I blog this, I can help you out if you need.
Just come down to vanier commonsblock thursday or friday afternoon, or if that doesn't work for you, just send me an email- jsussman@telus.net
Thursday, December 10, 2009
Free ECON 101 Tutoring
I blog this, I can help you out if you need.
Just come down to vanier commonsblock thursday or friday afternoon, or if that doesn't work for you, just send me an email- jsussman@telus.net
Wednesday, December 2, 2009
Government Intervention: When Markets Fail
WHAT IS THE BASIC FUNCTION OF THE GOVERNMENT?
-The government has a monopoly on violence, in order to keep society from dissolving into violent anarchy (in countries where the government does not have a monopoly on violence, anarchy and civil unrest make like very difficult- just think of Somalia, or Afghanistan)
-Because the government has this monopoly on violence, they can enforce property rights laws, and prevent people for stealing other people's property
-The government's main job from an economist's perspective, then, is to enforce property rights
-By enforcing property rights and maintaining stability, governments allow for economic activity and prosperity.
OKAY!
So, for most of this course, we have been focusing on how the market works. In most of the cases we have explored, an economy regulated by the invisible hand of the market leads to the best possible outcome for society. This chapter will examine certain situations where markets fail to provide the best possible outcome for society, and how the government can intervene to correct this. We're also going to look at some inherent problems with government intervention.
Basically, when looking at any economic situation, we should ask ourselves:
-"Is the market working or failing"
-"If the market is failing, what is the optimal level of government
Markets are working best when they are allocatively efficient. Competitive markets are allocatively efficient:
-Competitive Markets use marginal cost pricing, so the price is set at the marginal cost of producing the last unit
-Competitive Markets minimize price and maximize the quantity produced
-Competitive Markets maximize economic surplus
If all markets were perfectly competitive, then the economy would be allocatively efficient. This is a pareto optimum, and neither producers not consumers would be able to add to their own surplus without causing the other to lose surplus.
PROBLEM: Most markets aren't perfectly competitive!
Here is an informal defense of natural market forces- why governments should usually just let the economy run itself.
-Free markets are automatic, flexible, and decentralized
-The price system acts like an invisible hand, regulating the market: demand affects price, which in turn, affects supply.
-There is no need for inefficient, centralized planning
-The pursuit of profits stimulates innovation and economic growth
-Power is naturally challenged through competition and innovation, so it is ultimately difficult for monopolies to exist indefinitely.
-Milton Friedman argued that economic freedom is essential to political freedom (which makes sense: if you don't have enough money to afford a house or fixed address, then you can't vote).
--------------------------------
INSTANCES OF MARKET FAILURES: Sometimes we do need the government to intervene. Sometimes, intervention is a waste of public funds. Many of the services which the government provides are, according to our prof, unnecessary and wasteful.
---------------------------------
MONOPOLIES:
-Monopolies and monopolistic competition have downward-sloping demand, so they are allocatively inefficient.
-This is due to barriers to entry
-The government usually does not obliquely try to eliminate monopolies. Instead, they either punish monopolies with regulation, or they try to create a level playing field with competition policy
-Governments can intervene in monopolies to make things more allocatively efficient
EXTERNALITIES: Non-priced costs or benefits which affect third parties
-This refers to the results of economic functioning which effect people other than the buyer and the seller (for an example, if you buy a coat of paint for your house, and then paint the ugly front of your house to make it look nicer, this creates an external benefit for your neighbor, whose property values probably will increase as a result).
-EXTERNAL ECONOMIES are external benefits, such as the added benefit your neighbor receives when you paint your house
-EXTERNAL DISECONOMIES are external costs, such as pollution or second-hand smoke.
-PRIVATE COSTS are the costs to the buyer or seller (this includes opportunity cost)
-SOCIAL COSTS are the combined external costs and private costs of any economic decision. This is the opportunity cost to society.
Externalities create unrecorded discrepancies between private costs and social costs, and result in allocative inefficiencies on a societal level
Negative externalities can be treated like an extra cost, and thus shift supply to the left!
This means that when there are negative externalities which are not taken into account, usually an economy is overproducing at too low a price. By raising prices and scaling back production, these economies can become allocatively efficient
Positive externalities can be treated like an addition to demand, and this they shift demand to the right!
This means that when there are positive externalities which are not taken into account, usually an economy is underproducing at too low a price. By increasing production and raising prices, these economies can become allocatively efficient.
Governments can correct externalities by forcing corporations to pay for negative externalities as an added cost.
APPLICATIONS OF EXTERNALITIES:
Here are some negative externalities which are fairly well known
-Nuisance externalities (pollution is considered a nuisance in legal terms)
-Open access resources (eg: fish in the Fraser river. There is a negative externality, in that catching the fish depletes fish stocks and reduces the availability of fish in the future).
-Congestion of highways (The fact that cars take up space on the highway is not taken into account, so even though it doesn't cost to use the highway, a negative externality is created from the frustration and irritation of having to deal with too many extra drivers)
-A famous example is the tragedy of the commons. In olden days when peasants still had commons land where they could let their animals graze, many peasants failed to take into account the cost of maintaining the grass and animal food supply of the commons. As a result, they overused the commons, and eventually all of the natural animal food become depleted, so the livestock died of starvation. This is an example of overproduction (overuse of the commons) due to a failure to factor external diseconomies into social costs.
PUBLIC GOODS: Sometimes, governments must intervene in order to provide society with a specific kind of good which markets cannot provide. Here are the characteristic of a pure public good:
1: It must be non rivalrous- in other words, consuming this good will not reduce the ability of others to consume this good (a good example of this is information-- gathering information from a sources does not hinder anyone else from gathering that information (unless you are stealing library books or something stupid like that)
2: Non excludability- If this good is produced, it must be a product which can be consumed equally by all- there are no restrictions in who is allowed and not allowed to use the good (so within the context of Gateman's class, the lecture itself is non-excludable. Everyone in the class is equally able to listen to the lecture and learn about economics from it). Example here include a lighthouse, or national defence.
Normal Goods: Rivalrous and Excludable-- This includes most goods which are sold on a market, such as chocolate bars, legal advice, plane tickets, etc. Governments can let markets take care of the distribution of normal goods. The market works here!
Common Property Goods: Rivalrous and Non Excludable-- This includes goods which anybody can access, despite their being a limited supply of the good. Examples include camping sites, or fish stocks. Often, common property goods suffer from the tragedy of the commons, and are overused because negative externalities are not factored into private costs. The market fails due to external diseconomies here!
Psuedo Public Goods: Non-Rivalrous and Excludable-- This includes goods which do not deppreciate when consumed, but which are distributed in such a way that some people are excluded from using them. Examples include art galleries, day care, roads, public parks, education, and others. The fact that these are non-rivalrous implies that supply is always greater than demand, so this excess supply will often push the price of a quasi public good down to zero. Often, the government provides these as merit goods. The market fails due to $0 price demanded, here!
Pure Public Goods: Non-Rivalrous and Non Excludable-- These are goods which do not deppreciate with use, and which are accessible to everyone. This includes things like national defence, a ligthouse signal, public information, and public protection. The free rider problem means than consumers usually will not reveal their price preferences, because they would rather someone else pay for the pure public good (everyone wants a free ride). As such, the government must use taxation to force everybody to pay for this good, or else, the good will not be produced. As such, we need the government to intervene. The market fails due to the free rider effect here!
So we need the government to intervene!
ASYMMETRY OF INFORMATION: This is where the buyer and the seller have different levels of knowledge about a particular good
a MORAL HAZARD, is an example of assymetry of information where one party has the ability and incentive to shift costs onto the other party due to some special knowledge which they posess (for example, a car mechanic could trick you into getting expensive work done on your car which you don't need). Another example is a used car salesman inflating the price of a used car.
ADVERSE SELECTION is an example of assymetry of information where "self selection" adverse affects the group. Because people who are poor drivers are more likely to purchase insurance, and isurance companies often have no way of evaluating each customer's driving abilities, poor drivers increase the overall cost of insurance at the expense of good drivers. Similarly, people who are unhealthy pay the same medical premiums as everyone else, yet cost the medical system much more money. Here, there are negative externalities created by adverse selection. The private cost to a smoker for using the hospital is less than the social cost of that hospital visit.
THE PRINCIPLE AGENT PROBLEM: Where top employees for a company seek to maximize revenues (and their own salaries) at the expense of net profits. Here, marginal social benefits and marginal social costs are not equated, so the firm is inefficient.
THUS WE HAVE A CASE FOR GOVERNMENT INTERVENTION
OTHER SOCIAL GOALS: Sometimes, governments seek to intervene for reasons other than market failures! Here are some of them
-Income redistribution (many people think this a fairer way of allocating wealth. Professor Gateman thinks its just a throwback to communism)
-Merit Goods: The government provides goods which are not pure public goods based on their Merit to society (eg: Healthcare and education). They cold technically also be provided by private groups.
-Social obligations (eg: jury duty, conscription, voting, etc.)
-Economic Growth (research and developement)
That's all for now!
-The government has a monopoly on violence, in order to keep society from dissolving into violent anarchy (in countries where the government does not have a monopoly on violence, anarchy and civil unrest make like very difficult- just think of Somalia, or Afghanistan)
-Because the government has this monopoly on violence, they can enforce property rights laws, and prevent people for stealing other people's property
-The government's main job from an economist's perspective, then, is to enforce property rights
-By enforcing property rights and maintaining stability, governments allow for economic activity and prosperity.
OKAY!
So, for most of this course, we have been focusing on how the market works. In most of the cases we have explored, an economy regulated by the invisible hand of the market leads to the best possible outcome for society. This chapter will examine certain situations where markets fail to provide the best possible outcome for society, and how the government can intervene to correct this. We're also going to look at some inherent problems with government intervention.
Basically, when looking at any economic situation, we should ask ourselves:
-"Is the market working or failing"
-"If the market is failing, what is the optimal level of government
Markets are working best when they are allocatively efficient. Competitive markets are allocatively efficient:
-Competitive Markets use marginal cost pricing, so the price is set at the marginal cost of producing the last unit
-Competitive Markets minimize price and maximize the quantity produced
-Competitive Markets maximize economic surplus
If all markets were perfectly competitive, then the economy would be allocatively efficient. This is a pareto optimum, and neither producers not consumers would be able to add to their own surplus without causing the other to lose surplus.
PROBLEM: Most markets aren't perfectly competitive!
Here is an informal defense of natural market forces- why governments should usually just let the economy run itself.
-Free markets are automatic, flexible, and decentralized
-The price system acts like an invisible hand, regulating the market: demand affects price, which in turn, affects supply.
-There is no need for inefficient, centralized planning
-The pursuit of profits stimulates innovation and economic growth
-Power is naturally challenged through competition and innovation, so it is ultimately difficult for monopolies to exist indefinitely.
-Milton Friedman argued that economic freedom is essential to political freedom (which makes sense: if you don't have enough money to afford a house or fixed address, then you can't vote).
--------------------------------
INSTANCES OF MARKET FAILURES: Sometimes we do need the government to intervene. Sometimes, intervention is a waste of public funds. Many of the services which the government provides are, according to our prof, unnecessary and wasteful.
---------------------------------
MONOPOLIES:
-Monopolies and monopolistic competition have downward-sloping demand, so they are allocatively inefficient.
-This is due to barriers to entry
-The government usually does not obliquely try to eliminate monopolies. Instead, they either punish monopolies with regulation, or they try to create a level playing field with competition policy
-Governments can intervene in monopolies to make things more allocatively efficient
EXTERNALITIES: Non-priced costs or benefits which affect third parties
-This refers to the results of economic functioning which effect people other than the buyer and the seller (for an example, if you buy a coat of paint for your house, and then paint the ugly front of your house to make it look nicer, this creates an external benefit for your neighbor, whose property values probably will increase as a result).
-EXTERNAL ECONOMIES are external benefits, such as the added benefit your neighbor receives when you paint your house
-EXTERNAL DISECONOMIES are external costs, such as pollution or second-hand smoke.
-PRIVATE COSTS are the costs to the buyer or seller (this includes opportunity cost)
-SOCIAL COSTS are the combined external costs and private costs of any economic decision. This is the opportunity cost to society.
Externalities create unrecorded discrepancies between private costs and social costs, and result in allocative inefficiencies on a societal level
Negative externalities can be treated like an extra cost, and thus shift supply to the left!
This means that when there are negative externalities which are not taken into account, usually an economy is overproducing at too low a price. By raising prices and scaling back production, these economies can become allocatively efficient
Positive externalities can be treated like an addition to demand, and this they shift demand to the right!
This means that when there are positive externalities which are not taken into account, usually an economy is underproducing at too low a price. By increasing production and raising prices, these economies can become allocatively efficient.
Governments can correct externalities by forcing corporations to pay for negative externalities as an added cost.
APPLICATIONS OF EXTERNALITIES:
Here are some negative externalities which are fairly well known
-Nuisance externalities (pollution is considered a nuisance in legal terms)
-Open access resources (eg: fish in the Fraser river. There is a negative externality, in that catching the fish depletes fish stocks and reduces the availability of fish in the future).
-Congestion of highways (The fact that cars take up space on the highway is not taken into account, so even though it doesn't cost to use the highway, a negative externality is created from the frustration and irritation of having to deal with too many extra drivers)
-A famous example is the tragedy of the commons. In olden days when peasants still had commons land where they could let their animals graze, many peasants failed to take into account the cost of maintaining the grass and animal food supply of the commons. As a result, they overused the commons, and eventually all of the natural animal food become depleted, so the livestock died of starvation. This is an example of overproduction (overuse of the commons) due to a failure to factor external diseconomies into social costs.
PUBLIC GOODS: Sometimes, governments must intervene in order to provide society with a specific kind of good which markets cannot provide. Here are the characteristic of a pure public good:
1: It must be non rivalrous- in other words, consuming this good will not reduce the ability of others to consume this good (a good example of this is information-- gathering information from a sources does not hinder anyone else from gathering that information (unless you are stealing library books or something stupid like that)
2: Non excludability- If this good is produced, it must be a product which can be consumed equally by all- there are no restrictions in who is allowed and not allowed to use the good (so within the context of Gateman's class, the lecture itself is non-excludable. Everyone in the class is equally able to listen to the lecture and learn about economics from it). Example here include a lighthouse, or national defence.
Normal Goods: Rivalrous and Excludable-- This includes most goods which are sold on a market, such as chocolate bars, legal advice, plane tickets, etc. Governments can let markets take care of the distribution of normal goods. The market works here!
Common Property Goods: Rivalrous and Non Excludable-- This includes goods which anybody can access, despite their being a limited supply of the good. Examples include camping sites, or fish stocks. Often, common property goods suffer from the tragedy of the commons, and are overused because negative externalities are not factored into private costs. The market fails due to external diseconomies here!
Psuedo Public Goods: Non-Rivalrous and Excludable-- This includes goods which do not deppreciate when consumed, but which are distributed in such a way that some people are excluded from using them. Examples include art galleries, day care, roads, public parks, education, and others. The fact that these are non-rivalrous implies that supply is always greater than demand, so this excess supply will often push the price of a quasi public good down to zero. Often, the government provides these as merit goods. The market fails due to $0 price demanded, here!
Pure Public Goods: Non-Rivalrous and Non Excludable-- These are goods which do not deppreciate with use, and which are accessible to everyone. This includes things like national defence, a ligthouse signal, public information, and public protection. The free rider problem means than consumers usually will not reveal their price preferences, because they would rather someone else pay for the pure public good (everyone wants a free ride). As such, the government must use taxation to force everybody to pay for this good, or else, the good will not be produced. As such, we need the government to intervene. The market fails due to the free rider effect here!
So we need the government to intervene!
ASYMMETRY OF INFORMATION: This is where the buyer and the seller have different levels of knowledge about a particular good
a MORAL HAZARD, is an example of assymetry of information where one party has the ability and incentive to shift costs onto the other party due to some special knowledge which they posess (for example, a car mechanic could trick you into getting expensive work done on your car which you don't need). Another example is a used car salesman inflating the price of a used car.
ADVERSE SELECTION is an example of assymetry of information where "self selection" adverse affects the group. Because people who are poor drivers are more likely to purchase insurance, and isurance companies often have no way of evaluating each customer's driving abilities, poor drivers increase the overall cost of insurance at the expense of good drivers. Similarly, people who are unhealthy pay the same medical premiums as everyone else, yet cost the medical system much more money. Here, there are negative externalities created by adverse selection. The private cost to a smoker for using the hospital is less than the social cost of that hospital visit.
THE PRINCIPLE AGENT PROBLEM: Where top employees for a company seek to maximize revenues (and their own salaries) at the expense of net profits. Here, marginal social benefits and marginal social costs are not equated, so the firm is inefficient.
THUS WE HAVE A CASE FOR GOVERNMENT INTERVENTION
OTHER SOCIAL GOALS: Sometimes, governments seek to intervene for reasons other than market failures! Here are some of them
-Income redistribution (many people think this a fairer way of allocating wealth. Professor Gateman thinks its just a throwback to communism)
-Merit Goods: The government provides goods which are not pure public goods based on their Merit to society (eg: Healthcare and education). They cold technically also be provided by private groups.
-Social obligations (eg: jury duty, conscription, voting, etc.)
-Economic Growth (research and developement)
That's all for now!
Wednesday, November 25, 2009
Productive and Allocative Efficiency for different market structure
We know that there are 4 different market structures in economics.
Now we're going to explore the idea of efficiency
PRODUCTIVE EFFICIENCY:
-This is when firms minimize the cost of inputs required to produce a given number of outputs
-This is also when firms maximize the quantity of outputs given a set combination of inputs (or set amount of money to spend on inputs)
-This is maximizing the input/output ratio (the greatest bang for your buck)
-Either hold output constant and minimize inputs (in other words, get on the LRAC curve, because the LRAC shows the combination of inputs which will cost the least in order to produce any quantity of output): This is the condition needed to reach productive efficiency for individual firms
OR
-Hold inputs constant and maximize outputs (get on the Production Possibilities Boundary)
In order for the industry to reach productive efficiency, each individual firm must have the same marginal costs because if one firm has lower marginal costs, then it is more efficient for that industry to switch to favor the lower cost producer.
CONCLUSION: In order to reach the production possibilities boundary for any one industry, both individual firms and entire industries must be productively efficient
ALLOCATIVE EFFICIENCY:
-The Allocative Concept is build around the idea of Pareto Optimality: a scenario where we cannot make someone better off without making someone else worse off. The allocative concept states that it is good to reach Pareto Optimality, because there, the mix of commodities which are produced match the mix of commodities which are desired by consumers. Allocative efficiency refers to a quality of an entire industry- not just an individual firm. While there can be many productively efficient points on a production possibilities boundary, only ONE of these is allocatively efficient.
-Allocative efficiency is one definition for "the best society can do"
CONDITIONS FOR ALLOCATIVE EFFICIENCY:
-We know that consumers will buy any one product up until the marginal benefit equals the marginal cost of that product
-The marginal benefit is the marginal value of any unit of a product minus the price
-THEREFORE, consumers buy units of a product until the price is equal to the marginal cost
-Perfect competition uses MARGINAL COST PRICING
-If the marginal benefit to the consumer outweighs the marginal cost to the producer, too little is being produced from society's viewpoint
-If the marginal benefit to the consumer is smaller than the marginal cost to the producer, then too much is being produced from society's viewpoint
ALL INDUSTRIES MUST EQUATE PRICE TO MARGINAL COSTS in order to that industry to be allocatively efficient
ECONOMIC SURPLUS MAXIMIZATION:
-Economic surplus maximization is allocatively efficient because it maximizes total surplus for all members of society
-This occurs when the price is equal to the point where demand equals supply (as it will in perfect competition). Here, total economic surplus is maximized and there is no dead weight social loss
-With free markets (where demand and supply naturally reach an equilibrium), it is impossible to make either the producers or the consumers better off without hurting the other: THIS IS PARETO OPTIMUM! This is the best scenario for society!
To test for allocative efficiency, we must ensure that:
-Price is equal to marginal cost
-Total economic surplus is maximized- there is no dead weight social loss!
--------------------------
PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH A PPC Curve
ANY POINT ON THE PPC IS PRODUCTIVELY EFFICIENT, because by definition, the PPC is the maximum level of output where all inputs are fully employed and productively efficient
ONLY ONE POINT ON THE PPC IS ALLOCATIVELY EFFICIENT, because only one combination of outputs will exactly match consumer's demands. On any other point, a tradeoff could be made in order to better one group of consumers without making anyone worse off. At the one point of allocative efficiency, no one can be made better off.
It is possible to produce too much or too little of either product.
REMEMBER: If the price is lower than the marginal cost, the producer is getting ripped off. Meanwhile, if the price is higher than the marginal cost, then the consumer is getting ripped off.
-----------------
EFFICIENCY IN PERFECT COMPETITION AND MONOPOLIES
PERFECT COMPETITION
CONDITION ONE: Is each firm producing on the LRAC in the long run? YES, because in the long run, all firms in perfect competition will produce at minimum efficiency scale.
CONDITION TWO: Is the marginal cost equal for all firms? Yes, because all firms in perfect competition face the same prices, and at the MES output level, marginal cost will = the price for all firms!
As a result, no reallocation among firms can lower industry costs: Firms in perfect competition are productive efficient!
In perfect competition, firms maximize their profits by producing where the price is equal to the marginal cost (marginal cost pricing). This will guarantee Pareto Optimality if all firms are in perfect competition: Why? Because here, there is no deadweight social loss, so both consumer and producer surpluses are maximized
Any output greater than or less than QE will reduce the total sum of producer and consumer surplus
IN SUMMARY: For perfect competition,
-Firms will produce at the minimum efficiency scale, so individual firms are productively efficient
-Marginal costs are equal for all firms, so the industry is productively efficient
-Price is equal to the average cost minimum, so in the long run, firms only make normal profits
-Price = marginal cost, so this market structure is allocatively efficient
MONOPOLIES AND EFFICIENCY
Monopolies are productively efficient!
-In the long run, the monopolist will be on the long run average cost curve (although not necessarily at MES). Why? Because monopolies want to maximize their profits by minimizing costs.
-This is productively efficient
-NOTE: The long run average cost for monopolies may be abnormally high (due to high fixed costs and excess capacity)
Monopolies are not allocatively efficient in the long run!
-To maximize profits, monopolies produce where marginal revenue equals marginal costs
-BUT, marginal revenue falls much more quickly than average revenue (price) as output increases, and thus, price will be greater than the monopolist's marginal costs at the monopoly's selected output level
-Because MC < P, the consumer is getting ripped off in a monopoly, and as such, monopolies are allocatively ineffienct
P > MC
Price is higher and quantity produced is lower than it would be if that same industry was in perfect competition
There is a deadweight social loss
WHEN INDUSTRIES CARTELIZE, THERE IS A DEADWEIGHT SOCIAL LOSS
See?
Now we're going to explore the idea of efficiency
PRODUCTIVE EFFICIENCY:
-This is when firms minimize the cost of inputs required to produce a given number of outputs
-This is also when firms maximize the quantity of outputs given a set combination of inputs (or set amount of money to spend on inputs)
-This is maximizing the input/output ratio (the greatest bang for your buck)
-Either hold output constant and minimize inputs (in other words, get on the LRAC curve, because the LRAC shows the combination of inputs which will cost the least in order to produce any quantity of output): This is the condition needed to reach productive efficiency for individual firms
OR
-Hold inputs constant and maximize outputs (get on the Production Possibilities Boundary)
In order for the industry to reach productive efficiency, each individual firm must have the same marginal costs because if one firm has lower marginal costs, then it is more efficient for that industry to switch to favor the lower cost producer.
CONCLUSION: In order to reach the production possibilities boundary for any one industry, both individual firms and entire industries must be productively efficient
ALLOCATIVE EFFICIENCY:
-The Allocative Concept is build around the idea of Pareto Optimality: a scenario where we cannot make someone better off without making someone else worse off. The allocative concept states that it is good to reach Pareto Optimality, because there, the mix of commodities which are produced match the mix of commodities which are desired by consumers. Allocative efficiency refers to a quality of an entire industry- not just an individual firm. While there can be many productively efficient points on a production possibilities boundary, only ONE of these is allocatively efficient.
-Allocative efficiency is one definition for "the best society can do"
CONDITIONS FOR ALLOCATIVE EFFICIENCY:
-We know that consumers will buy any one product up until the marginal benefit equals the marginal cost of that product
-The marginal benefit is the marginal value of any unit of a product minus the price
-THEREFORE, consumers buy units of a product until the price is equal to the marginal cost
-Perfect competition uses MARGINAL COST PRICING
-If the marginal benefit to the consumer outweighs the marginal cost to the producer, too little is being produced from society's viewpoint
-If the marginal benefit to the consumer is smaller than the marginal cost to the producer, then too much is being produced from society's viewpoint
ALL INDUSTRIES MUST EQUATE PRICE TO MARGINAL COSTS in order to that industry to be allocatively efficient
ECONOMIC SURPLUS MAXIMIZATION:
-Economic surplus maximization is allocatively efficient because it maximizes total surplus for all members of society
-This occurs when the price is equal to the point where demand equals supply (as it will in perfect competition). Here, total economic surplus is maximized and there is no dead weight social loss
-With free markets (where demand and supply naturally reach an equilibrium), it is impossible to make either the producers or the consumers better off without hurting the other: THIS IS PARETO OPTIMUM! This is the best scenario for society!
To test for allocative efficiency, we must ensure that:
-Price is equal to marginal cost
-Total economic surplus is maximized- there is no dead weight social loss!
--------------------------
PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH A PPC Curve
ANY POINT ON THE PPC IS PRODUCTIVELY EFFICIENT, because by definition, the PPC is the maximum level of output where all inputs are fully employed and productively efficient
ONLY ONE POINT ON THE PPC IS ALLOCATIVELY EFFICIENT, because only one combination of outputs will exactly match consumer's demands. On any other point, a tradeoff could be made in order to better one group of consumers without making anyone worse off. At the one point of allocative efficiency, no one can be made better off.
It is possible to produce too much or too little of either product.
REMEMBER: If the price is lower than the marginal cost, the producer is getting ripped off. Meanwhile, if the price is higher than the marginal cost, then the consumer is getting ripped off.
-----------------
EFFICIENCY IN PERFECT COMPETITION AND MONOPOLIES
PERFECT COMPETITION
CONDITION ONE: Is each firm producing on the LRAC in the long run? YES, because in the long run, all firms in perfect competition will produce at minimum efficiency scale.
CONDITION TWO: Is the marginal cost equal for all firms? Yes, because all firms in perfect competition face the same prices, and at the MES output level, marginal cost will = the price for all firms!
As a result, no reallocation among firms can lower industry costs: Firms in perfect competition are productive efficient!
In perfect competition, firms maximize their profits by producing where the price is equal to the marginal cost (marginal cost pricing). This will guarantee Pareto Optimality if all firms are in perfect competition: Why? Because here, there is no deadweight social loss, so both consumer and producer surpluses are maximized
Any output greater than or less than QE will reduce the total sum of producer and consumer surplus
IN SUMMARY: For perfect competition,
-Firms will produce at the minimum efficiency scale, so individual firms are productively efficient
-Marginal costs are equal for all firms, so the industry is productively efficient
-Price is equal to the average cost minimum, so in the long run, firms only make normal profits
-Price = marginal cost, so this market structure is allocatively efficient
MONOPOLIES AND EFFICIENCY
Monopolies are productively efficient!
-In the long run, the monopolist will be on the long run average cost curve (although not necessarily at MES). Why? Because monopolies want to maximize their profits by minimizing costs.
-This is productively efficient
-NOTE: The long run average cost for monopolies may be abnormally high (due to high fixed costs and excess capacity)
Monopolies are not allocatively efficient in the long run!
-To maximize profits, monopolies produce where marginal revenue equals marginal costs
-BUT, marginal revenue falls much more quickly than average revenue (price) as output increases, and thus, price will be greater than the monopolist's marginal costs at the monopoly's selected output level
-Because MC < P, the consumer is getting ripped off in a monopoly, and as such, monopolies are allocatively ineffienct
P > MC
Price is higher and quantity produced is lower than it would be if that same industry was in perfect competition
There is a deadweight social loss
WHEN INDUSTRIES CARTELIZE, THERE IS A DEADWEIGHT SOCIAL LOSS
See?
Sunday, November 22, 2009
Game Theory Pt. 2
In Oligopolies, and in game theory, there are also sequential games. Chess is a good example of a sequential game. In sequential games, there is time-sensitive sequencing, OR simultaneous knowledge of the other player's decision by both players. As such, we use decision trees to mark off the outcomes of sequential games.
DIFFERENT PATHS: The first player to move can use BACKWARDS INDUCTION to predict which moves their opponent will make given their move. The first mover here can predict all of the outcomes, and will probably choose the "large" strategy, because they will receive 30 points in every outcome for the large scenario. Given that the first player will always choose the "large" strategy, the second mover will always choose the large strategy as well, because they prefer having 3 points to having 0.3 points. AS SUCH, we know that there is a NASH EQUILIBRIUM, because both players are playing their best strategy given the strategy of the other play. Additionally, this is Pareto, as we cannot make either player better off.
ULTIMATUM BARGAINING GAME: In an ultimatum, the first player imposes a "take it or leave it offer". For an example, lets say that my mom gives my sister a dollar. My mom tells my sister that she must take that dollar and share some of it with me, or else she will take it away. In other words, my sister will offer me a portion of the money she has received, and I can accept it, or decline it. If I reject the offer, then neither me nor my sister will get a dollar. This is the payoff tree:
SISTER will propose $X for herself, and $(1-X) for me. If I accept this offer, I will get $(1-X), and my sister gets $X. If I reject this offer, we both get nothing.
Nash Equilibrium Occurs where I accept my sister's offer (regardless of the offer). This is because I would rather get a little bit of money than no money. Neither me nor my sister has any incentive to use any strategy other than this.
WHAT SHOULD MY SISTER'S STRATEGY BE? She should offer me the smallest amount as possible, because it is to my advantage to accept ANY offer. SO...
If my sister offers me 1 cent, it is still in my best interest to accept it, because 1 cent is better than nothing. In this scenario, my sister will get to keep 99 cents, and I will get 1 cent!
ULTIMATUM BARGAINING WITH AN ACCEPTANCE THRESHOLD: This is a version of ultimatum bargaining, but here, the second mover (me) can declare a minimum acceptance threshold (Y) in advance. This changes the payoff tree.
My sister can either propose an offer greater or equal to my minimum acceptance threshold (100-X > or = Y), or lower than it (100-X < Y). If she offers me an amount equal to or greater than my minimum acceptance threshold, then I will get $1-X, and she will get $X. If she offers me an amount lower than my minimum acceptance threshold, then I will reject the offer, and we will both get nothing.
Here, Nash Equilibrium occurs where my sister accepts my minimum acceptance threshold. This is because she would rather have a little bit of money than no money. Given my minimum acceptance threshold, it is always in my sister's best interests to offer an amount which complies with it.
SO WHAT IS MY BEST STRATEGY? Well, because it is always in my sister's best interest to accept my threshold, I stand to make the most money by setting my threshold as high as possible (99 cents). If I do this, then I will make 99 cents, and my sister will only make one cent.
KIDNAPPER GAMES ARE ALSO IMPORTANT, AS ARE COMPETITIVE MARKETS, but my internet just died and deleted all of the previous crap I typed up, and I am NOT spending another hour and typing it all up again. FORGET IT!
DIFFERENT PATHS: The first player to move can use BACKWARDS INDUCTION to predict which moves their opponent will make given their move. The first mover here can predict all of the outcomes, and will probably choose the "large" strategy, because they will receive 30 points in every outcome for the large scenario. Given that the first player will always choose the "large" strategy, the second mover will always choose the large strategy as well, because they prefer having 3 points to having 0.3 points. AS SUCH, we know that there is a NASH EQUILIBRIUM, because both players are playing their best strategy given the strategy of the other play. Additionally, this is Pareto, as we cannot make either player better off.
ULTIMATUM BARGAINING GAME: In an ultimatum, the first player imposes a "take it or leave it offer". For an example, lets say that my mom gives my sister a dollar. My mom tells my sister that she must take that dollar and share some of it with me, or else she will take it away. In other words, my sister will offer me a portion of the money she has received, and I can accept it, or decline it. If I reject the offer, then neither me nor my sister will get a dollar. This is the payoff tree:
SISTER will propose $X for herself, and $(1-X) for me. If I accept this offer, I will get $(1-X), and my sister gets $X. If I reject this offer, we both get nothing.
Nash Equilibrium Occurs where I accept my sister's offer (regardless of the offer). This is because I would rather get a little bit of money than no money. Neither me nor my sister has any incentive to use any strategy other than this.
WHAT SHOULD MY SISTER'S STRATEGY BE? She should offer me the smallest amount as possible, because it is to my advantage to accept ANY offer. SO...
If my sister offers me 1 cent, it is still in my best interest to accept it, because 1 cent is better than nothing. In this scenario, my sister will get to keep 99 cents, and I will get 1 cent!
ULTIMATUM BARGAINING WITH AN ACCEPTANCE THRESHOLD: This is a version of ultimatum bargaining, but here, the second mover (me) can declare a minimum acceptance threshold (Y) in advance. This changes the payoff tree.
My sister can either propose an offer greater or equal to my minimum acceptance threshold (100-X > or = Y), or lower than it (100-X < Y). If she offers me an amount equal to or greater than my minimum acceptance threshold, then I will get $1-X, and she will get $X. If she offers me an amount lower than my minimum acceptance threshold, then I will reject the offer, and we will both get nothing.
Here, Nash Equilibrium occurs where my sister accepts my minimum acceptance threshold. This is because she would rather have a little bit of money than no money. Given my minimum acceptance threshold, it is always in my sister's best interests to offer an amount which complies with it.
SO WHAT IS MY BEST STRATEGY? Well, because it is always in my sister's best interest to accept my threshold, I stand to make the most money by setting my threshold as high as possible (99 cents). If I do this, then I will make 99 cents, and my sister will only make one cent.
KIDNAPPER GAMES ARE ALSO IMPORTANT, AS ARE COMPETITIVE MARKETS, but my internet just died and deleted all of the previous crap I typed up, and I am NOT spending another hour and typing it all up again. FORGET IT!
Monday, November 16, 2009
Introduction to Imperfect Competition
Monopolies and Perfect Competition are both fairly extreme market structures. In reality, most firms operate in conditions known as imperfect competition. There are two different kinds of imperfect competition: Monopolistic Competition and Oligopoly
THERE IS A SPECTRUM OF DIFFERENT MARKET STRUCTURES:
Monopoly---Duopoly---Oligopoly---Monopolistic Competition---Perfect Competition
Competition increases as we go to the right (with the exception of perfect competition, in which there is no competitive behavior)
Market power increases as we go to the left (remember, market power is the ability of a single firm to control the price of a good).
CANADA: A large country with a small population (but it's getting bigger).
-The large geographic area of Canada creates higher transportation costs and natural barriers to entry (for an example, atlantic fishers cannot enter the pacific fishing market, because the costs of transporting their goods to BC for sale are too high).
-Our small population causes excess capacity (in other words, most Canadian firms which only operate domestically do not get to reap the benefits of a minimum efficiency scale because demand in Canada is not high enough to warrant such a large scale of output. This is why Canada is a big proponent of free trade- Because Canadian industries must sell their goods on the international market in order to maximize profits- domestic demand is not high enough).
MONOPOLISTIC COMPETITION: A large number of small firms. (Ie: the canadian wine market, grocery stores, night clubs, restaurants)
OLIGOPOLY: A small number of large firms (Ie: banks, insurance industries, power companies)
THE INDUSTRIAL CONCENTRATION RATIO: This lets us know what fraction of total market sales (or shipments or orders or anything really) are controlled by a given number of an industries largest firms. For an example, CR4 could be the fraction of total market sales controlled by the top 4 firms of any industry.
The industrial concentration ratio is ONE indicator of market power and competition in any industry, and can help us decide whether a market is an Oligopoly, or Monopolistic Competition. AS A GENERAL RULE, HIGHER LEVELS OF MARKET CONCENTRATION IMPLY HIGHER LEVELS OF MARKET POWER. There are, however, some issues which arise when only using industrial concentration ratios as a barometer for a market.
1: It is difficult to define a relative market for any good- are we talking about domestic markets? International markets? Is a coke part of the pop market, or is it a part of the 'junk food' market, or is it part of the much larger food and beverage market?
2: Tying the degree of competitiveness in any market to the number of firms within that market can be deceptive. For an example, a market in which the CR4 = 100%, and the top four firms each control 25% of the market could still involve fierce competition between these 4 markets. In contrast, a different market's CR4 could be only 33%, but if one of those 4 largest firms controls 30% of the market, and the rest only control 1% if the market, the firm which controls 30% of the industry will be the market leader, and will effectively set the price of goods within that market, with the other firms acting as price takers. This market has a lower industrial concentration ratio, but involves much less competition.
3: The standard concentration ratio in Canada overstates the degree of industrial concentration in Canada due to the openness of the Canadian economy (because we lack trade barriers).
IMPERFECT COMPETITION: Rivalrous behavior with some market power to set a price within a range (a combination of perfect competition and monopoly). Basically, any intermediate market structure
There are 2 types of imperfect competition:
-Monopolistic Competition (involves non-strategic behavior)
-Oligopoly (involves strategic behavior)
In Imperfect Competition There Are:
-Many Sellers
-Selling a differentiated product
-Entry and exit are possible, but not easy
-Each firm acts as a price setter within a range
MARKET CHARACTERISTICS FOR IMPERFECT COMPETITION:
1: Firms select their products (each firm decides what sort of a product they are going to produce. Often this involves product differentiation, in which the producers must somehow distinguish their product from competitor products in the eyes of the consumer. This involves associating certain products with happiness, beauty or sex appeal through clever advertising. This also ensures that different products from different producers are not PERFECT substitutes for each other. For this reason, crest toothpaste is considered a different good than oral-b toothpaste).
2: Firms select their prices (The individual firms decide what price to sell their goods at... within a reasonable range with reference to supply and demand. For instance, a sock firm knows better than to try and charge consumers $400 for a pair of socks. Firms then, act as price setters and let demand determine sales. If demand changes, firms can gage this through increased or declining sales for their goods.
3: Prices are sticky in the short run (In perfect competition, prices change in response to supply and demand. In imperfect competition, however, it is much easier for firms to directly alter their output in response to changes in demand than it is to change the price of a product (ie: for vending machines, this would take considerable effort). Price DO change in the long run, but in the short run, they tend to remain the same, regardless of demand (ie: a dairy queen blizzard costs the same in winter as it does in summer).
4: Non-price competition versus price competition.
Traditionally, people believe that firms can compete in ways other than lowering the price of a good. For instance, they can
-Create funny advertisements which entice consumers to purchase their product
-Cash in on their brand appeal
-Offer additional services (real people on the help lines)
-Guarantee Quality
-Have various warrantees of guarantees
-Have contests
According to Gateman, these are all just different forms of price competition- consumers are just getting more goods (ie: a telephone line, and nice, even-tempered technicians to help with troubleshooting) for the same price. This is economically similar to lowering the price of the good- consumers can still get more for less.
5: Barriers to entry. Unlike in markets of monopolies, these are not insurmountable.
MONOPOLISTIC COMPETITION:
-Many Sellers (so sellers will ignore each others actions, and engage in non-strategic behavior)
-Differentiated Goods (So different firms try and sell their BRANDS)
-Entry and exit CAN and DO occur (like in perfect competition)
-The firms set prices within a range (prices are sticky- they tend to stay put for a while, but firms can change them if they have to [usually, in the short run, it isn't worth their trouble])
-It is different from perfect competition because of differentiated brands (thus, demand curve is downward sloping for each firm, as they each have a slightly different product)
-Different from monopolies because of entry and exit (so demand can shift!)
PROFIT MAXIMIZATION FOR MONOPOLISTIC COMPETITION: In the short run, this is similar to monopoly profits.
-In the short run, firms can enjoy economic profits.
-These profits signal other firms to enter the industry
-As more firms enter the industry, set industry demand is divided further and further amongst competing firms. The demand for each individual firm will thus DECREASE
-Once each firm is only making normal profit (when the price is tangent to average total costs--see graph above), no new firms will enter the industry.
EXCESS CAPACITY: The difference between the minimum efficiency scale and the quantity actually produced in long run equilibrium.
In perfect competition, there is no excess capacity for individual firms in the long run.
In imperfect competition, there is excess capacity for individual firms in the long run. This means that compared to perfect competition, firms in imperfect competition will produce fewer goods at higher prices. In this way, brands (what differentiates perfectly competitive markets from imperfectly competitive markets) create a deadweight social loss (when production is limited, deadweight social loss occurs).
That's all
THERE IS A SPECTRUM OF DIFFERENT MARKET STRUCTURES:
Monopoly---Duopoly---Oligopoly---Monopolistic Competition---Perfect Competition
Competition increases as we go to the right (with the exception of perfect competition, in which there is no competitive behavior)
Market power increases as we go to the left (remember, market power is the ability of a single firm to control the price of a good).
CANADA: A large country with a small population (but it's getting bigger).
-The large geographic area of Canada creates higher transportation costs and natural barriers to entry (for an example, atlantic fishers cannot enter the pacific fishing market, because the costs of transporting their goods to BC for sale are too high).
-Our small population causes excess capacity (in other words, most Canadian firms which only operate domestically do not get to reap the benefits of a minimum efficiency scale because demand in Canada is not high enough to warrant such a large scale of output. This is why Canada is a big proponent of free trade- Because Canadian industries must sell their goods on the international market in order to maximize profits- domestic demand is not high enough).
MONOPOLISTIC COMPETITION: A large number of small firms. (Ie: the canadian wine market, grocery stores, night clubs, restaurants)
OLIGOPOLY: A small number of large firms (Ie: banks, insurance industries, power companies)
THE INDUSTRIAL CONCENTRATION RATIO: This lets us know what fraction of total market sales (or shipments or orders or anything really) are controlled by a given number of an industries largest firms. For an example, CR4 could be the fraction of total market sales controlled by the top 4 firms of any industry.
The industrial concentration ratio is ONE indicator of market power and competition in any industry, and can help us decide whether a market is an Oligopoly, or Monopolistic Competition. AS A GENERAL RULE, HIGHER LEVELS OF MARKET CONCENTRATION IMPLY HIGHER LEVELS OF MARKET POWER. There are, however, some issues which arise when only using industrial concentration ratios as a barometer for a market.
1: It is difficult to define a relative market for any good- are we talking about domestic markets? International markets? Is a coke part of the pop market, or is it a part of the 'junk food' market, or is it part of the much larger food and beverage market?
2: Tying the degree of competitiveness in any market to the number of firms within that market can be deceptive. For an example, a market in which the CR4 = 100%, and the top four firms each control 25% of the market could still involve fierce competition between these 4 markets. In contrast, a different market's CR4 could be only 33%, but if one of those 4 largest firms controls 30% of the market, and the rest only control 1% if the market, the firm which controls 30% of the industry will be the market leader, and will effectively set the price of goods within that market, with the other firms acting as price takers. This market has a lower industrial concentration ratio, but involves much less competition.
3: The standard concentration ratio in Canada overstates the degree of industrial concentration in Canada due to the openness of the Canadian economy (because we lack trade barriers).
IMPERFECT COMPETITION: Rivalrous behavior with some market power to set a price within a range (a combination of perfect competition and monopoly). Basically, any intermediate market structure
There are 2 types of imperfect competition:
-Monopolistic Competition (involves non-strategic behavior)
-Oligopoly (involves strategic behavior)
In Imperfect Competition There Are:
-Many Sellers
-Selling a differentiated product
-Entry and exit are possible, but not easy
-Each firm acts as a price setter within a range
MARKET CHARACTERISTICS FOR IMPERFECT COMPETITION:
1: Firms select their products (each firm decides what sort of a product they are going to produce. Often this involves product differentiation, in which the producers must somehow distinguish their product from competitor products in the eyes of the consumer. This involves associating certain products with happiness, beauty or sex appeal through clever advertising. This also ensures that different products from different producers are not PERFECT substitutes for each other. For this reason, crest toothpaste is considered a different good than oral-b toothpaste).
2: Firms select their prices (The individual firms decide what price to sell their goods at... within a reasonable range with reference to supply and demand. For instance, a sock firm knows better than to try and charge consumers $400 for a pair of socks. Firms then, act as price setters and let demand determine sales. If demand changes, firms can gage this through increased or declining sales for their goods.
3: Prices are sticky in the short run (In perfect competition, prices change in response to supply and demand. In imperfect competition, however, it is much easier for firms to directly alter their output in response to changes in demand than it is to change the price of a product (ie: for vending machines, this would take considerable effort). Price DO change in the long run, but in the short run, they tend to remain the same, regardless of demand (ie: a dairy queen blizzard costs the same in winter as it does in summer).
4: Non-price competition versus price competition.
Traditionally, people believe that firms can compete in ways other than lowering the price of a good. For instance, they can
-Create funny advertisements which entice consumers to purchase their product
-Cash in on their brand appeal
-Offer additional services (real people on the help lines)
-Guarantee Quality
-Have various warrantees of guarantees
-Have contests
According to Gateman, these are all just different forms of price competition- consumers are just getting more goods (ie: a telephone line, and nice, even-tempered technicians to help with troubleshooting) for the same price. This is economically similar to lowering the price of the good- consumers can still get more for less.
5: Barriers to entry. Unlike in markets of monopolies, these are not insurmountable.
MONOPOLISTIC COMPETITION:
-Many Sellers (so sellers will ignore each others actions, and engage in non-strategic behavior)
-Differentiated Goods (So different firms try and sell their BRANDS)
-Entry and exit CAN and DO occur (like in perfect competition)
-The firms set prices within a range (prices are sticky- they tend to stay put for a while, but firms can change them if they have to [usually, in the short run, it isn't worth their trouble])
-It is different from perfect competition because of differentiated brands (thus, demand curve is downward sloping for each firm, as they each have a slightly different product)
-Different from monopolies because of entry and exit (so demand can shift!)
PROFIT MAXIMIZATION FOR MONOPOLISTIC COMPETITION: In the short run, this is similar to monopoly profits.
-In the short run, firms can enjoy economic profits.
-These profits signal other firms to enter the industry
-As more firms enter the industry, set industry demand is divided further and further amongst competing firms. The demand for each individual firm will thus DECREASE
-Once each firm is only making normal profit (when the price is tangent to average total costs--see graph above), no new firms will enter the industry.
EXCESS CAPACITY: The difference between the minimum efficiency scale and the quantity actually produced in long run equilibrium.
In perfect competition, there is no excess capacity for individual firms in the long run.
In imperfect competition, there is excess capacity for individual firms in the long run. This means that compared to perfect competition, firms in imperfect competition will produce fewer goods at higher prices. In this way, brands (what differentiates perfectly competitive markets from imperfectly competitive markets) create a deadweight social loss (when production is limited, deadweight social loss occurs).
That's all
Saturday, November 14, 2009
Monopolies! OH NO!
Making money is so fun, we've even made a game out of it. And then we made money by selling that game to consumers. Coincidence? I think not!
TODAY: Monopolies! We already have a pretty good idea about how markets work in perfect competition. Not all markets are perfectly competitive though: ENTER THE MONOPOLY!
Most Important: There is no competition, and no competitive behavior in monopolies, because in a monopoly market structure, one firm has absolute market power (power to raise and lower the price of a product without losing buyers to competitors).
CHARACTERISTICS OF MONOPOLIES:
1: There is only one seller, so THE FIRM IS THE INDUSTRY
2: This firm is selling a unique, exclusive good which other firms cannot sell (ie: exclusive pharmaceutical drugs which cannot be copied by non-name brand drug companies due to patent restrictions)
3: Entry and Exit into and out of the industry is impossible. In other words, there are insurmountable barriers to entry (and they are often created by the government).
MONOPOLIES ARE PRICE SETTERS! They choose which price to sell their product at.
Let's just do a quick recap for comparison's sake.
PERFECT COMPETITION
-Many Firms
-Selling a Homogenous Good
-Entry and Exit is Easy
-Firms are Price Takers
MONOPOLIES
-Single Firm
-Selling a Unique Good
-Entry and Exit is Impossible
-The Firm is the Price Setter
So, for the most part, a monopoly is the total opposite of perfect competition. The only similarity they share is a total lack of competitive behavior within the market.
----------------------------
THE DEMAND CURVE FOR THE FIRM IN A MONOPOLY
Well: In a monopoly, the firms is the industry. Logically then, the industry demand is the same as the demand curve for the firm. This means that the demand curve for firms is DOWNWARD SLOPING in monopolies.
We know that monopolists have the freedom to set the price at any level. We know that in a situation of downward sloping demand, consumer demand for a particular good decreases as the price increases. We also know that monopolists, like all producers, will seek to maximize their profits. The question we have to answer then is this:
AT WHAT PRICE WILL MONOPOLISTS SELL TO MAXIMIZE PROFITS?
In order to answer this question, we first need to understand how revenue curves for monopolies work.
First, a chart for revenues with downward sloping demand in effect.
Quantity Demanded--Price--Total Revenue---Average Revenue---Marginal Revenue
0----------------100---0------------------------------------------
1----------------90----90-------------90-----------------90-------
2----------------80----160------------80-----------------70-------
3----------------70----210------------70-----------------50-------
4----------------60----240------------60-----------------30-------
5----------------50----250------------50-----------------10-------
6----------------40----240------------40----------------(-10)------
7----------------30----210------------30----------------(-30)------
8----------------20----160------------20----------------(-50)------
9----------------10----90-------------10----------------(-70)------
10---------------0-----0--------------0-----------------(-90)------
Things you should notice: The average revenue for each of these different potential prices is still equal to the price (just like it was in perfect competition). Marginal revenue, on the other hand, falls twice as quickly as average revenue.
NOTE: As long as marginal revenue is positive, elasticity of demand is greater than one. When marginal revenue = zero, elasticity of demand = 1. When marginal revenue is negative, elasticity of demand is a fraction smaller than 1.
So, why is the marginal revenue always lower than the price (average revenue) for monopolists? Well, in order to sell one more unit of their good, monopolists have to lower the price of that good. This increases demand, so more units will be sold, but at the same time, that lower price will apply to the entire quantity of products sold, including the additional unit which required a lower price in order to sell. As such, the marginal revenue for the 20,323rd iphone sold by apple will be slightly less than the marginal revenue for the 20,322nd iphone.
Monopolists will never produce when the elasticity of demand is negative and marginal revenue is less than zero. Why? because this implies that the firm's total revenue is falling. Firms will not produce extra units if the price adjustment required to sell those extra units creates negative marginal revenue. Firms like profits. Monopolists do not like producing extra units which cost more to produce, and lower total revenue when sold.
When drawing marginal revenue lines, just draw the x-intercept of the marginal revenue line at the midway point between the x intercept of demand and the origin (just trust me, it works)
---------------------------------------
SHORT RUN PROFIT MAXIMIZATION: AT WHAT PRICE WILL MONOPOLISTS SELL TO MAXIMIZE PROFITS?
There are three rules which monopolists must follow to maximize profits.
Rule 1: Monopolists will not produce when elasticity of demand is less than 1. They can only produce when elasticity is equal to or greater than one, or where marginal revenue is equal to or greater than zero (when total revenue is rising). Why? Because for every level of output with elasticity lower than 1, there is another, lower level of output with higher elasticity which will yield the same total revenue, but for a much lower cost (remember, it costs firms to produce units of a good).
Rule 2: A profit maximizing monopolist will produce output where it covers day-to-day expenses (in other words, the price must be higher than the average variable cost)
Rule 3: A profit maximizing monopolist will produce output where marginal revenue equals marginal costs.
SUMMARY:
1: e > or = 1
2: P > or = AVC
3: MR = MC
---------------------------
DIFFERENT SHORT RUN REVENUE SCENARIOS: Here, we're going to look at different revenue scenarios which an affect firms in the short run.
First- we we find the point where MC = MR to determine the profit-maximizing quantity
Then, we find total revenue (price X quantity sold)
Then, we find total costs (average costs X quantity sold)
Finally, we subtract total costs from total revenues to find total profit
SCENARIO 1: Economic Profit!
Here, total revenue is greater than total costs, so economic profit is positive
SCENARIO 2: Normal Profit!
Here, total revenue is equal to total costs, so economic profit is zero
SCENARIO 3: Economic Loss!
Here, total revenue is less than total costs, so economic profit is negative
NOTE: Although there is only one output level which will completely maximize profits, any output quantity where the price (demand) is greater than average costs will render positive economic profits. This gives monopolies some flexibility- they can adjust output to comply with various regulations (ie: lower their output due to environmental legislation) and still reap positive profits.
That's all!
Short Run Decisions in Perfect Competition
REMEMBER:
-Demand in perfect competition is constant for individual firms (it does not change with quantity produced), and demand is equal to price, average revenue, and marginal revenue.
-Supply is equal to the marginal cost curve above the average variable cost curve.
We're going to look at some different scenarios for firms in perfect competition in the short run. For each of these, we try to calculate economic profit. Here's how:
-First, we find out which quantity will allow Marginal Revenues is equal to Marginal Costs
-Next we calculate total revenue, which is the price X the quantity exchanged
-Next we calculate the total cost, which is the average cost for this quantity X the quantity exchanged
-Finally we determine economic profit by subtracting the total costs from the total revenue. The remaining money is economic profit!
SCENARIO ONE: ECONOMIC PROFIT
Here, marginal revenue = marginal costs at a point where the average revenue (price) is greater than the average costs. Because of this, revenue will exceed costs, thus creating positive economic profit in the short run. NOTE: This usually signals firms to enter the industry, which occurs over the long run.
SCENARIO TWO: NORMAL PROFIT
Here, marginal revenue = marginal costs at a point where the average revenue (price) is just equal to average costs. Because of this, revenue will equal costs, thus creating zero economic profit (aka: normal profit). In a normal profit scenario, firms are making the same amount of accounting profits in this industry that they would anywhere else. There is no incentive for firms to enter or leave the industry.
SCENARIO THREE: ECONOMIC LOSS
Here. marginal revenue = marginal costs at a point where the average revenue (price) is lower than average costs. As a result, firms in this scenario will take an economic loss on production (they could still be making accounting profits on their business, but that money would make more profits if invested elsewhere). In the long run, economic losses act as a signal for firms to leave a business. However, firms which are operating at an economic loss should not necessarily exit the industry. As long as they continue to cover daily operating costs, they are 'breaking even' in an accounting sense, and should continue to produce.
SCENARIO FOUR: SHUT DOWN POINT
Here, total revenue is much lower than total costs (negative economic profit). Average revenue JUST equal average variable costs, which means that this firm can JUST cover daily expenses (zero accounting profit). Any point below this, and the firm will be operating at a loss, and should shut down.
-----------------------
SHORT RUN SUPPLY CURVES:
-a supply curve shows a firm's willingness to produce at any given price.
remember:
-a demand curve is derived using the principles of total utility maximization, so when price increases, quantity demanded decreases
-a supply curve is derived using the principles of profit maximization, so when the price increases, quantity supplied increases.
THE MARGINAL COST ABOVE THE AVERAGE VARIABLE COST CURVE IS THE SHORT RUN SUPPLY CURVE FOR FIRMS IN PERFECT COMPETITION! As the price increases, marginal costs will = marginal revenue at a greater quantity of production.
INDUSTRY SUPPLY IN THE SHORT RUN FOR PERFECT COMPETITION
Industry supply for the short run is just the horizontal sum of each individual firm's supply curves (aka their marginal cost curve above average variable cost)
-It is the short run, because the cost curves are holding capital constant (so individual firms cannot change their scale of production)
CONDITIONS FOR SHORT RUN INDUSTRY EQUILIBRIUM:
1-The demand and supply must be equal for the industry
2-Each firms must be maximizing profits (minimizing losses)
3-This does not necessarily mean that all of the firms will be making economic profit. If there are too many firms in the industry, in the short run, all of the firms may be making economic losses while operating at maximum profit
THATS ALL FOR NOW
-Demand in perfect competition is constant for individual firms (it does not change with quantity produced), and demand is equal to price, average revenue, and marginal revenue.
-Supply is equal to the marginal cost curve above the average variable cost curve.
We're going to look at some different scenarios for firms in perfect competition in the short run. For each of these, we try to calculate economic profit. Here's how:
-First, we find out which quantity will allow Marginal Revenues is equal to Marginal Costs
-Next we calculate total revenue, which is the price X the quantity exchanged
-Next we calculate the total cost, which is the average cost for this quantity X the quantity exchanged
-Finally we determine economic profit by subtracting the total costs from the total revenue. The remaining money is economic profit!
SCENARIO ONE: ECONOMIC PROFIT
Here, marginal revenue = marginal costs at a point where the average revenue (price) is greater than the average costs. Because of this, revenue will exceed costs, thus creating positive economic profit in the short run. NOTE: This usually signals firms to enter the industry, which occurs over the long run.
SCENARIO TWO: NORMAL PROFIT
Here, marginal revenue = marginal costs at a point where the average revenue (price) is just equal to average costs. Because of this, revenue will equal costs, thus creating zero economic profit (aka: normal profit). In a normal profit scenario, firms are making the same amount of accounting profits in this industry that they would anywhere else. There is no incentive for firms to enter or leave the industry.
SCENARIO THREE: ECONOMIC LOSS
Here. marginal revenue = marginal costs at a point where the average revenue (price) is lower than average costs. As a result, firms in this scenario will take an economic loss on production (they could still be making accounting profits on their business, but that money would make more profits if invested elsewhere). In the long run, economic losses act as a signal for firms to leave a business. However, firms which are operating at an economic loss should not necessarily exit the industry. As long as they continue to cover daily operating costs, they are 'breaking even' in an accounting sense, and should continue to produce.
SCENARIO FOUR: SHUT DOWN POINT
Here, total revenue is much lower than total costs (negative economic profit). Average revenue JUST equal average variable costs, which means that this firm can JUST cover daily expenses (zero accounting profit). Any point below this, and the firm will be operating at a loss, and should shut down.
-----------------------
SHORT RUN SUPPLY CURVES:
-a supply curve shows a firm's willingness to produce at any given price.
remember:
-a demand curve is derived using the principles of total utility maximization, so when price increases, quantity demanded decreases
-a supply curve is derived using the principles of profit maximization, so when the price increases, quantity supplied increases.
THE MARGINAL COST ABOVE THE AVERAGE VARIABLE COST CURVE IS THE SHORT RUN SUPPLY CURVE FOR FIRMS IN PERFECT COMPETITION! As the price increases, marginal costs will = marginal revenue at a greater quantity of production.
INDUSTRY SUPPLY IN THE SHORT RUN FOR PERFECT COMPETITION
Industry supply for the short run is just the horizontal sum of each individual firm's supply curves (aka their marginal cost curve above average variable cost)
-It is the short run, because the cost curves are holding capital constant (so individual firms cannot change their scale of production)
CONDITIONS FOR SHORT RUN INDUSTRY EQUILIBRIUM:
1-The demand and supply must be equal for the industry
2-Each firms must be maximizing profits (minimizing losses)
3-This does not necessarily mean that all of the firms will be making economic profit. If there are too many firms in the industry, in the short run, all of the firms may be making economic losses while operating at maximum profit
THATS ALL FOR NOW
Sunday, November 1, 2009
Isoquant and Isocost and The Very Long Run
Short Run:
-Fixed Factor
-Fixed Input Prices
-Fixed Technology
Grahpically: Short-run-average-cost
Long Run:
-All factors vary
-Price of inputs can be fixed, or can vary
-Technology is fixed
Graphically: Long -run-average-cost-curve (or shifts in the long-run-average-cost curve for the case of changes in factor prices)
THE VERY LONG RUN:
-Technology can vary
-Price of inputs can vary
Graphically: Shown by shifts in the long run average cost curve (generally, downward shifts)
3 types of changes in technology:
-Change in process (for an example, robotic assembly lines instead of human assembly lines. Bull dozers and forklifts instead of pickaxes and brute strength)
-Improved inputs (aluminum bikes instead of iron bikes)
-New Products (Ipods instead of portable walkmen)
Usually, a change in technology changes the productive process, and therefore, would change the production function (the functional relationship between inputs and outputs). Remember, productivity is output per input.
There are 2 theories about technological innovation. The second one is more correct.
Old Theory: Technological Changes were seen as exogenous, or independent variables unaffected by changes in the economy (think crazy old scientists sitting around in the their labs and coming up with new technologies "just because they want to").
New Theory: Technology Changes are endogenous, or dependent on the economy. A production-side want to innovate away from costly inputs often drives firms to finance new technological changes. It is a FEEDBACK MECHANISM (for instance, many oil producers are now looking into unconventional drilling methods which use water pressure to release the oil from rocks. This turns land which was previously unproductive and cheap into a great asset, and helps companies move away from pricier traditional drilling sites) .
GENERALLY, TECHNOLOGICAL CHANGES SHIFT THE DEMAND CURVE DOWNWARD!
So... in the very long run, firms can both substitute away from costly inputs, or innovate away from them.
OKAY! Isoquants and Isocosts! These are very similar to indifference curves and budget lines from chapter six!
Isocost Lines:
The isocost line reflects two things
-The total cost of inputs
-The factor prices of inputs
Each isocost line shows all possible combinations of factors available for a given cost (sort of like a budget line, except with inputs, not products)
For an example, an isocost line could show the amount of cooks and ingredients a restaurant can utilize for a set cost.
The formula: Total Cost = (Px X Qx) + (Py X Qy)
The slope: -Px/Py (I'm doing this by axes so not to confuse people, because technically, you could graph labour or capitol on either axis).
As your total costs increase, the isocost line moves out from the origin. Changes in input factor prices will cause the isocost line to tilt.
Isoquant Lines
Each isoquant line shows all possible combinations of the factors of production that yield a given level of output. (Sort of like an indifference curve, except with productive output held constant instead of total utility)
In other words, total product is constant: the /\TP = 0
The formula: /\x*MPx + /\y*MPy = 0
The slope: -MPx/MPy
Finding the conditions for cost minimization is a little bit different for Isoquant and Isocost lines. Instead of finding the optimal quantity level for a given budget (like we do for indifference curves), we figure out which level of production we need to meet (for example, how many teddy bears we want to produce in a day). We first draw the Isoquant line which corresponds to that level of production (so we would draw the isoquant line showing the combination of inputs needs to produce 100 bears in a day). After that, whichever isocost line is JUST tangent to the desired isoquant line will represent the minimum cost for that level of output, and the point of tangency will show the exact quantity of inputs required to achieve this minimum cost.
If an isocost line is not quite touching the isoquant line, then expenditure is not high enough to meet those production goals. Meanwhile, if an isocost line bisects the isoquant line, that production goal can be met, but efficiency is not being maximized, as that same level of production could be facilitated with a less-costly combination of inputs.
At the point of tangency, the slope of the isoquant line = the slope of the isocost line!
MPx/MPy = Px/Py
which is the same condition for marginal productivity maximization! (again, this parallels indifference curves in a BIG way)
REMEMBER, EFFICIENCY IS IMPORTANT!
SO... if you were to study efficiently, you should know that anything after this point will NOT be on the big, evil Gateman-style midterm this Friday!
It's hard to believe it's already November...
-Fixed Factor
-Fixed Input Prices
-Fixed Technology
Grahpically: Short-run-average-cost
Long Run:
-All factors vary
-Price of inputs can be fixed, or can vary
-Technology is fixed
Graphically: Long -run-average-cost-curve (or shifts in the long-run-average-cost curve for the case of changes in factor prices)
THE VERY LONG RUN:
-Technology can vary
-Price of inputs can vary
Graphically: Shown by shifts in the long run average cost curve (generally, downward shifts)
3 types of changes in technology:
-Change in process (for an example, robotic assembly lines instead of human assembly lines. Bull dozers and forklifts instead of pickaxes and brute strength)
-Improved inputs (aluminum bikes instead of iron bikes)
-New Products (Ipods instead of portable walkmen)
Usually, a change in technology changes the productive process, and therefore, would change the production function (the functional relationship between inputs and outputs). Remember, productivity is output per input.
There are 2 theories about technological innovation. The second one is more correct.
Old Theory: Technological Changes were seen as exogenous, or independent variables unaffected by changes in the economy (think crazy old scientists sitting around in the their labs and coming up with new technologies "just because they want to").
New Theory: Technology Changes are endogenous, or dependent on the economy. A production-side want to innovate away from costly inputs often drives firms to finance new technological changes. It is a FEEDBACK MECHANISM (for instance, many oil producers are now looking into unconventional drilling methods which use water pressure to release the oil from rocks. This turns land which was previously unproductive and cheap into a great asset, and helps companies move away from pricier traditional drilling sites) .
GENERALLY, TECHNOLOGICAL CHANGES SHIFT THE DEMAND CURVE DOWNWARD!
So... in the very long run, firms can both substitute away from costly inputs, or innovate away from them.
OKAY! Isoquants and Isocosts! These are very similar to indifference curves and budget lines from chapter six!
Isocost Lines:
The isocost line reflects two things
-The total cost of inputs
-The factor prices of inputs
Each isocost line shows all possible combinations of factors available for a given cost (sort of like a budget line, except with inputs, not products)
For an example, an isocost line could show the amount of cooks and ingredients a restaurant can utilize for a set cost.
The formula: Total Cost = (Px X Qx) + (Py X Qy)
The slope: -Px/Py (I'm doing this by axes so not to confuse people, because technically, you could graph labour or capitol on either axis).
As your total costs increase, the isocost line moves out from the origin. Changes in input factor prices will cause the isocost line to tilt.
Isoquant Lines
Each isoquant line shows all possible combinations of the factors of production that yield a given level of output. (Sort of like an indifference curve, except with productive output held constant instead of total utility)
In other words, total product is constant: the /\TP = 0
The formula: /\x*MPx + /\y*MPy = 0
The slope: -MPx/MPy
Finding the conditions for cost minimization is a little bit different for Isoquant and Isocost lines. Instead of finding the optimal quantity level for a given budget (like we do for indifference curves), we figure out which level of production we need to meet (for example, how many teddy bears we want to produce in a day). We first draw the Isoquant line which corresponds to that level of production (so we would draw the isoquant line showing the combination of inputs needs to produce 100 bears in a day). After that, whichever isocost line is JUST tangent to the desired isoquant line will represent the minimum cost for that level of output, and the point of tangency will show the exact quantity of inputs required to achieve this minimum cost.
If an isocost line is not quite touching the isoquant line, then expenditure is not high enough to meet those production goals. Meanwhile, if an isocost line bisects the isoquant line, that production goal can be met, but efficiency is not being maximized, as that same level of production could be facilitated with a less-costly combination of inputs.
At the point of tangency, the slope of the isoquant line = the slope of the isocost line!
MPx/MPy = Px/Py
which is the same condition for marginal productivity maximization! (again, this parallels indifference curves in a BIG way)
REMEMBER, EFFICIENCY IS IMPORTANT!
SO... if you were to study efficiently, you should know that anything after this point will NOT be on the big, evil Gateman-style midterm this Friday!
It's hard to believe it's already November...
Wednesday, October 21, 2009
Introduction to cost curves!
Okay! Last lecture was all about firms. Now today, we're gonna talk about how we derive the Short-run supply curve. We must examine the theoretical link between price and quantity produced!
Price --------> [?]----> Quantity Supplied
What is the missing link???
PROFITS!!!!
We assume, as economists that producers (like consumers) want to be as happy as possible. Instead of maximizing utility, however, consumers are made the most happy by maximizing total profits!
Total profits = total revenue - total costs
TOTAL REVENUE
-total revenue = price X quantity
-Total revenue is changes based on different kinds of markets (there are different revenue curves for markets with perfect competition, imperfect competition, and monopolies. We talk about all of these in the upcoming chapters!)
TOTAL COSTS on the other hand are the same for each market structure. We're gonna talk about total costs in this chapter!
OKAY! Let's think about production! What is production?
Well... production is the transformation of various inputs into outputs, which is performed by a firm. For an example, when joe the employee, rent for a smoothie shop, electricity, a blender, yoghurt, mangoes, and bananas are used together to create a mango-banana smoothie, THAT is production.
INPUTS are the factors of production (factors)
OUTPUTS are goods and services (commodities)
There are 5 factors of production
Capital- (Plant or Factory, Equipment, Inventory, and Residential Inputs)
Land- Natural Resources
Labour- Human Resources (Employees)
Technology- Changes and innovations in the production process
Entrepreneurship- Innovation, Invention, Research and Development (new and exciting ideas)
THE PRODUCTION FUNCTION: Maximum output is a function of inputs
For the sake of simplicity, we focus on the relationship between 2 inputs: Capital and Labour.
TP = f (Labour, Capitol)
Let's say we've got an office where we produce written letters using secrataries. The number of letters written is a function of the office infrastructure and the number of secrataries employed.
COSTS: The value of the factor used up in production (the value of inputs)
REMEMBER: Opportunity costs determine decision-making in the firm (inputs are valued depending on their next best allocation, not their sticker-price). We call the costs with ppportunity cost factored in the IMPUTED OR IMPLIED COST (OR IN GATEMAN'S LECTURES, THE OPPORTUNITY COST).
The Accounting Cost is not something we look at in Economics. It is used in business school, and merely includes the explicit invoice prices of factors. It does not take the owner's time and money, for example, into consideration.
SUNK COSTS, however, are not factored in to opportunity cost, because they have no alternative use (or salvage value). In other words, they have No 'next best' allocation. An example of a sunk cost would be a computer program which is designed and purhcased specifically for your business. This input cannot be used any other way, so Opportunity cost is 0, and it is a sunk cost!
PROFITS!
ACCOUNTING PROFIT = total revenue - Accounting costs (the sticker prices of inputs). This does not include opportunity costs.
ECONOMIC PROFIT = Total Revenue - Total Costs (and includes opportunity costs). This is also known as pure profit, supra-normal profit, or in an econmics class, simply 'profit'. It basically measures profit compared to other opportunities. In order to understand economic profit, it is important to understand the idea of normal profit.
NORMAL PROFIT is actually a cost. It is the cost of technology and entreprenuership, or the implicit cost of risk taking. It is the cost of choosing to devote time and money into a certain business instead of simply putting money in the bank or working at the next-most-profitable business. For an example, if I can make 5% returns on my money in the bank, then those 5% returns are considered normal profit, and should be added to my economic costs. In the long run, the profit level of surviving firms (after a business trend has come and gone) can be seen as the normal profit.
When a firm is making no economic profit, we say that it is allocatively efficient.
Firms can make accounting profts, but no economic profits. If this is the case, we know that the firm would be better off using their resources in a different way to make more profit.
Economic profit in a particular sector acts as a sugnal for firms to enter that sector. Conversely, economic loss is a signal for firms to exit the market for that sector! Pretty cool, hey?
NOW.. let's try and get into the idea of cost curves.
We know that profit is total revenue minus total costs. We don't know how to determine revenue quite yet, but we're going to learn how to determine costs. Now, we're going to have a closer looks at how total costs relate to quantity. Cost theory is similar for all firms, no matter what the revenue market is.
OKAY: There are 3 different cost scenarios:
THE SHORT RUN (Operating Decisions): at least one of the input factors is fixed. Q = f (variable factor, fixed factor)
THE LONG RUN (Planning Decisions): all factors are variable except technology. Q = f (variable factor, variable factor)
THE LONG RUN (Growth Decisions): all factors are variable including technology. Q = f (variable factor, variable factor, with variable technology)
In other words, time isn't actually a factor- it just depends on whether facors are variable or not. The short run could extend for years in some industries, while the long run may only last a few weeks in other industries.
NOW FOR THE COST CURVE:
from 0-3 is specialization
from 3-7 is saturation
from 7-8 is congestion
Usually, when you initially add more people (labour), division of labour and specialization can happen! As a result, efficiency increases, so the total product (grapgically represented as a lazy S) rises at an increasing rate.
Since production is a function of labour, it looks like the additional unit of labour (extra worker) added after the first worker can produce 2 extra products. In real life, the extra worker allows both the new worker and the old worker to produce 1.5 products (for a total of 3). The average product (total output per worker, represented as a slope of a ray from the origin on the total product curve) is 1.5, and the marginal product (extra productivity added by the last hired worker represented as the slope of the tangent of the product curve) is 2.
AP = quantity produced/number of workers = 3/2 = 1.5
MP = change in quantity/change in number of workers = 2/1 = 2
The marginal production rate always intersects the average production rate at it's maximum. This is because the average rate will continue to logically rise until an additional worker will no longer cause an increase in productivity. If a worker is added whose added productivity is exactly the same as the present level of productivity, then the average productivity will be equal to the marginal productivity. Any point after this in which another worker's marginal productivity will be lower than the average productivity, and will therefore cause the average to decrease.
After a certain point (the inflection point), each additional worker still adds to total productivity, but at a decreasing rate. Here, total productivity is rising, and marginal productivity is positive, but falling. This is called saturation.
Eventually, due to overcrowding and other inefficiencies (400 people in a tiny office for example), addional workers will actually cause a decrease in total productivity. Here, margical productivity is negative, and falling, and total productivity is decreasing.
This is for situations when Output is a function of Capital and Labour.
WE CAN USE THIS TO FIND THE COST CURVE!
There is a law of diminshing marginal product, which states that after a certain point (the inflection point), adding more of the variable factor will dimish the additional output generated by that extra variable factor.
Why?
-Because the variable factor has less of the fixed factor to work with (EG: 12 secratories sharing 4 computers). This is the reason for the shape of the product curve
Price --------> [?]----> Quantity Supplied
What is the missing link???
PROFITS!!!!
We assume, as economists that producers (like consumers) want to be as happy as possible. Instead of maximizing utility, however, consumers are made the most happy by maximizing total profits!
Total profits = total revenue - total costs
TOTAL REVENUE
-total revenue = price X quantity
-Total revenue is changes based on different kinds of markets (there are different revenue curves for markets with perfect competition, imperfect competition, and monopolies. We talk about all of these in the upcoming chapters!)
TOTAL COSTS on the other hand are the same for each market structure. We're gonna talk about total costs in this chapter!
OKAY! Let's think about production! What is production?
Well... production is the transformation of various inputs into outputs, which is performed by a firm. For an example, when joe the employee, rent for a smoothie shop, electricity, a blender, yoghurt, mangoes, and bananas are used together to create a mango-banana smoothie, THAT is production.
INPUTS are the factors of production (factors)
OUTPUTS are goods and services (commodities)
There are 5 factors of production
Capital- (Plant or Factory, Equipment, Inventory, and Residential Inputs)
Land- Natural Resources
Labour- Human Resources (Employees)
Technology- Changes and innovations in the production process
Entrepreneurship- Innovation, Invention, Research and Development (new and exciting ideas)
THE PRODUCTION FUNCTION: Maximum output is a function of inputs
For the sake of simplicity, we focus on the relationship between 2 inputs: Capital and Labour.
TP = f (Labour, Capitol)
Let's say we've got an office where we produce written letters using secrataries. The number of letters written is a function of the office infrastructure and the number of secrataries employed.
COSTS: The value of the factor used up in production (the value of inputs)
REMEMBER: Opportunity costs determine decision-making in the firm (inputs are valued depending on their next best allocation, not their sticker-price). We call the costs with ppportunity cost factored in the IMPUTED OR IMPLIED COST (OR IN GATEMAN'S LECTURES, THE OPPORTUNITY COST).
The Accounting Cost is not something we look at in Economics. It is used in business school, and merely includes the explicit invoice prices of factors. It does not take the owner's time and money, for example, into consideration.
SUNK COSTS, however, are not factored in to opportunity cost, because they have no alternative use (or salvage value). In other words, they have No 'next best' allocation. An example of a sunk cost would be a computer program which is designed and purhcased specifically for your business. This input cannot be used any other way, so Opportunity cost is 0, and it is a sunk cost!
PROFITS!
ACCOUNTING PROFIT = total revenue - Accounting costs (the sticker prices of inputs). This does not include opportunity costs.
ECONOMIC PROFIT = Total Revenue - Total Costs (and includes opportunity costs). This is also known as pure profit, supra-normal profit, or in an econmics class, simply 'profit'. It basically measures profit compared to other opportunities. In order to understand economic profit, it is important to understand the idea of normal profit.
NORMAL PROFIT is actually a cost. It is the cost of technology and entreprenuership, or the implicit cost of risk taking. It is the cost of choosing to devote time and money into a certain business instead of simply putting money in the bank or working at the next-most-profitable business. For an example, if I can make 5% returns on my money in the bank, then those 5% returns are considered normal profit, and should be added to my economic costs. In the long run, the profit level of surviving firms (after a business trend has come and gone) can be seen as the normal profit.
When a firm is making no economic profit, we say that it is allocatively efficient.
Firms can make accounting profts, but no economic profits. If this is the case, we know that the firm would be better off using their resources in a different way to make more profit.
Economic profit in a particular sector acts as a sugnal for firms to enter that sector. Conversely, economic loss is a signal for firms to exit the market for that sector! Pretty cool, hey?
NOW.. let's try and get into the idea of cost curves.
We know that profit is total revenue minus total costs. We don't know how to determine revenue quite yet, but we're going to learn how to determine costs. Now, we're going to have a closer looks at how total costs relate to quantity. Cost theory is similar for all firms, no matter what the revenue market is.
OKAY: There are 3 different cost scenarios:
THE SHORT RUN (Operating Decisions): at least one of the input factors is fixed. Q = f (variable factor, fixed factor)
THE LONG RUN (Planning Decisions): all factors are variable except technology. Q = f (variable factor, variable factor)
THE LONG RUN (Growth Decisions): all factors are variable including technology. Q = f (variable factor, variable factor, with variable technology)
In other words, time isn't actually a factor- it just depends on whether facors are variable or not. The short run could extend for years in some industries, while the long run may only last a few weeks in other industries.
NOW FOR THE COST CURVE:
from 0-3 is specialization
from 3-7 is saturation
from 7-8 is congestion
Usually, when you initially add more people (labour), division of labour and specialization can happen! As a result, efficiency increases, so the total product (grapgically represented as a lazy S) rises at an increasing rate.
Since production is a function of labour, it looks like the additional unit of labour (extra worker) added after the first worker can produce 2 extra products. In real life, the extra worker allows both the new worker and the old worker to produce 1.5 products (for a total of 3). The average product (total output per worker, represented as a slope of a ray from the origin on the total product curve) is 1.5, and the marginal product (extra productivity added by the last hired worker represented as the slope of the tangent of the product curve) is 2.
AP = quantity produced/number of workers = 3/2 = 1.5
MP = change in quantity/change in number of workers = 2/1 = 2
The marginal production rate always intersects the average production rate at it's maximum. This is because the average rate will continue to logically rise until an additional worker will no longer cause an increase in productivity. If a worker is added whose added productivity is exactly the same as the present level of productivity, then the average productivity will be equal to the marginal productivity. Any point after this in which another worker's marginal productivity will be lower than the average productivity, and will therefore cause the average to decrease.
After a certain point (the inflection point), each additional worker still adds to total productivity, but at a decreasing rate. Here, total productivity is rising, and marginal productivity is positive, but falling. This is called saturation.
Eventually, due to overcrowding and other inefficiencies (400 people in a tiny office for example), addional workers will actually cause a decrease in total productivity. Here, margical productivity is negative, and falling, and total productivity is decreasing.
This is for situations when Output is a function of Capital and Labour.
WE CAN USE THIS TO FIND THE COST CURVE!
There is a law of diminshing marginal product, which states that after a certain point (the inflection point), adding more of the variable factor will dimish the additional output generated by that extra variable factor.
Why?
-Because the variable factor has less of the fixed factor to work with (EG: 12 secratories sharing 4 computers). This is the reason for the shape of the product curve
Monday, October 19, 2009
Econ 101: An introduction to FIRMS
We have been studying consumer and consumer behavior a LOT lately... well not anymore! It's time for us to turn our attention to the strange and wonderful world of PRODUCERS!
Scary stuff, right?
First-off: The role of the firm.
In economics, we define a firm as any self-contained, profit maximizing entity that produces and sells goods or services (or both)
A firm is an economic construct, and may not necessarily be exactly the same as a "business". There are three main kinds of firms in the economic universe: Single Proprietorships, Partnerships, and Corporations.
Single (Sole) Proprietorship:
In this type of firm, the owner IS the business. For an example, Mr. Wong owns Mr. Wong's Confectionary, so Mr. Wong IS Mr. Wong's Confectionary! What this means is that Mr. Wong is personally liable for all damage done by his business, and will be accordingly held responsible. For an example, if I ate a pie from Mr. Wong's Confectionary and it made me sick, I could sue Mr. Wong's Confectionary for damages and uncleanliness. If I won, Mr. Wong would have to pay me out of his own pocket.
Some other characteristics of proprietorships:
-There is only one owner
-Unlimited liability
-There are obvious incentives for the owner to get the firm to generate profit
-They can be difficult to finance (because the burden of financing proprietorships falls on one individual)
-Transfering ownership is difficult (selling your business can be hard)
-Owners are taxed at the personal rate
Partnership:
In this type of firm, two or more individuals who perform the same kind of work (for an exampple, two laser hair removal specialists) join together under a contract in order to make PROFIT! This partnership is legal and binding. What it entails is that all of the individuals who have entered the partnership are jointly liable for all damage their business causes. For an example if I get laser hair removal from doctor A, and the procedures somehow gives me skin cancer, I can sue A & B hair removal and force Doctor B to pay me for damages out of his own pocket, even though he had nothing to do with me contracting skin cancer. For this reason, it is important to REALLY TRUST anyone you enter a partnership with.
Some other characteristics of partnerships:
-2 or more owners
-Unlimited shared liability
-They can be difficult to finance (because the burden of financing proprietorships falls on only a few individual)
-Transfering ownership is difficult (selling your small business can be hard, especially if you are a group of specialized professionals and there is no one with a similar skill set who is willing to take over your business)
-Owners are taxed at the personal rate
Both of these types of firms can be very risky to own, due to the unlimited liability imposed on all owners. SO, laws were invented to pave the way for...
THE CORPORATION:
These have lots of different names (company, ltd, inc)
http://en.wikipedia.org/wiki/Salomon_v_A_Salomon_&_Co_Ltd
Basically, the corporation is treated as a separate legal entity. Each shareholder (owner) has limited liability equal only to the dollar amount of the company which they own as shares
-Corporations are easier to finance (many different people can become part owners and finance corporations as shareholders without having to assume liability)
-Shareholders can easily buy and sell their partial ownership (this is what trading stocks and selling shares is all about)
-Usually, the shareholders elect a board of directors, who in turn hire the top-ranking employees (the CEO, CFO, and VPs)
-Corporations are taxed twice: once for corporate profits and once for shareholder dividends.
There are also a few hybrid firms, which combine aspects of several different kinds of firms.
A limited partnership is a cross-breed between a partnership and a company. In a limited partnership, there is at least one general partner with unlimited liability. There can be other limited partners, however, who own limited shares of the business, but aren't involved in running it (kind of like shareholders). Limited partnerships are used to get around security legislation and gives limited partners the chance to invest in riskier operations without being held liable for shortcomings
A limited liability partnership is only available for professionals. It is very similar to a limited partnership, but the limited partners can be involved in the business.
A crown corporation is a company in which the controlling shareholder is the government. The business may function as an entity independent from the government, but often they act as a sounding board for government policy (ie CBC).
Not For Profit Corporations try to just break even, not making any excess profit.
TransNational Corporations (TNGs) are the big boys. THINK McDonalds and Wal-Mart
Proprietorship Partnership Corp
Ownership Easy Easy Easy
Liability Unlimited Unlimited Limited (but with conditions)
Transfer Difficult P-ship Agmnt Easy
Finance Difficult Difficult Easier
Mgmt Easy Tough Separate
Taxes Tough Tough Excruciating
3 problems which small businesses face:
- Government Regulation and payroll taxes (Canada Pension Plan, Unemployment Insurance, Workers Compensation Board)
-Financing Problems
-A lack of Qualified Labor
Canadian Federation of Independent Business is a lobby group for small businesses.
A shelf company is just a piece of paper created by company lawyers. After it is created, a firm needs to raise financial capital (money) to carry on their business.
There are 2 ways most firms do this:
1: Equity Financing: Firms grant others a share of control of their company in return for a gift of money. Investor, however, expect a divident- a return on their investment. It should be noted that this return is completely DISCRETIONARY (firms can withhold it). Capital gain is an increase in the market value of the share (the share becomes more valuable, eg: a stock goes from $12 to $16). If a company pumps profits back into the company instead of distributing them to the shareholders, this is called undistributed profit.
2: Debt Financing: Firms borrow money from external lenders (usually banks)
Debtor = Borrower
Creditor = Lender
Principal = Originally Borrowed Amount
Interest = Extra money paid as a return on the loan
Redemption Date = The date the loan must be repaid
Term = The period between the date of the loan and the redemption date.
There are 3 Kinds of debt instruments!
1: Loans
-Short Terms
-Principal must be repaid
-Interest must be paid
2: Bill and Notes (ie you loan $90 and expect $100 back)
-Short Term
-Principal Guaranteed
-No interest, but sold by debtors to creditors for less than their real worth
3: Bonds and Debentures
-Long term
-Principal must be paid
-Interest payments must be made
Debentures:
If they are unsecured, there is no charge on specific assets
If they are secured all assets which are no specifically secured can be charged
Assets are taken by the creditor in the case of bankruptcies
This lets you use your assets as a credit (ie- you can use your house as a line of credit if it is paid for)
BIG IDEA: We assume that firms want to maximize profit!
This may not happen in corporations where management is hired by the owners. Management may be more focused on increasing their own salaries in this case. Here, they will maximize sales sometimes at the expense of profit.
There IS a range of profit which companies can work within which can be adjusted for different situations while still keeping the owners reasonably happy.
In the end, the companies that make profits are the one which survive. it's evolutionary.
Scary stuff, right?
First-off: The role of the firm.
In economics, we define a firm as any self-contained, profit maximizing entity that produces and sells goods or services (or both)
A firm is an economic construct, and may not necessarily be exactly the same as a "business". There are three main kinds of firms in the economic universe: Single Proprietorships, Partnerships, and Corporations.
Single (Sole) Proprietorship:
In this type of firm, the owner IS the business. For an example, Mr. Wong owns Mr. Wong's Confectionary, so Mr. Wong IS Mr. Wong's Confectionary! What this means is that Mr. Wong is personally liable for all damage done by his business, and will be accordingly held responsible. For an example, if I ate a pie from Mr. Wong's Confectionary and it made me sick, I could sue Mr. Wong's Confectionary for damages and uncleanliness. If I won, Mr. Wong would have to pay me out of his own pocket.
Some other characteristics of proprietorships:
-There is only one owner
-Unlimited liability
-There are obvious incentives for the owner to get the firm to generate profit
-They can be difficult to finance (because the burden of financing proprietorships falls on one individual)
-Transfering ownership is difficult (selling your business can be hard)
-Owners are taxed at the personal rate
Partnership:
In this type of firm, two or more individuals who perform the same kind of work (for an exampple, two laser hair removal specialists) join together under a contract in order to make PROFIT! This partnership is legal and binding. What it entails is that all of the individuals who have entered the partnership are jointly liable for all damage their business causes. For an example if I get laser hair removal from doctor A, and the procedures somehow gives me skin cancer, I can sue A & B hair removal and force Doctor B to pay me for damages out of his own pocket, even though he had nothing to do with me contracting skin cancer. For this reason, it is important to REALLY TRUST anyone you enter a partnership with.
Some other characteristics of partnerships:
-2 or more owners
-Unlimited shared liability
-They can be difficult to finance (because the burden of financing proprietorships falls on only a few individual)
-Transfering ownership is difficult (selling your small business can be hard, especially if you are a group of specialized professionals and there is no one with a similar skill set who is willing to take over your business)
-Owners are taxed at the personal rate
Both of these types of firms can be very risky to own, due to the unlimited liability imposed on all owners. SO, laws were invented to pave the way for...
THE CORPORATION:
These have lots of different names (company, ltd, inc)
http://en.wikipedia.org/wiki/Salomon_v_A_Salomon_&_Co_Ltd
Basically, the corporation is treated as a separate legal entity. Each shareholder (owner) has limited liability equal only to the dollar amount of the company which they own as shares
-Corporations are easier to finance (many different people can become part owners and finance corporations as shareholders without having to assume liability)
-Shareholders can easily buy and sell their partial ownership (this is what trading stocks and selling shares is all about)
-Usually, the shareholders elect a board of directors, who in turn hire the top-ranking employees (the CEO, CFO, and VPs)
-Corporations are taxed twice: once for corporate profits and once for shareholder dividends.
There are also a few hybrid firms, which combine aspects of several different kinds of firms.
A limited partnership is a cross-breed between a partnership and a company. In a limited partnership, there is at least one general partner with unlimited liability. There can be other limited partners, however, who own limited shares of the business, but aren't involved in running it (kind of like shareholders). Limited partnerships are used to get around security legislation and gives limited partners the chance to invest in riskier operations without being held liable for shortcomings
A limited liability partnership is only available for professionals. It is very similar to a limited partnership, but the limited partners can be involved in the business.
A crown corporation is a company in which the controlling shareholder is the government. The business may function as an entity independent from the government, but often they act as a sounding board for government policy (ie CBC).
Not For Profit Corporations try to just break even, not making any excess profit.
TransNational Corporations (TNGs) are the big boys. THINK McDonalds and Wal-Mart
Proprietorship Partnership Corp
Ownership Easy Easy Easy
Liability Unlimited Unlimited Limited (but with conditions)
Transfer Difficult P-ship Agmnt Easy
Finance Difficult Difficult Easier
Mgmt Easy Tough Separate
Taxes Tough Tough Excruciating
3 problems which small businesses face:
- Government Regulation and payroll taxes (Canada Pension Plan, Unemployment Insurance, Workers Compensation Board)
-Financing Problems
-A lack of Qualified Labor
Canadian Federation of Independent Business is a lobby group for small businesses.
A shelf company is just a piece of paper created by company lawyers. After it is created, a firm needs to raise financial capital (money) to carry on their business.
There are 2 ways most firms do this:
1: Equity Financing: Firms grant others a share of control of their company in return for a gift of money. Investor, however, expect a divident- a return on their investment. It should be noted that this return is completely DISCRETIONARY (firms can withhold it). Capital gain is an increase in the market value of the share (the share becomes more valuable, eg: a stock goes from $12 to $16). If a company pumps profits back into the company instead of distributing them to the shareholders, this is called undistributed profit.
2: Debt Financing: Firms borrow money from external lenders (usually banks)
Debtor = Borrower
Creditor = Lender
Principal = Originally Borrowed Amount
Interest = Extra money paid as a return on the loan
Redemption Date = The date the loan must be repaid
Term = The period between the date of the loan and the redemption date.
There are 3 Kinds of debt instruments!
1: Loans
-Short Terms
-Principal must be repaid
-Interest must be paid
2: Bill and Notes (ie you loan $90 and expect $100 back)
-Short Term
-Principal Guaranteed
-No interest, but sold by debtors to creditors for less than their real worth
3: Bonds and Debentures
-Long term
-Principal must be paid
-Interest payments must be made
Debentures:
If they are unsecured, there is no charge on specific assets
If they are secured all assets which are no specifically secured can be charged
Assets are taken by the creditor in the case of bankruptcies
This lets you use your assets as a credit (ie- you can use your house as a line of credit if it is paid for)
BIG IDEA: We assume that firms want to maximize profit!
This may not happen in corporations where management is hired by the owners. Management may be more focused on increasing their own salaries in this case. Here, they will maximize sales sometimes at the expense of profit.
There IS a range of profit which companies can work within which can be adjusted for different situations while still keeping the owners reasonably happy.
In the end, the companies that make profits are the one which survive. it's evolutionary.
Wednesday, October 14, 2009
Econ 101 Indifference Curves:
Indifference curves are graphs which incorporate the idea of tastes or preferences.
We assume that consumers are rational thinkers, and that they can rank their preferences. There are three parts to this 'rationality':
1- COMPLETE the consumer must either prefer good A to good B, good B to good A, or be indifferent
2- REFLEXIVE A is always as good as A. Preferences don't change based on exogenous variables
3- TRANSITIVE If A > B and B > C, then A > C
THESE SUBJECTIVE PREFERENCES ARE INDEPENDANT (EXOGENOUS).
-We cannot make comparisons between different people (because you can't compare my happiness to yours)
-We cannot make comparisons between different times
-This shows us that psychology is the basis of microeconomics!
HOKAY! Now that the background stuff is out of the way, let's actually look at one of these again.
FUNCTION OF A UTILITY CURVE: U = U(x,y) higher number = higher utility...
All of the different points on one indifference curve show different combined quantities of 2 goods (x and y) which yield a constant total utility.
Because the utility derived from any product is different for different people, the indifference curve shows PERSONAL PREFERENCES.
CHARACTERISTICS:
For any two products, there are an infinite number of indifference curves expanding outward. The total utility for each progressive curve is higher than the last one, because each progressive curve represents a greater combined quantity of goods x and y, and in most cases, we prefer to have MORE (more goods = greater total utility).
Two indifference curves for the same product cannot cross, because that would suggest that we can achieve the same total utility with a set combination of x and y as we could with the same quantity of x, but fewer of y. Also the point of intersection would imply two different total utilities for the same combination of goods. That's illogical.
EQUATION: Change in X (Marginal utility of X) + Change in Y (Marginal utility of Y) = 0
Why? Because if two points are on the same indifference curve, the utility lost on one axis is gained on the other axis.
utility lost = Change in X (Marginal utility of X)
utility gained = Change in Y (Marginal utility of Y)
The slope of the indifference curve = change in X/change in Y
OR
negative marginal utility of X/marginal utility of Y
OR
the marginal rate of substitution!
COMBINING BUDGET LINES AND INDIFFERENCE CURVES:
both budget lines and indifference curves have the same axes: quantities of different products. Budget lines show us possible combinations of different products, and indifference curve show us desired combinations of different products!
REMEMBER, price changes are represented as rotations or stretches of the budget line. SO, if the price of soda falls, the budget line for soda stretches out further along the x-axis, and the possible quantity of soda increases. Consumers want to maximize total utility, so places where the indifference line meets the budget line represent the demanded combinations of goods, given the prices of both products. As the prices of a good falls, consumers substitute into that good in order to reach higher indifference curves with the stretched budget line.
.
In this way, we can see the formation of a demand curve- consumers buy greater quantities of a product as the price decreases in order to maximize total utility (intersect with the highest indifference curve). This results in a negatively sloped demand curve.
-------------
We assume that consumers are rational thinkers, and that they can rank their preferences. There are three parts to this 'rationality':
1- COMPLETE the consumer must either prefer good A to good B, good B to good A, or be indifferent
2- REFLEXIVE A is always as good as A. Preferences don't change based on exogenous variables
3- TRANSITIVE If A > B and B > C, then A > C
THESE SUBJECTIVE PREFERENCES ARE INDEPENDANT (EXOGENOUS).
-We cannot make comparisons between different people (because you can't compare my happiness to yours)
-We cannot make comparisons between different times
-This shows us that psychology is the basis of microeconomics!
HOKAY! Now that the background stuff is out of the way, let's actually look at one of these again.
FUNCTION OF A UTILITY CURVE: U = U(x,y) higher number = higher utility...
All of the different points on one indifference curve show different combined quantities of 2 goods (x and y) which yield a constant total utility.
Because the utility derived from any product is different for different people, the indifference curve shows PERSONAL PREFERENCES.
CHARACTERISTICS:
For any two products, there are an infinite number of indifference curves expanding outward. The total utility for each progressive curve is higher than the last one, because each progressive curve represents a greater combined quantity of goods x and y, and in most cases, we prefer to have MORE (more goods = greater total utility).
Two indifference curves for the same product cannot cross, because that would suggest that we can achieve the same total utility with a set combination of x and y as we could with the same quantity of x, but fewer of y. Also the point of intersection would imply two different total utilities for the same combination of goods. That's illogical.
EQUATION: Change in X (Marginal utility of X) + Change in Y (Marginal utility of Y) = 0
Why? Because if two points are on the same indifference curve, the utility lost on one axis is gained on the other axis.
utility lost = Change in X (Marginal utility of X)
utility gained = Change in Y (Marginal utility of Y)
The slope of the indifference curve = change in X/change in Y
OR
negative marginal utility of X/marginal utility of Y
OR
the marginal rate of substitution!
COMBINING BUDGET LINES AND INDIFFERENCE CURVES:
both budget lines and indifference curves have the same axes: quantities of different products. Budget lines show us possible combinations of different products, and indifference curve show us desired combinations of different products!
REMEMBER, price changes are represented as rotations or stretches of the budget line. SO, if the price of soda falls, the budget line for soda stretches out further along the x-axis, and the possible quantity of soda increases. Consumers want to maximize total utility, so places where the indifference line meets the budget line represent the demanded combinations of goods, given the prices of both products. As the prices of a good falls, consumers substitute into that good in order to reach higher indifference curves with the stretched budget line.
.In this way, we can see the formation of a demand curve- consumers buy greater quantities of a product as the price decreases in order to maximize total utility (intersect with the highest indifference curve). This results in a negatively sloped demand curve.
-------------
Friday, October 9, 2009
Econ 101: More on deriving supply curves!
UBC is pretty awesome according to the Globe and Mail.
OKAY:
Conspicuous Consumption Goods
Veblen coined this term in 1900 with "The Theory of the Leisure Class"
Basically, he asserted that certain goods have "snob appeal" and can be seen as "status symbols"
Things like designer clothes and big expensive cars.
Here, the substitution effect is POSITIVE! So, as relative prices of conspicuous consumption goods rise, consumers buy more of them. What this shows is that:
-Happiness is relative (we often derive our happiness by comparing what we have with what other people have. As such, exclusive products (made exclusive through high prices) often make us very very very happy.
-There is a great deal of passive consumption which occurs. Advertisements brainwash us into buying certain products, and we never really question whether we really like them, or if we are just buying them because we feel we have to.
Conspicuous Consumption Goods:
-The demand would probably be negatively sloped if consumers could buy the good without anyone knowing the prices (in other words, the public knowledge of the exclusivity of the product is what causes this positive substitution effect). It isn't as simple as we'd like to think- sometimes dropping the price will sell more.
-These goods may exist for the individual, but not for the entire market
BEWARE: A positive substitution effect may look like an overly positive income effect... but these two situations are very different.
Giffen Good: Negative substitution effect over shadowed by price effect
Conspicuous Consumption Good: The Substitution Effect is positive.
CONSUMER SURPLUS:
We can arrange the maximized total utility formula like so:
The marginal utility of product X = (The Price of Product X / The Price of Y) X The Marginal Utility of Y
Let Y be money.
Let the price of 1$ be 1
Let the marginal utility of money remain constant.
Then..
The marginal utility of a product is the price of that product times the marginal utility of money! Thus, demand is a marginal utility curve.
So...
The marginal utility gained from an extra unit of product X is the utility of the money spent to purchase that good.
WE KNOW that marginal utility diminishes as consumption increases
WE KNOW that the marginal utility of a product is the price of that product times the marginal utility of money.... so
Consumer surplus is the difference between what the consumer is willing to pay, and what the consumer must pay for a product.
The demand curve price is the price the consumer is willing to pay for each additional unit of a good (notice, it goes down as more and more of the good is consumed)
The market price is the price consumers actually pay to receive this good.
The total utility lost is the boxed area.
The total utility gained is the entire pencil-shaped area
The consumer surplus is the difference between what the consumer is willing to pay and what the consumer must pay. It's FREE HAPPINESS!
The producer surplus is the difference between the cost of producing each unit and the market price.
THE PARADOX OF VALUE:
People value water very highly, and yet they pay a very low price for it. Why? Because the MARGINAL UTILITY of water is very low compared to other products (1 glass of water is not worth as much to us as one glass of coke). The important point is not to mistake total utility for marginal utility.
HOKAY
Now onto the next part of this unit:
---------------------------
Indifference Curve Analysis:
Decision Theory or Choice Theory:
-There are three factors at work when we choose how to allocate our incomes: How large are incomes are, the prices of the products we want to purchase, and our personal tastes.
A BUDGET LINE shows all possible combinations of two goods given your income (Y) and the price of the two goods (sort of like a PPC, but for consumers).
A budget line incorporates two of the three factors: income and prices.
So let's say tacos cost $1 and burgers cost $3. I have a $30 income, so this is my budget line:
The maximum quantity of tacos I can buy is 30
The maximum quantity of burgers I can buy is 10
We can play with the prices and incomes to change the shape of the budget line.
THE EQUATION OF A BUDGET LINE:
(Price of Product A X Quantity of Product A) + (Price of Product B X Quantity of Product B) = Income
The slope = -(price of product on X axis/price of product on Y axis)
or... -(maximum quantity of product on Y axis/maximum quantity of product on X axis)
or -(income/price of the product on the Y axis)/(income/price of the product on the x axis)
The slope is the ratio of the relative prices
The slope is also the opportunity cost.
If income changes, the budget line moves parallel to it's previous position. It's a positive relation. If income increases, it shifts out and vice versa.
If relative price change, then the budget line will rotate and the slope will change. As price increases on one axis, the quantity decreases for that product, so there is a negative relation.
A proportional change in both price is like an income change (ie a price effect)
If both prices and your income change proportionally, the budget line will not change.
THATS ALL!
OKAY:
Conspicuous Consumption Goods
Veblen coined this term in 1900 with "The Theory of the Leisure Class"
Basically, he asserted that certain goods have "snob appeal" and can be seen as "status symbols"
Things like designer clothes and big expensive cars.
Here, the substitution effect is POSITIVE! So, as relative prices of conspicuous consumption goods rise, consumers buy more of them. What this shows is that:
-Happiness is relative (we often derive our happiness by comparing what we have with what other people have. As such, exclusive products (made exclusive through high prices) often make us very very very happy.
-There is a great deal of passive consumption which occurs. Advertisements brainwash us into buying certain products, and we never really question whether we really like them, or if we are just buying them because we feel we have to.
Conspicuous Consumption Goods:
-The demand would probably be negatively sloped if consumers could buy the good without anyone knowing the prices (in other words, the public knowledge of the exclusivity of the product is what causes this positive substitution effect). It isn't as simple as we'd like to think- sometimes dropping the price will sell more.
-These goods may exist for the individual, but not for the entire market
BEWARE: A positive substitution effect may look like an overly positive income effect... but these two situations are very different.
Giffen Good: Negative substitution effect over shadowed by price effect
Conspicuous Consumption Good: The Substitution Effect is positive.
CONSUMER SURPLUS:
We can arrange the maximized total utility formula like so:
The marginal utility of product X = (The Price of Product X / The Price of Y) X The Marginal Utility of Y
Let Y be money.
Let the price of 1$ be 1
Let the marginal utility of money remain constant.
Then..
The marginal utility of a product is the price of that product times the marginal utility of money! Thus, demand is a marginal utility curve.
So...
The marginal utility gained from an extra unit of product X is the utility of the money spent to purchase that good.
WE KNOW that marginal utility diminishes as consumption increases
WE KNOW that the marginal utility of a product is the price of that product times the marginal utility of money.... so
Consumer surplus is the difference between what the consumer is willing to pay, and what the consumer must pay for a product.
The demand curve price is the price the consumer is willing to pay for each additional unit of a good (notice, it goes down as more and more of the good is consumed)
The market price is the price consumers actually pay to receive this good.
The total utility lost is the boxed area.
The total utility gained is the entire pencil-shaped area
The consumer surplus is the difference between what the consumer is willing to pay and what the consumer must pay. It's FREE HAPPINESS!
The producer surplus is the difference between the cost of producing each unit and the market price.
THE PARADOX OF VALUE:
People value water very highly, and yet they pay a very low price for it. Why? Because the MARGINAL UTILITY of water is very low compared to other products (1 glass of water is not worth as much to us as one glass of coke). The important point is not to mistake total utility for marginal utility.
HOKAY
Now onto the next part of this unit:
---------------------------
Indifference Curve Analysis:
Decision Theory or Choice Theory:
-There are three factors at work when we choose how to allocate our incomes: How large are incomes are, the prices of the products we want to purchase, and our personal tastes.
A BUDGET LINE shows all possible combinations of two goods given your income (Y) and the price of the two goods (sort of like a PPC, but for consumers).
A budget line incorporates two of the three factors: income and prices.
So let's say tacos cost $1 and burgers cost $3. I have a $30 income, so this is my budget line:
The maximum quantity of tacos I can buy is 30
The maximum quantity of burgers I can buy is 10
We can play with the prices and incomes to change the shape of the budget line.
THE EQUATION OF A BUDGET LINE:
(Price of Product A X Quantity of Product A) + (Price of Product B X Quantity of Product B) = Income
The slope = -(price of product on X axis/price of product on Y axis)
or... -(maximum quantity of product on Y axis/maximum quantity of product on X axis)
or -(income/price of the product on the Y axis)/(income/price of the product on the x axis)
The slope is the ratio of the relative prices
The slope is also the opportunity cost.
If income changes, the budget line moves parallel to it's previous position. It's a positive relation. If income increases, it shifts out and vice versa.
If relative price change, then the budget line will rotate and the slope will change. As price increases on one axis, the quantity decreases for that product, so there is a negative relation.
A proportional change in both price is like an income change (ie a price effect)
If both prices and your income change proportionally, the budget line will not change.
THATS ALL!
Monday, October 5, 2009
ECON 101: The beginning of consumer behavior
WE ARE STARTING TO LOOK AT CONSUMER BEHAVIOR!
Isn't it exciting!? In order to nicely coordinate with the way the midterm is working out, we are going to spread this unit out over a period of two weeks. The online test won't pop up until the 16th.
An interesting note: Prof Gateman thinks that population growth is the reason behind all of the world's problems.
OKAY! For this unit, we are going BEHIND the demand curve to discover what the psychological link is between consumer behavior and HAPPINESS
For instance, we will discover why the demand of a Louis Vitton Purse increases when the price increases. Sounds crazy? It might be, but it works, and we're going to find out why!
--------------
WE'RE STARTING WITH MARGINAL UTILITY ANALYSIS
In order to add up total demand for any specific product, we set the price for the product and then add up the quantity each individual consumer demands at that price (ceteris paribus) to find the total. The total market demand is the sum of each individual household's demand for the product!
Super-easy, right?
Total demand + total supply = An economy, but we don't get to total supply until next chapter...
See, there is a chain of 'bigness'
Individual consumer preferences make up household demand
Total household demand makes up market demand
Market demand plus market supply makes up an economy
An economy is awesome and interesting
In the mean while, we need to come to understand the basis for that demand at the individual consumer level.
HOKAY, now for the juicy stuff: MARGINAL UTILITY THEORY
Utility: We define utility as satisfaction, happiness, fulfillment of a want. Sometimes utility is also used as a method ranking products, or illustrating personal preferences.
Utility is an ORDINAL MEASURE (which means that we can rank utility, but unlike a cardinal measure, we cannot assign specific numeric value to it)
TOTAL UTILITY is the total satisfaction derived from consuming all units of the good (for instance, the total amount of satisfaction I derive from chugging 10 bottles of beer)
MARGINAL (extra, or incremental) UTILITY is the change in total utility which occurs as a result of consuming one additional unit of the good (ie, the amount of satisfaction I derive from chugging the 10th bottle of beer)
There is this thing in economics, and it is known as the
LAW OF DIMINISHING MARGINAL UTILITY
What it means is that marginal utility decreases as we continue to consume a certain product AFTER A CERTAIN POINT (ceteris paribus)
SEE!?
Why does this happen?
Well, it's because of opportunity cost. Usually, consumers are willing to give up more for the first quantity of a product than the for the 39th quantity of a product. A good example here is water. We would give up a LOT in order to have use of at least 1 litre of water per day. We would give up a significantly smaller amount to have use of 390 litres of water per day.
The FORMULAS:
Marginal Utility = (Change in Total Utility)/(Change in Quantity)
Marginal Utility is a derivative of total utility with regard to quantity
Total utility = The sum of the marginal utilities
Total utility is an integral of marginal utility
Let's review:
-Total utilty increases as a decreasing rate after a certain point (ceteris paribus)
-Marginal utility is the change in total utility divided by the change in quantity
-The slope of a line between two points on a total utility curve is the marginal utility of that product for that change in quantity
-Generally, total utility curve is S-shaped
The point where marginal utility stops increasing and begins to decrease is the inflexion point.
The reason why marginal utlity rises up to the inflexion point is that usually, the first bit of a product makes you crave or require even more of it (it's psychological).
After the inflexion point, total utility can still increase, but at a decreasing rate.
So... what can we do with this knowledge?
WELL we can try and maximize our utility, given two different products at different prices.
IN ECONOMICS, WE ALWAYS ASSUME THAT INDIVIDUALS SEEK TO MAXIMIZE THEIR TOTAL UTILITY. (We call this maximization principle). Individuals prefer happiness to unhappiness.
We will prove that individuals allocate income such that the utilty gained from the last dollar spent on each good is equal. In other words, that marginal utility per price on each good is equal. This can be expressed as an equation.
(marginal utility of product 1)/(Price of Product 1) = (Marginal utility of product 2)/(Price of product 2)
WE MAXIMIZE THE TOTAL UTILITY BY EQUATING THE MARGINAL UTILITIES.
Why do we use 'per dollar' utility? Because utility gained from one very expensive product is going to be much higher than utility gained from one cheap product, so we have to accomodate for that.
In these equations, we always assume that there is no utility gained by holding on to money (unless the money is considered a good, like in currency exchange scenarios)
So just think about that for a little while...
Isn't it exciting!? In order to nicely coordinate with the way the midterm is working out, we are going to spread this unit out over a period of two weeks. The online test won't pop up until the 16th.
An interesting note: Prof Gateman thinks that population growth is the reason behind all of the world's problems.
OKAY! For this unit, we are going BEHIND the demand curve to discover what the psychological link is between consumer behavior and HAPPINESS
For instance, we will discover why the demand of a Louis Vitton Purse increases when the price increases. Sounds crazy? It might be, but it works, and we're going to find out why!
--------------
WE'RE STARTING WITH MARGINAL UTILITY ANALYSIS
In order to add up total demand for any specific product, we set the price for the product and then add up the quantity each individual consumer demands at that price (ceteris paribus) to find the total. The total market demand is the sum of each individual household's demand for the product!
Super-easy, right?
Total demand + total supply = An economy, but we don't get to total supply until next chapter...
See, there is a chain of 'bigness'
Individual consumer preferences make up household demand
Total household demand makes up market demand
Market demand plus market supply makes up an economy
An economy is awesome and interesting
In the mean while, we need to come to understand the basis for that demand at the individual consumer level.
HOKAY, now for the juicy stuff: MARGINAL UTILITY THEORY
Utility: We define utility as satisfaction, happiness, fulfillment of a want. Sometimes utility is also used as a method ranking products, or illustrating personal preferences.
Utility is an ORDINAL MEASURE (which means that we can rank utility, but unlike a cardinal measure, we cannot assign specific numeric value to it)
TOTAL UTILITY is the total satisfaction derived from consuming all units of the good (for instance, the total amount of satisfaction I derive from chugging 10 bottles of beer)
MARGINAL (extra, or incremental) UTILITY is the change in total utility which occurs as a result of consuming one additional unit of the good (ie, the amount of satisfaction I derive from chugging the 10th bottle of beer)
There is this thing in economics, and it is known as the
LAW OF DIMINISHING MARGINAL UTILITY
What it means is that marginal utility decreases as we continue to consume a certain product AFTER A CERTAIN POINT (ceteris paribus)
SEE!?
Why does this happen?
Well, it's because of opportunity cost. Usually, consumers are willing to give up more for the first quantity of a product than the for the 39th quantity of a product. A good example here is water. We would give up a LOT in order to have use of at least 1 litre of water per day. We would give up a significantly smaller amount to have use of 390 litres of water per day.
The FORMULAS:
Marginal Utility = (Change in Total Utility)/(Change in Quantity)
Marginal Utility is a derivative of total utility with regard to quantity
Total utility = The sum of the marginal utilities
Total utility is an integral of marginal utility
Let's review:
-Total utilty increases as a decreasing rate after a certain point (ceteris paribus)
-Marginal utility is the change in total utility divided by the change in quantity
-The slope of a line between two points on a total utility curve is the marginal utility of that product for that change in quantity
-Generally, total utility curve is S-shaped
The point where marginal utility stops increasing and begins to decrease is the inflexion point.
The reason why marginal utlity rises up to the inflexion point is that usually, the first bit of a product makes you crave or require even more of it (it's psychological).
After the inflexion point, total utility can still increase, but at a decreasing rate.
So... what can we do with this knowledge?
WELL we can try and maximize our utility, given two different products at different prices.
IN ECONOMICS, WE ALWAYS ASSUME THAT INDIVIDUALS SEEK TO MAXIMIZE THEIR TOTAL UTILITY. (We call this maximization principle). Individuals prefer happiness to unhappiness.
We will prove that individuals allocate income such that the utilty gained from the last dollar spent on each good is equal. In other words, that marginal utility per price on each good is equal. This can be expressed as an equation.
(marginal utility of product 1)/(Price of Product 1) = (Marginal utility of product 2)/(Price of product 2)
WE MAXIMIZE THE TOTAL UTILITY BY EQUATING THE MARGINAL UTILITIES.
Why do we use 'per dollar' utility? Because utility gained from one very expensive product is going to be much higher than utility gained from one cheap product, so we have to accomodate for that.
In these equations, we always assume that there is no utility gained by holding on to money (unless the money is considered a good, like in currency exchange scenarios)
So just think about that for a little while...
Wednesday, September 30, 2009
Econ 101: A Jarring Look at Agriculture Markets
Hokay!
Farmers basically experience two kinds of problems which make their lives miserables.
THE LONG TERM PROBLEM is that farmer's incomes fall, relative to the incomes of urban workers. There are three reasons for this.
1: Increasing domestic supply: as time moves on and technologies improve in farming, the domestic supply of farmed products shifts to the right (increases). This wouldn't be necessarily such a bad thing if demand would also shift to the right... however...
2: The is a lagging domestic demand for farm products: Because farm products are necessities (food), they have low income elasticity. As such, increases in income do not cause consumers to purchase much more farm products.
also
3: The is a decreased demand for exported farm goods: There is less of a demand now for Canadian farm products on the global market because countries which we have sold to in the past now produce their own farmed goods domestically.
So basically, demand for farm products remains relatively stagnant, while the supply of farm products increases. This means that the price of farm products inevitally drops, as do farmer incomes.
AGRICULTURE SUPPORT: RAISING INCOME
Government argicultural policy often aims to raise farmer's incomes above what they would make selling goods at equilibrium prices (in addition to stabilizing incomes).
There are two ways to maintain an effective price floor above the equilibrium price
1: PRICE SUPPORT
In price support, the government legislates an effectual price floor, by buying all of a farmer's output at a set price higher than the equilibrium price. By doing this, the government creates a situation where demand is perfectly elastic (and prices will not change regardless of quantity supplied).
The price and quantity exchanged both rise from the orginal equilibrium level. There is, however, an excess in supply (the farmers produce more than customers will actually buy at that set price). Excess supply is stockpiled each year.
The government is subidizing an amount equal to (the artificially inflated price) X (The excess in demand)
The consumer is subsidizing an amount equal to (quantity demanded at inflated prices) X (The difference between the equilibrium price, and the inflated price)
BASICALLY, this method allows farmers to make more money by rellocating money from the consumer and from the taxpayer.
2: QUOTAS
In a quota scenario, the government sets a limit on the quantity of a farm good that is supplied (like a quantity wall). The quota quantity is less than the equilibrium quantity, and as such, the price at the quota quantity is higher than the equilibrium price.
The effect is that quota holders get extra revenue equal to (the difference between the price demanded at the quota quantity and the price supplied at quota quantities)
Because demand is inelastic if for whatever reason quantity falls, farmer's total renevues increase! And quantity cannot rise above the quota level.
Pe X Qe < Pq X Qq BECAUSE OF INELASTIC DEMAND
Advantages: Farmer's income is stabilized without stockpiling
Disadvantages: The consumer pays more for less, and the cost of purchasing quota rights effectually allows quota licenses to become a market in and of themselves.
-----------------------------------
-------------------------------------
----------------------------------------
--------------------------------------------
THE SHORT TERM PROBLEM is that the prices of farm products fluctuate tremendously, and as a result, the farmer has a difficult time securing a steady income. These fluctuations can happen on a few levels.
INTERNATION MARKETS- changes in world prices cause changes in export prices. When the world market goes up or down, farmers make more or less money off of exports.
Basically, the demand in the world market is perfectly elastic, because Canada's contributions to international farm product markets are so small, they are practically insignificant. As a result, whatever quantities Canadian producers put on the international market do not affect the price determined for the product. FARMERS HAVE NO CONTROL OVER FLUCTUATIONS IN WORLD PRICE. Because prices are uncontrollable, farmers incomes increase in the same direction as supply (if the weather is good for some reason and a large crop is harvested, they make more money) and vice versa. Farmer incomes also increase when world prices arbitrarily rise, and fall when world prices fall.
The big complaint for farmers is that they have very little control over their incomes due to these uncontrollable changes in both the world market and their own supply. As a result, the government will often step in and try and fix things.
STABILIZATION POLICIES FOR INTERNATIONAL MARKETS (in order to adjust for fluctuations)
1: Stabilize Quantity!
How? Stockpile farm products when there are too many being produced (a good year), and then dip into this stockpile when there is not enough being produced (a bad year)
Problems: This won't work for perishable items, and also, there are extra costs farmers will have to pay to stockpile their products.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
2: Stabilize Price!
How? Create a system of 'guarunteed price' where the government subsidizes farmers when world prices are too low, and farmers pay the government when the prices are too high.
Major Problem: How do you determine what prices are too high and which are too low? If the government sets the 'ideal' price at a rate which does not correspond to acceptable world prices, either the government or the farmers will be getting a bad deal.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
DOMESTIC MARKETS- Basically, supply is inelastic from year to year (farmers can't substitute inputs and change production mid-growing season without much difficulty), and unplanned changes can occur to this inelastic supply due to changes in weather or other uncontrollable factors.
Domestic demand for farm products is very inelastic (there isn't a whole lot of substitution people can make for food). Because price is so inelastic, farmers can ACTUALLY LOSE OVERALL PROFIT by supplied a LARGER QUANTITY THAN EXPECTED (because, remember, total revenue is price X quantity, and for inelastic demand, total revenue increases when you lower quantity exchanged and increase the price). In other words, farmers incomes will fluctuate in the same direction as the price, and in the opposite direction to supply (the higher the price of wheat, the more money wheat farmers will make), and exogenous factors can raise or lower the price of wheat (by changing the quantity supplied)
HOKAY! Farmers hate this because again, they have no control over their own incomes.
THIS IS WHAT THE GOVERNMENT DOES!
1: Stabilize Quantity!
How? Stockpile farm products when there are too many being produced (a good year), and then dip into this stockpile when there is not enough being produced (a bad year)
Problems: This won't work for perishable items, and also, there are extra costs farmers will have to pay to stockpile their products.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
2: Stabilize Price!
How? Create a system of 'guarunteed price' where the government subsidizes farmers when world prices are too low, and farmers pay the government when the prices are too high.
Major Problem: How do you determine a good average price? Also, farm income will still vary with the quantity supplied.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
3: Suggestions for income stabilization in domestic markets:
-With too little government intervention, farmer incomes will vary inversely with supply. (The artificial demand curve is too inelastic)
-With too much government intervention, farmer incomes will vary directly with supply. (The artificial demand curve is too elastic)
-So in order to be most effective, the government tries to intervene in an intermediate fashion by providing unit elasticity. In other words, the government's 'guaranteed' price for farm products will vary in an inverse proportion to the quantity.
FOR EXAMPLE: If output rises 10%, the government allows the 'guaranteed price' to fall 10%, so total revenue remains unchanged.
Agricultural Policies in CANADA:
1: DIFFERENT KINDS OF MARKETING BOARDS
a) Supply Management (which is a marketing board)
-sets quotas
-used for milk, eggs, cheese, butter, and poultry
-they are provincial bodies
-they allow for huge profits for farmers... at the expense of the consumer
-Food processor (who buy farm products as inputs) also incur high costs
-In 1995, the quotas were replaced tariff equivalents in order to conform with the World Trade Organization. The tariffs were set as high at 300% though, so our farmers are still making a lot of money
b) Marketing Agents
-The Canadian Wheat Board in an example of this
-Every farmer is required to sell all of their wheat to the Canadian wheat board
-The wheat board pays the farmer the world price for their wheat
2: INCOME SUPPLEMENTS
"Farm safety net programs"
-Crop failure insurance
-Income stabilization
-Bailouts
Farms are pretty big businesses... small farmers are pretty much a thing of the past. =(
ISN'T IT DEPRESSING!?
Farmers basically experience two kinds of problems which make their lives miserables.
THE LONG TERM PROBLEM is that farmer's incomes fall, relative to the incomes of urban workers. There are three reasons for this.
1: Increasing domestic supply: as time moves on and technologies improve in farming, the domestic supply of farmed products shifts to the right (increases). This wouldn't be necessarily such a bad thing if demand would also shift to the right... however...
2: The is a lagging domestic demand for farm products: Because farm products are necessities (food), they have low income elasticity. As such, increases in income do not cause consumers to purchase much more farm products.
also
3: The is a decreased demand for exported farm goods: There is less of a demand now for Canadian farm products on the global market because countries which we have sold to in the past now produce their own farmed goods domestically.
So basically, demand for farm products remains relatively stagnant, while the supply of farm products increases. This means that the price of farm products inevitally drops, as do farmer incomes.
AGRICULTURE SUPPORT: RAISING INCOME
Government argicultural policy often aims to raise farmer's incomes above what they would make selling goods at equilibrium prices (in addition to stabilizing incomes).
There are two ways to maintain an effective price floor above the equilibrium price
1: PRICE SUPPORT
In price support, the government legislates an effectual price floor, by buying all of a farmer's output at a set price higher than the equilibrium price. By doing this, the government creates a situation where demand is perfectly elastic (and prices will not change regardless of quantity supplied).
The price and quantity exchanged both rise from the orginal equilibrium level. There is, however, an excess in supply (the farmers produce more than customers will actually buy at that set price). Excess supply is stockpiled each year.
The government is subidizing an amount equal to (the artificially inflated price) X (The excess in demand)
The consumer is subsidizing an amount equal to (quantity demanded at inflated prices) X (The difference between the equilibrium price, and the inflated price)
BASICALLY, this method allows farmers to make more money by rellocating money from the consumer and from the taxpayer.
2: QUOTAS
In a quota scenario, the government sets a limit on the quantity of a farm good that is supplied (like a quantity wall). The quota quantity is less than the equilibrium quantity, and as such, the price at the quota quantity is higher than the equilibrium price.
The effect is that quota holders get extra revenue equal to (the difference between the price demanded at the quota quantity and the price supplied at quota quantities)
Because demand is inelastic if for whatever reason quantity falls, farmer's total renevues increase! And quantity cannot rise above the quota level.
Pe X Qe < Pq X Qq BECAUSE OF INELASTIC DEMAND
Advantages: Farmer's income is stabilized without stockpiling
Disadvantages: The consumer pays more for less, and the cost of purchasing quota rights effectually allows quota licenses to become a market in and of themselves.
-----------------------------------
-------------------------------------
----------------------------------------
--------------------------------------------
THE SHORT TERM PROBLEM is that the prices of farm products fluctuate tremendously, and as a result, the farmer has a difficult time securing a steady income. These fluctuations can happen on a few levels.
INTERNATION MARKETS- changes in world prices cause changes in export prices. When the world market goes up or down, farmers make more or less money off of exports.
Basically, the demand in the world market is perfectly elastic, because Canada's contributions to international farm product markets are so small, they are practically insignificant. As a result, whatever quantities Canadian producers put on the international market do not affect the price determined for the product. FARMERS HAVE NO CONTROL OVER FLUCTUATIONS IN WORLD PRICE. Because prices are uncontrollable, farmers incomes increase in the same direction as supply (if the weather is good for some reason and a large crop is harvested, they make more money) and vice versa. Farmer incomes also increase when world prices arbitrarily rise, and fall when world prices fall.
The big complaint for farmers is that they have very little control over their incomes due to these uncontrollable changes in both the world market and their own supply. As a result, the government will often step in and try and fix things.
STABILIZATION POLICIES FOR INTERNATIONAL MARKETS (in order to adjust for fluctuations)
1: Stabilize Quantity!
How? Stockpile farm products when there are too many being produced (a good year), and then dip into this stockpile when there is not enough being produced (a bad year)
Problems: This won't work for perishable items, and also, there are extra costs farmers will have to pay to stockpile their products.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
2: Stabilize Price!
How? Create a system of 'guarunteed price' where the government subsidizes farmers when world prices are too low, and farmers pay the government when the prices are too high.
Major Problem: How do you determine what prices are too high and which are too low? If the government sets the 'ideal' price at a rate which does not correspond to acceptable world prices, either the government or the farmers will be getting a bad deal.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
DOMESTIC MARKETS- Basically, supply is inelastic from year to year (farmers can't substitute inputs and change production mid-growing season without much difficulty), and unplanned changes can occur to this inelastic supply due to changes in weather or other uncontrollable factors.
Domestic demand for farm products is very inelastic (there isn't a whole lot of substitution people can make for food). Because price is so inelastic, farmers can ACTUALLY LOSE OVERALL PROFIT by supplied a LARGER QUANTITY THAN EXPECTED (because, remember, total revenue is price X quantity, and for inelastic demand, total revenue increases when you lower quantity exchanged and increase the price). In other words, farmers incomes will fluctuate in the same direction as the price, and in the opposite direction to supply (the higher the price of wheat, the more money wheat farmers will make), and exogenous factors can raise or lower the price of wheat (by changing the quantity supplied)
HOKAY! Farmers hate this because again, they have no control over their own incomes.
THIS IS WHAT THE GOVERNMENT DOES!
1: Stabilize Quantity!
How? Stockpile farm products when there are too many being produced (a good year), and then dip into this stockpile when there is not enough being produced (a bad year)
Problems: This won't work for perishable items, and also, there are extra costs farmers will have to pay to stockpile their products.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
2: Stabilize Price!
How? Create a system of 'guarunteed price' where the government subsidizes farmers when world prices are too low, and farmers pay the government when the prices are too high.
Major Problem: How do you determine a good average price? Also, farm income will still vary with the quantity supplied.
GATEMAN'S AWESOME SUGGESTION: Why not just save extra money made during good years and borrow money lost during bad years (like the rest of us)
3: Suggestions for income stabilization in domestic markets:
-With too little government intervention, farmer incomes will vary inversely with supply. (The artificial demand curve is too inelastic)
-With too much government intervention, farmer incomes will vary directly with supply. (The artificial demand curve is too elastic)
-So in order to be most effective, the government tries to intervene in an intermediate fashion by providing unit elasticity. In other words, the government's 'guaranteed' price for farm products will vary in an inverse proportion to the quantity.
FOR EXAMPLE: If output rises 10%, the government allows the 'guaranteed price' to fall 10%, so total revenue remains unchanged.
Agricultural Policies in CANADA:
1: DIFFERENT KINDS OF MARKETING BOARDS
a) Supply Management (which is a marketing board)
-sets quotas
-used for milk, eggs, cheese, butter, and poultry
-they are provincial bodies
-they allow for huge profits for farmers... at the expense of the consumer
-Food processor (who buy farm products as inputs) also incur high costs
-In 1995, the quotas were replaced tariff equivalents in order to conform with the World Trade Organization. The tariffs were set as high at 300% though, so our farmers are still making a lot of money
b) Marketing Agents
-The Canadian Wheat Board in an example of this
-Every farmer is required to sell all of their wheat to the Canadian wheat board
-The wheat board pays the farmer the world price for their wheat
2: INCOME SUPPLEMENTS
"Farm safety net programs"
-Crop failure insurance
-Income stabilization
-Bailouts
Farms are pretty big businesses... small farmers are pretty much a thing of the past. =(
ISN'T IT DEPRESSING!?
Friday, September 25, 2009
Eco 101 Income and Cross Elasticity
Here's a quick review of what we know.
Elasticity is basically the responsiveness of demand to changes in price.
There are three equations for elasticity. They all work.
Relative Change in Demand/Relative Change in Price
/\ Q / Avg Q
/\ P / Avg P
(Avg P / Avg Q) X (1 / Slope)
INCOME ELASTICITY OF DEMAND IS EXACTLY THE SAME, except instead of responding to changes in Price, demand is responding to changes in Income. As such, we use 'Y' instead of 'P' in the formula
Relative Change in Demand/Relative Change in Price
/\ Q / Avg Q
/\ Y / Avg Y
(Avg Y / Avg Q) X (1 / Slope)
There are two main kinds of goods which are affected by changes in income in different ways.
Normal goods are items which respond positively to changes in income. If your income increases, you buy more of them. As your income decreases, you buy less of them. These include items such as cars or food.
Inferior goods are abnormal goods (although not necessarily of lower quality) which repond negatively to income changes. You buy less of them as your income increases, and more of them as your income decreases. This includes things like Wal-Mart shoes and craft dinner, but it is also dependent on personal tastes. Some inferior goods may be consumed less as income increases, because education also increases as income increases, and these products are considered unhealthy.
LUXURY: Movies (3.5) Electricity (2.0) Autos (1.0) --------> Elasticity is greater than 1
NECESSITIES: Furniture (0.5) Clothing (0.5) Food (0.2)-----> Elasticity is less than 1, but still positive
INFERIOR: Whole Milk (-0.5) Pig Products (-0.2)---------> Elasticity is negative
There are two factors which determine the elasticity of income:
1: Characteristics of the good
2: Taste Preferences
The nature of the good itself will define elasticity, but often, preferences will determine the necessity level of a good. Often, as income increases, there is a move away from staple foods to produce and meats, to restaurant meals.
CROSS ELASTICITY OF DEMAND: The sensitivity of demand in one product to price changes of another product
Relative Change in Demand for Product X/Relative Change in Price for Product Y
/\ QX / Avg QX
/\ PY / Avg PY
(Avg PY / Avg QX) X (1 / Slope)
There are two different scenarios here:
COMPLIMENTARY GOODS: Eg, CDs and Walkman Players
THESE HAVE A NEGATIVE CORRELATION
In other words, the cross elasticity of demand for complimentary goods is negative.
SUBSTITUTE GOODS: EG, Pepsi and Coke
THESE HAVE A POSITIVE CORRELATION
In other words, the cross elasticity of demand for substitute goods is positive
Here is a case scenario which could make us think about the cross elasticity of substitute goods. Gateman was, at one point, down in Ottawa to study this case. Here, Fritto-Lay (a subsidiary of Pepsico) was essentially buying out Hostess Chips (through a multimillion dollar merger). The government saw that this was essentially the creation of a monopoly in the potato chip industry, and rushed in to prevent the merger. The company lawyers for Fritto-Lay, however, were able to conclusively prove that the merger would not, in effect, create a monopoly, because in real markets, other goods such as popcorn and cheese puffs serve as de facto substitute goods for potato chips. Potato chips have a higher cross elasticity of demand with these substitute snack foods, so as a result, Fritto-lay would not be able to create a real market monopoly. Frito-Lay naturally won the case and was allowed the merger..... Hooray!
Elasticity is basically the responsiveness of demand to changes in price.
There are three equations for elasticity. They all work.
Relative Change in Demand/Relative Change in Price
/\ Q / Avg Q
/\ P / Avg P
(Avg P / Avg Q) X (1 / Slope)
INCOME ELASTICITY OF DEMAND IS EXACTLY THE SAME, except instead of responding to changes in Price, demand is responding to changes in Income. As such, we use 'Y' instead of 'P' in the formula
Relative Change in Demand/Relative Change in Price
/\ Q / Avg Q
/\ Y / Avg Y
(Avg Y / Avg Q) X (1 / Slope)
There are two main kinds of goods which are affected by changes in income in different ways.
Normal goods are items which respond positively to changes in income. If your income increases, you buy more of them. As your income decreases, you buy less of them. These include items such as cars or food.
Inferior goods are abnormal goods (although not necessarily of lower quality) which repond negatively to income changes. You buy less of them as your income increases, and more of them as your income decreases. This includes things like Wal-Mart shoes and craft dinner, but it is also dependent on personal tastes. Some inferior goods may be consumed less as income increases, because education also increases as income increases, and these products are considered unhealthy.
LUXURY: Movies (3.5) Electricity (2.0) Autos (1.0) --------> Elasticity is greater than 1
NECESSITIES: Furniture (0.5) Clothing (0.5) Food (0.2)-----> Elasticity is less than 1, but still positive
INFERIOR: Whole Milk (-0.5) Pig Products (-0.2)---------> Elasticity is negative
There are two factors which determine the elasticity of income:
1: Characteristics of the good
2: Taste Preferences
The nature of the good itself will define elasticity, but often, preferences will determine the necessity level of a good. Often, as income increases, there is a move away from staple foods to produce and meats, to restaurant meals.
CROSS ELASTICITY OF DEMAND: The sensitivity of demand in one product to price changes of another product
Relative Change in Demand for Product X/Relative Change in Price for Product Y
/\ QX / Avg QX
/\ PY / Avg PY
(Avg PY / Avg QX) X (1 / Slope)
There are two different scenarios here:
COMPLIMENTARY GOODS: Eg, CDs and Walkman Players
THESE HAVE A NEGATIVE CORRELATION
In other words, the cross elasticity of demand for complimentary goods is negative.
SUBSTITUTE GOODS: EG, Pepsi and Coke
THESE HAVE A POSITIVE CORRELATION
In other words, the cross elasticity of demand for substitute goods is positive
Here is a case scenario which could make us think about the cross elasticity of substitute goods. Gateman was, at one point, down in Ottawa to study this case. Here, Fritto-Lay (a subsidiary of Pepsico) was essentially buying out Hostess Chips (through a multimillion dollar merger). The government saw that this was essentially the creation of a monopoly in the potato chip industry, and rushed in to prevent the merger. The company lawyers for Fritto-Lay, however, were able to conclusively prove that the merger would not, in effect, create a monopoly, because in real markets, other goods such as popcorn and cheese puffs serve as de facto substitute goods for potato chips. Potato chips have a higher cross elasticity of demand with these substitute snack foods, so as a result, Fritto-lay would not be able to create a real market monopoly. Frito-Lay naturally won the case and was allowed the merger..... Hooray!
Wednesday, September 23, 2009
Econ-101-Elasticity continues
Announcements: It's flu season, apparently. If you're sick, don't show up. It's that simple!
Review:
Elasticity of Demand: The sensitivity of quantity demanded to changes in price
Relative change in Q
Relative change in P
or
/\Q / Average Q
/\P / Average P
or
(Average P / Average Q) X (1 / Slope)
It's an oversimplification, but flat demand is more elastic, and steep demand is less elastic. This is due to the increase or decrease in inverted slope
Also, more right-shifted demand curves are less elastic than left-shifted demand curves. This is due to the increase or decrease in average quantity demanded at any price
HOKAY!
Why do we get different sensitivity rates to price changes (elasticity rates) for different products?
Why are certain firms able to get away with 'jacking up the price' of certain products?
THE ANSWER:
Different degrees of availability of substitutes products (outputs on the demand side) effect elasticity. The more options, and higher the quality of available substitutes, the easier it will be for consumers to simply buy a substitute product if the price of a good increases. This means that it is easier for consumers to respond to price changes by lowering or heightening demand for products with many viable substitutes...
MORE SUBSTITUTES = HIGHER ELASTICITY
The more specific a product is, the higher elasticity will be.
Coke is much more elastic as a good than 'pop'
Pop is much more elastic as a good than 'fluids'
TIME PERIOD EFFECTS THINGS
Over time, competition increases, the availability of substitutes increases, and elasticity increases.
PERCEPTION ALSO EFFECTS THINGS
products viewed as 'luxury' items will simply not be purchased if their price is raised. How consumers perceive products effects elasticity.
HOKAY Time for comparisons
NAME SHAPE ELASTICITY REASON
perfectly inelastic vertical line 0 demand never changes with price
inelastic steep line less than 1 /\ Q < /\ P
unit elastic rectangular hyperbola 1 /\ Q = /\ P
elastic flat line more than 1 /\ Q > /\ P
perfectly elastic horizontal line infinite price never changes with demand
THE PRICE ELASTICITY OF SUPPLY!
-the responsiveness of supply to changes in price
-the formulas are the same...
HOWEVER, unit elasticity is a straight line through the origin, not a rectangular hyperbola. Why- ask Jude Drutz!
Here, elasticity is determined by the availability of substitute inputs!
The more viable substitute factors of production you have to work with as a producer, the more elastic the supply if your product will be.
EG: you farm wheat and oats. It is fairly easy to divert production towards wheat if the price of wheat increases, because wheat is a substitute input for many other grain products, it is also easy to divert production away from wheat, because it uses the same machinery and land as other substitute crops. SO WHEAT has a high price elasticity of supply.
Durin fruit is difficult and unique to farm. It requires a very specific method to cultivate and harvest, which is not used to cultivate other fruits. It is very difficult to change the production quantity of Durin in response to price changes, so Durin has low elasticity.
FIN
Review:
Elasticity of Demand: The sensitivity of quantity demanded to changes in price
Relative change in Q
Relative change in P
or
/\Q / Average Q
/\P / Average P
or
(Average P / Average Q) X (1 / Slope)
It's an oversimplification, but flat demand is more elastic, and steep demand is less elastic. This is due to the increase or decrease in inverted slope
Also, more right-shifted demand curves are less elastic than left-shifted demand curves. This is due to the increase or decrease in average quantity demanded at any price
HOKAY!
Why do we get different sensitivity rates to price changes (elasticity rates) for different products?
Why are certain firms able to get away with 'jacking up the price' of certain products?
THE ANSWER:
Different degrees of availability of substitutes products (outputs on the demand side) effect elasticity. The more options, and higher the quality of available substitutes, the easier it will be for consumers to simply buy a substitute product if the price of a good increases. This means that it is easier for consumers to respond to price changes by lowering or heightening demand for products with many viable substitutes...
MORE SUBSTITUTES = HIGHER ELASTICITY
The more specific a product is, the higher elasticity will be.
Coke is much more elastic as a good than 'pop'
Pop is much more elastic as a good than 'fluids'
TIME PERIOD EFFECTS THINGS
Over time, competition increases, the availability of substitutes increases, and elasticity increases.
PERCEPTION ALSO EFFECTS THINGS
products viewed as 'luxury' items will simply not be purchased if their price is raised. How consumers perceive products effects elasticity.
HOKAY Time for comparisons
NAME SHAPE ELASTICITY REASON
perfectly inelastic vertical line 0 demand never changes with price
inelastic steep line less than 1 /\ Q < /\ P
unit elastic rectangular hyperbola 1 /\ Q = /\ P
elastic flat line more than 1 /\ Q > /\ P
perfectly elastic horizontal line infinite price never changes with demand
THE PRICE ELASTICITY OF SUPPLY!
-the responsiveness of supply to changes in price
-the formulas are the same...
HOWEVER, unit elasticity is a straight line through the origin, not a rectangular hyperbola. Why- ask Jude Drutz!
Here, elasticity is determined by the availability of substitute inputs!
The more viable substitute factors of production you have to work with as a producer, the more elastic the supply if your product will be.
EG: you farm wheat and oats. It is fairly easy to divert production towards wheat if the price of wheat increases, because wheat is a substitute input for many other grain products, it is also easy to divert production away from wheat, because it uses the same machinery and land as other substitute crops. SO WHEAT has a high price elasticity of supply.
Durin fruit is difficult and unique to farm. It requires a very specific method to cultivate and harvest, which is not used to cultivate other fruits. It is very difficult to change the production quantity of Durin in response to price changes, so Durin has low elasticity.
FIN
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