes.

There is a choice to invest in a $100,000 municipal bond which pays 6% in tax-free interest or in a taxable corporate bond paying 8% interest. The tax free bond provides $6,000, which is obviously less than $8,000 from the corporate bond. However, if she opts for the corporate bond, she is going to owe $2,240 in taxes. Clearly then, she will prefer the lower interest rate with the tax-free bond, because after taxes it will yield $240 more than the corporate bond.




11. Public Goods and Externalities




11.1. Why markets fail and the government’s role


Two of most important concepts and problems in economics are public goods and externalities. To put the public goods and externalities problems in perspective, it should be noted that perfect competition provides an efficient allocation of society's resources. However, when one or more of the assumptions of perfect competition are not met, a market failure results. So far, the market failures of imperfect competition has been discussed. These are monopoly, monopolistic competition and oligopoly. Public goods and externalities are two market failures that provide much of the rational for government intervention. For example, each year the United States Government spends billions of dollars on national defence, parks, roads and bridges, to the criminal justice system, flood control programmes, and light houses on the high seas.

It is the government rather than the private marketplace that often has to provide for all these public goods. The externalities market failure helps to explain not only the existence of many environmental protection laws, but also many government health services. In analyzing this important problem, it is possible to come to understand the many different ways the government can address it, from liability rules, lawsuits and direct controls to the use taxes to discourage negative externalities and subsidies to encourage positive externalities.

Government intervention in the free market has in a normative effect on the everyday lives of people. Taxpayers heavily subsidise the education of students at a public college or university. For employers or workers in private corporations, the government imposes a wide range of health, safety and environmental regulations. At the same time it takes a large bite out of profits and wages. When people visit a restaurant or butcher shop, the government is there too, helping to prevent food poisoning through meat inspections. And as people jump into their cars or onto their motorcycles, that seat belt or helmet they must wear has been mandated by the government as well.



11.2. Public versus private goods; Non-rival consumption; Non-excludability; Free rider problem


11.2.1. Public versus private goods

Each year the United States government spends billions on one public good alone, national defence. At the same time, billions more are spent on other public goods ranging from parks, roads, and bridges to the criminal justice system, flood control programmes and even lighthouses on the high seas. So why is it that the government rather than the private marketplace has to provide for all these public goods? The answer lies in understanding the nature of public goods market failure.

Private goods, like hot dogs and shotguns and flash lights are divisible. They come in small enough units to be afforded by individual buyers. A private good is also rival in consumption. If one person consumes the good, someone else cannot. Finally, a private good is subject to the exclusion principle. Those unable or unwilling to pay can be excluded from the benefits.

In contrast, public goods like national defence or lighthouses have several characteristics that make them indivisible. They come in such large units that individual buyers cannot afford them. Public goods are also non-rival in consumption. Different people consume a public good without interfering with the other's enjoyment. Perhaps most important of all, exclusion from the consumption of a public good is difficult or impossible. This non-excludability makes it difficult for the private market place to supply the good.


11.2.2. Non-rival consumption

Okay so far that is an abstract comparison. Suppose John is holding a hot dog in his hand. Further suppose that Jane is really hungry and wants the hot dog. But John is hungry too, so that if Jane eats that hot dog, John cannot. In other words, that hot dog is rival in consumption. Now, contrast this hot dog with national defence. Here John is standing on American soil protected by an army, a navy, and air force, and a deadly array of nuclear missles. Jane is protected as well. More importantly, John's protection by this defence umbrella does not interfere with Jane's protection. In other words, the defence umbrella is non-rival in consumption. And one of the reasons is public goods like national defence are indivisible and too large to be purchased by one individual.


11.2.3. Non-excludability

The problem with the free market providing public goods like national defence is that nobody wants to pay for public goods. The reason has to do with the third characteristic of a public good, non-excludablility. Once the public good is provided, a producer cannot exclude non-payers from recieving its indivisible benefits. This creates a perverse incentive among potential buyers to want to free ride. That is potential buyers will not want to pay for a good that they can obtain the benefit of for free. Nor will they want to reveal their true preferences as to how much they value the good and would be willing to pay for it prior to its provision for fear of being taxed that amount. As a result, the market demand curve for a public good is either non-existent or significantly understated.


11.2.4. Free rider problem

The result of this free-rider problem, which by the way is one of the most famous concepts in economics, is that the perceived demand for the public good doesn't generate enough revenue to cover the costs of production. This is so, even though the collective benefits of the public good may exceed the economic costs. The free rider problem can be illustrated with the case of flood control in a beautiful but flood plagued valley. No one in this valley wants to be flooded out. But each landowner knows that a flood control programme will protect all landowners, regardless of who pays.

This is because either the entire valley is protected or no one is. Accordingly, individual farmers and landowners may say they do not really want a dam and are not willing to pay for it. But all the while, what they are really doing, is waiting and hoping that someone else will step in and pay for the flood control. In other words, everyone wants a free ride, and if this project is left to market forces, no one will demand flood control and all the property in the valley will sooner or later be washed away.

The economic difference between public goods and private goods rests on technical considerations, not political philosophy. The central question is whether there is the technical capability to exclude non-payers from non-rival goods like national defence or flood control. It is not just that there is the technical capability, it is also that exclusion must be economically feasible, as is the case for city streets. In theory, it is possible to restrict the use of streets to only those who pay to use them by putting a gate on every corner, but that would be exceedingly expensive and impractical to do so, so city streets have the characteristics of a public good, just like the administration of justice, the regulation of commerce, the conduct of foreign relations and the provision of certain types of goods, such as lighthouses, bridges, and roads.

 
Demand for private goods
 


11.3. Economic efficiency and public goods; Market demand for public goods


The private marketplace will not provide public goods or will under-supply them. The next question is th en how is it possible to ensure that the government provides an economically efficient supply of a public good? In real world terms, how does a society decide how much national defence and flood control is optimal and how many lighthouses and parks the government should provide? To answer these questions, a better understanding of the demand for public goods is needed, and more importantly, how the market demand curves for private and public goods differ.

The market demand curve for private goods is the horizontal sum of the individual demand curves. Because of this, individual consumers will pay the same price for a good but consume different quantities. In contrast, the market demand curve for a public good is the vertical sum of the individual demand curves and individual consumers will all consume the same amount of the goods, but value that amount at different prices.

To illustrate this distinction let's start with the demand schedule of Carlos, Carla and Leon for a private good like corn. The market demand curve D is found by summing horizontally the individual demand curves D1, D2, and D3. Equilibrium in this market will occur where supply equals demand, which is also where social marginal benefits equal social marginal costs. Thus in a competitive market this equilibrium output will be economically efficient because it maximises the combined well-being of the buyers and sellers, the only people affected by the transactions.

 
Demand schedule for public goods
 
Now contrast this situation with the demand schedules for national defence of Mr. Hawk and Mr. Dove. These demand schedules are phantom demand curves because as these two people will not actually reveal their true preferences in the market place about how they value defence, but rather, prefer a free ride. For the purposes of this example, it is assumed that this information has been discovered through an opinion survey indicating the willingness of both Mr. Hawk and Mr. Dove to pay for added units of national defence. The market demand curve for this public good can be derived by summing vertically.

 
Willingness to pay
 
If the government provides two units of national defence, Mr. Hawk would be willing to pay $4 for it, while Mr. Dove would be willing to pay only $3. Summing these amounts gets us to $7.00 on the collective demand curve. Similarly, at four units, Mr. Hawk would ante up $2.00, while Mr. Dove would be willing to pay only $1.00. Thus, the price for four units is $3.00. To answer the question about what the optimal quantity of a public good provided by the government should be, the supply curve can be added.

 
Willingness to pay
 
This supply curve slopes upwards because of the law of diminishing returns, which applies to producing private goods like muffins as well as public goods like missiles. This supply curve also measures the marginal cost to society of providing each unit of defence. The optimal output occurs therefore at the intersection of supply and demand where the social marginal benefit equals the social marginal cost. The optimal quantity in this case is three units. At three units, the combined willingness to pay for the extra unit the marginal benefit to society just matches that unit's marginal cost of $5. You can see, then, that this marginal benefit equals marginal cost principle is analogous to both the MR equals MC output rule and the MRP equals MRC input rule for maximising profit.



11.4. Benefit-cost analysis and the decision rule


This theoretical principle can be put to work in the real world using benefit-cost analysis. Suppose the government is contemplating the flood control project. Questions are, should government undertake the project, and if so, what is its proper size or scope? The benefits of such a project will come from the reduction in damage to the land in the valley in the event of a flood. The cost of such a project is the loss of satisfaction associated with the accompanying decline in the production of private goods or some other public good. This cost can usually be measured simply by the cost of building the project.

 
Willingness to pay
 
The benefit-cost decision rule is simply that if the benefits from the project exceed its cost, the project should be built. However, if the costs exceed the benefits, it should not. Benefit-cost analysis can indicate much more than just whether a public project is worth building. It can also help government choose among the best competing alternatives. For example, a government may have to choose from a series of increasingly ambitious and increasingly costly flood control plans. The plans range from a small levee with a total annual cost of $3,000, to a large reservoir with the total annual cost of $30,000.

The total annual benefit of each project and the marginal costs and marginal benefits can be calculated as well as the net benefits of each plan. The net benefits are positive for all four plans. Which plan should be chosen will be determined by comparing the additional or marginal cost, and the additional or marginal benefit associated with each plan. Clearly, Plan C is preferred as it provides the largest total net benefits.

What is perhaps most interesting about benefit-cost analysis, is that it helps shatter the simplistic notion that the best way to make government more efficient is to always reduce government spending. Putting this point another way, efficient governance does not necessarily mean minimising public spending. Rather, it means using tools like benefit-cost analysis to efficiently allocate resources between the private and public sectors until no net benefits can be had from further reallocation of resources.



11.5. Negative and positive externalities


The second major market failure is that of negative externalities and positive externalities. The idea behind externalities is that the production or consumption of a good may generate spillover effects. External benefits or costs are not accurately reflected in the supply and demand curves of producers and consumers. As a result of the spillover effects or externalities, the free market may be inefficient and under-supply or over-supply the good. For example, suppose a company makes computer chips in silicon valley. In order to make those chips, the firm must pay its workers, invest in new plant equipment and buy raw materials. Each of these costs will be reflected in the firm's private marginal cost curve, which is also your firm's supply curve. Further assume, that in producing those computer chips, the company also generates large amounts of toxic waste.

In a free market, and in the absence of any laws to the contrary, the company may simply dump these toxic wastes into a nearby river to minimise its costs. Nonetheless, the resulting pollution will not be without cost to the broader society. Children may get leukemia from drinking water from the river. Fishermen may catch less fish because of the toxic waste killing of fish, and homeowners along the river may get sick from the smell. These types of external or spill over effects are called negative externalities. Because they will not be borne by your firm in a free market, they are not reflected in the firm's supply curve. The likely result is that the firm will produce both too many computer chips and too much pollution from society's point of view.

Externalities are not always bad. In fact, positive externalities arise when all of the benefits of consuming a good, do not accrue to the individual consumer. To understand this concept, suppose Sherlock Holmes is concerned about getting the flu, and decides to go for a flu shot to his private physician, Dr. Watson. By getting this shot, the good detective Holmes not only protects himself from getting the flu, he also helps protect the broader London population from catching the flu from him. When magnifying Holmes' behaviour to the entire population, vaccinations mean a healthier and more productive workforce, a larger national output, and higher incomes for society.

Problem, however, is that the free market tends to lead to the underconsumption of goods that yield positive externalities. Vaccinations to education. The broader point here, is that the externalities problem provides a strong economic rationale for a good portion of federal, state and local intervention into the free market. On issues ranging from environmental protection and traffic congestion, to education and public health. Accordingly, it is appropriate that we take a more systematic theoretical look now at this important market failure.



11.6. Graphical analysis of externalities; Coase theorem and property rights; Tort system


 
Negative externality
 

11.6.1. Graphical analysis of externalities

One of the key assumptions of perfect competition is that, the demand curve accurately measures marginal social benefits and the supply curve accurately measures marginal social costs. When this assumption is met, equilibrium output occurs where supply equals demand and society's resources are effeciently allocated. Suppose however that the supply curve does not accurately measure social costs, but rather only measures a firm's private cost of production as in the computer chip example.

Here is what this situation might look like. The new supply curve St, which is not observed by the firm reflects both the private cost of production as well as the spill over effects, and thereby measures the social marginal cost. The actual free market equilibrium will be where supply crosses demand at P1 and Q1. However, the preferred equilibrium is where St crosses the demand curve or social marginal benefit curve at P2 and Q2.

 
Positive externality
 
There are also positive externalities. There is an upward sloping supply curve of vaccinations and a downward sloping demand curve for vaccinations. With this downward sloping curve, reflecting the private marginal benefits that accrue to consumers. But now, in the presence of a positive externality, there also is a social marginal benefit curve Dt that reflects the positive spill over effects from the vaccination programme. In the absence of government intervention, equilibrium will be at P1 and P1. In this case, equilibrium output is less than the optimal output Q2 at price P2.

In the case of negative externalities, like pollution and congestion, the free market is likely to produce too much of the externality, and too much of the good generating the externality. In contrast, with a positive externality, the market under-supplies the good, and generates too few spill-over benefits.


11.6.2. Coase theorem and property rights

Should the government intervene in the private marketplace to somehow correct such externalities? And if so, what form should such intervention take? To answer these questions, the Coase Theorem helps to illustrate that, at least in some situations, government intervention into the marketplace may not be necessary, because externalities can be solved through individual bargaining. The Coase Theorem was conceived by University of Chicago professor and Nobel laureate, Ronald Coase. Coase argued that negative or positive externalities do not require government intervention where (1) property ownership is clearly defined, (2) the number of people involved is small, and (3) bargaining costs are negligible.

Here is an example of how the Coase theorem might work. Suppose there is a small town with 100 people and there is a tannery in that town that, in addition to producing leather, also stinks to high heaven. Suppose further that the owner makes a lot of money from that tannery but the inhabitants suffer a lot from the stench. In thinking about how they might resolve this problem, assume that the property rights to the air are assigned to the tannery owner, meaning that, under current law, the tannery owner has the right to pollute as much of the air he wants.

The Coase theorem predicts that the village people might offer to pay tannery owner to reduce my output, or alternatively, simply buy the tannery and shut it down. How much they will pay depends on how much profits the plant generates, how much the village people value eliminating the discomfort caused by the plant, and how well each side negotiates. If the value the village people assign to eliminating your discomfort is more than the profits from the plant, they may well come to some bargain.

The property rights can also be the other way around. If the village people own the rights to the air, and the only way the tannery owner can produce leather is to purchase from the village people the right to pollute, the Coase theorem predicts that the tannery owner will have to pay the village people at least as much as the value this group puts on having clean air. If the profits are high enough to afford that, the tannery owner will presumably do so. If not, he will simply have to close the plant.

Now one thing that is interesting about this example is that, who has to pay who, to reduce or eliminate the externality. This is completely determined by the initial assigning of the property rights. If the plant owner has the rights, the village people pays him and vice versa. It may seem that the people in the village should own the rights to clean air as a matter of fairness. Suppose now that the factory was there first and that the village people only recently moved into the area. Would this make a difference?

Now the other interesting question about this example is how might the Coase theorem break down. In the case where the village people have to pay the plant owner not to pollute, there has to be some mechanism to collect the money from the village people. In reality, this might be rather difficult. Some people may be bothered more than others by the stench and some may not be bothered at all. Should everyone pay the same amount? Should only those who are bothered pay? There is also the free rider problem that plagues the provision of public goods. Is it possible to tell if people are telling the truth about how much the stench bothers them, particularly if their payment will depend on their answer?

From these questions, it is possible to see that as the number of people involved in the negotiations increases, the Coase theorem tends to break down. The is the case for the acid rain problem in the United States and Canada, which affects millions of people, spread out over two nations. The vast number of affected parties could not possibly independently negotiate an agreement or remedy this problem. Instead, they must rely on both governments to find acceptable solutions. While the Coase theorem makes clear that clearly defined property rights can be a positive factor in remedying externalities, many negative externalities involve large numbers of affected people, high bargaining cost and community property, such as air and water.


11.6.3. Tort system

A second approach to internalising externalities that likewise has some limited applicability, relies upon a legal framework of liability laws. This framework is known in legal circles as the wrongful act or tort system. And the idea behind torts is that the person or corporation that produces the negative externality is legally liable for any caused to other persons. For example, suppose the Ajax Degreaser Company regularly dumps leaky barrels of solvents into a nearby canyon owned by the Bar B Q Ranch. But the Bar B Q Ranch discovers this dump site and traces the leaky barrels to Ajax. Under the torte system, Ajax will get sued, and if Ajax loses, it will not only have to pay the Bar B Q Ranch for the cleanup It may well have to pay additional damages for despoiling ranch property.

As with the Coase theorem, the tort system has its limitations. For one thing, lawsuits are expensive, time-consuming, and have uncertain outcomes, while major time delays in the court system are commonplace. In addition, there is great uncertainty. Will the court or a jury accept a claim that your child's leukaemia has resulted from the toxic waste emitted by the degreaser plant next door? Is it possible to prove that a specific firm in the area is the source of the contamination of a well? Are people willing to risk all their money to sue a deep-pocketed corporation with hundreds of millions of dollars in assets and a team of 50 lawyers?

These obstacles not withstanding there is an even larger problem with the tort system. Many negative externalities do not involve private property, but rather property held in common. Indeed, it is the public bodies of water, public lands, and the public air that often bear the brunt of negative externalities. This observations leads us to our third approach to internalising externalities, direct government intervention.



11.7. Direct government intervention; Pigouvian taxes and subsidies; Internalising externalities


 
Correcting negative externalities
 

11.7.1. Direct government intervention

Direct government intervention into the free market involves placing limits on the amount of pollution a polluter may emit. In fact, this command and control approach has dominated environmental public policy in the United States for decades. For example, the Clean Air Act limits the amounts of sulphur dioxide, nitrogen oxide, particulates, and other substances that power plants and factories may emit into the air. Similarly, the Clean Water Act specifies the amount of heavy metals, detergents, and other pollutants that firms can dump into rivers and bays. Violation of these laws means fines and, on occasion, imprisonment.

It is possible to consider the impact such direct controls can have on our previous figure illustrating the negative exernality. Recall that in a free market, equilibrium occurs where supply and demand cross at P1 and Q1. However, the efficient outcome is at P2 and Q2. Direct controls can force new firms to incur costs associated with pollution control. By doing so, the regulations drive up the private marginal costs of the firm, and thereby shift the private supply curve backwards towards the social marginal cost curve. Thus, at least in theory, if the direct controls are administered properly, the firm can be forced to operate at the desired efficient equilibrium.

 
Internalising negative externalities
 

11.7.2. Pigouvian taxes and subsidies

There is a second way that this same result can be achieved. It is a method that many economists prefer, both because it is less intrusive into the marketplace, and because it relies more upon market and pricing signals. This method involves the use of Pigouvian taxes and subsidies to tax negative externalities and subsidise positive externalities. The French economist A.C. Pigou originally thought up the idea. For example, negative externalities can be corrected using a specific Peguvian tax T per unit. This Paguvian tax raises the firms' private marginal costs up to the point where the firm perceives its private marginal cost curve to be the same as the social marginal cost curve. By doing so, the tax is said to internalise the externality.

 
Internalising positive externalities
 

11.7.3. Internalising externalities

Pigouvian-like taxes are regularly used to internalise externalities. For example, the Federal government has placed an excise tax on the manufacturers of chlorofluorocarbons or CFC's which deplete the stratospheric ozone layer. Protecting the earth from excessive solar ultraviolet radiation. This substance is used widely as a coolant in refrigeration, a blowing agent for foam and a solvent for electronics. Facing such a tax, manufacturers must decide whether to pay it or expend additional funds to purchase or develop substitute products. In either case, the tax will increase the marginal cost of producing CFCs, thereby shifting the private supply curve for this product leftward and presumably closer towards the optimal level.

 
Solutions for externalities
 
Pigouvian subsidies can likewise be used to internalise positive externalities. These figures illustrate the two basic approaches. One involving a subsidy to producers and the other involving a subsidy to consumers. In the left-hand figure, we start with a simple illustration of positive spillover effects associated with the provision of vaccinations. Note the under allocation of resources at the free market outcome P1 and Q1.

For example, the government might give each new mother a discount coupon with a value of V to spend on a polio vaccination for her child. This programme would increase the demand for vaccinations from D to Dt, and vaccinations would rise from Q1 to Q2. It is also possible to offer a producer subsidy. In this case, the government might provide a subsidy of U to physicians and medical clinics. This subsidy would reduce the producer's marginal cost and thereby shift the supply curve rightward from St to S't. As a result output would increase to the optimal level Q2. In fact, the US government largely eradicated the crippling disease of polio by administering free vaccines to all children.




References