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Learning Objectives
By the end of this section, you will be able to:
• Show the relationship between production costs and comparative advantage
• Identify situations of mutually beneficial trade
• Identify trade benefits by considering opportunity costs
What happens to the possibilities for trade if one country has an absolute advantage in everything? This is typical for high-income countries that often have well-educated workers, technologically advanced equipment, and the most up-to-date production processes. These high-income countries can produce all products with fewer resources than a low-income country. If the high-income country is more productive across the board, will there still be gains from trade? Good students of Ricardo understand that trade is about mutually beneficial exchange. Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in one’s comparative advantage.
Production Possibilities and Comparative Advantage
Consider the example of trade between the United States and Mexico described in Table 20.7. In this example, it takes four U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to do so. It takes one U.S. worker to produce 1,000 refrigerators, but it takes four Mexican workers to do so. The United States has an absolute advantage in productivity with regard to both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.
Country Number of Workers needed to produce 1,000 units — Shoes Number of Workers needed to produce 1,000 units — Refrigerators
United States 4 workers 1 worker
Mexico 5 workers 4 workers
Table 20.7 Resources Needed to Produce Shoes and Refrigerators
Absolute advantage simply compares the productivity of a worker between countries. It answers the question, “How many inputs do I need to produce shoes in Mexico?” Comparative advantage asks this same question slightly differently. Instead of comparing how many workers it takes to produce a good, it asks, “How much am I giving up to produce this good in this country?” Another way of looking at this is that comparative advantage identifies the good for which the producer’s absolute advantage is relatively larger, or where the producer’s absolute productivity disadvantage is relatively smaller. The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus five), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus four). So, the comparative advantage of the United States, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexico’s comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes.
Mutually Beneficial Trade with Comparative Advantage
When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. Again, the production possibility frontier is a useful tool to visualize this benefit.
Consider a situation where the United States and Mexico each have 40 workers. For example, as Table 20.8 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). If the 40 workers in the United States are making refrigerators, and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced.
Country Shoe Production — using 40 workers Refrigerator Production — using 40 workers
United States 10,000 shoes or 40,000 refrigerators
Mexico 8,000 shoes or 10,000 refrigerators
Table 20.8 Production Possibilities before Trade with Complete Specialization
As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe production–when labor is transferred from producing the latter to producing the former (see Figure 20.4).
Figure 20.4 Production Possibility Frontiers (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. Point A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade.
Let’s say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Table 20.9 shows the output of each good for each country and the total output for the two countries.
Country Current Shoe Production Current Refrigerator Production
United States 5,000 20,000
Mexico 4,000 5,000
Total 9,000 25,000
Table 20.9 Total Production at Point A before Trade
Continuing with this scenario, suppose that each country transfers some amount of labor toward its area of comparative advantage. For example, the United States transfers six workers away from shoes and toward producing refrigerators. As a result, U.S. production of shoes decreases by 1,500 units (6/4 × 1,000), while its production of refrigerators increases by 6,000 (that is, 6/1 × 1,000). Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. As a result, production of refrigerators in Mexico falls by 2,500 (10/4 × 1,000), but production of shoes increases by 2,000 pairs (10/5 × 1,000). Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table 20.10. The reduction of shoe production by 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States.
Country Shoe Production Refrigerator Production
United States 3,500 26,000
Mexico 6,000 2,500
Total 9,500 28,500
Table 20.10 Shifting Production Toward Comparative Advantage Raises Total Output
This numerical example illustrates the remarkable insight of comparative advantage: even when one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Even though the United States has an absolute advantage in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which it has a comparative advantage. The United States will export refrigerators and in return import shoes.
How Opportunity Cost Sets the Boundaries of Trade
This example shows that both parties can benefit from specializing in their comparative advantages and trading. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country.
Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators (see Figure 20.4 and Table 20.9). Then, in the numerical example given, Mexico shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. Thus, if Mexico can export no more than 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in exchange for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will be able to consume more of both goods than before trade. Mexico will be unambiguously better off. Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. If the United States can export no more than 6,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, it will be able to consume more of both goods and will be unambiguously better off.
The range of trades that can benefit both nations is shown in Table 20.11. For example, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would be able to consume more of both goods than in a world without trade.
The U.S. economy, after specialization, will benefit if it: The Mexican economy, after specialization, will benefit if it:
Exports fewer than 6,000 refrigerators Imports at least 2,500 refrigerators
Imports at least 1,500 pairs of shoes Exports no more than 2,000 pairs of shoes
Table 20.11 The Range of Trades That Benefit Both the United States and Mexico
Trade allows each country to take advantage of lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. If Mexico, instead, produces more shoes and then trades for refrigerators made in the United States, where the opportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the United States. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in Mexico, international trade allows the United States to take advantage of the lower opportunity cost of shoe production in Mexico.
The theory of comparative advantage explains why countries trade: they have different comparative advantages. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. The following Work It Out feature shows how to calculate absolute and comparative advantage and the way to apply them to a country’s production.
Work It Out
Calculating Absolute and Comparative Advantage
In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce 60 barrels of oil or 30 tons of lumber.
Country Oil (barrels) Lumber (tons)
Canada 20 or 40
Venezuela 60 or 30
Table 20.12
1. Who has the absolute advantage in the production of oil or lumber? How can you tell?
2. Which country has a comparative advantage in the production of oil?
3. Which country has a comparative advantage in producing lumber?
4. In this example, is absolute advantage the same as comparative advantage, or not?
5. In what product should Canada specialize? In what product should Venezuela specialize?
Step 1. Make a table like Table 20.12.
Step 2. To calculate absolute advantage, look at the larger of the numbers for each product. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20.
Step 3. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. The country with the lowest opportunity cost has the comparative advantage. With the same labor time, Canada can produce either 20 barrels of oil or 40 tons of lumber. So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. 20/20 oil = 40/20 lumber. 1 oil = 2 lumber. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Calculate the same way for Venezuela: 60 oil = 30 lumber. Divide both sides of the equation by 60. One oil in Venezuela has an opportunity cost of 1/2 lumber. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil.
Step 4. Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. Divide each side of the equation by 40. The opportunity cost of one lumber is 1/2 oil. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Divide each side by 30. One lumber has an opportunity cost of two oil. Canada has the lower opportunity cost in producing lumber.
Step 5. In this example, absolute advantage is the same as comparative advantage. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil.
Step 6. Canada should specialize in the commodity for which it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber.
Comparative Advantage Goes Camping
To build an intuitive understanding of how comparative advantage can benefit all parties, set aside examples that involve national economies for a moment and consider the situation of a group of friends who decide to go camping together. The six friends have a wide range of skills and experiences, but one person in particular, Jethro, has done lots of camping before and is also a great athlete. Jethro has an absolute advantage in all aspects of camping: he is faster at carrying a backpack, gathering firewood, paddling a canoe, setting up tents, making a meal, and washing up. So here is the question: Because Jethro has an absolute productivity advantage in everything, should he do all the work?
Of course not! Even if Jethro is willing to work like a mule while everyone else sits around, he, like all mortals, only has 24 hours in a day. If everyone sits around and waits for Jethro to do everything, not only will Jethro be an unhappy camper, but there will not be much output for his group of six friends to consume. The theory of comparative advantage suggests that everyone will benefit if they figure out their areas of comparative advantage—that is, the area of camping where their productivity disadvantage is least, compared to Jethro. For example, it may be that Jethro is 80% faster at building fires and cooking meals than anyone else, but only 20% faster at gathering firewood and 10% faster at setting up tents. In that case, Jethro should focus on building fires and making meals, and others should attend to the other tasks, each according to where their productivity disadvantage is smallest. If the campers coordinate their efforts according to comparative advantage, they can all gain. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/20%3A_International_Trade/20.03%3A_What_Happens_When_a_Country_Has_an_Absolute_Advantage_in_All_Goods.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify at least two advantages of intra-industry trading
• Explain the relationship between economies of scale and intra-industry trade
Absolute and comparative advantages explain a great deal about global trading patterns. For example, they help to explain the patterns that we noted at the start of this chapter, like why you may be eating fresh fruit from Chile or Mexico, or why lower productivity regions like Africa and Latin America are able to sell a substantial proportion of their exports to higher productivity regions like the European Union and North America. Comparative advantage, however, at least at first glance, does not seem especially well-suited to explain other common patterns of international trade.
The Prevalence of Intra-Industry Trade between Similar Economies
The theory of comparative advantage suggests that trade should happen between economies with large differences in opportunity costs of production. Roughly half of all U.S. trade involves shipping goods between the fairly similar high-income economies of Japan, Canada, and the United States. Furthermore, the trade has an important geographic component—the biggest trading partners of the United States are Canada and Mexico (see Table 20.13).
Country U.S. Exports Go to ... U.S. Imports Come from ...
China 8.6% 17.7%
Canada 17.6% 12.6%
Japan 4.3% 4.3%
Mexico 15.8% 13.6%
South Korea 3.8% 3.3%
Table 20.13 Top Trading Partners (November 2021)
Moreover, the theory of comparative advantage suggests that each economy should specialize to a degree in certain products, and then exchange those products. A high proportion of trade, however, is intra-industry trade—that is, trade of goods within the same industry from one country to another. For example, the United States produces and exports autos and imports autos. Table 20.14 shows some of the largest categories of U.S. exports and imports. In all of these categories, the United States is both a substantial exporter and a substantial importer of goods from the same industry. In 2021, according to the U.S. Census Bureau, the United States exported \$131 billion worth of autos, and imported \$317 billion worth of autos. About 60% of U.S. trade and 60% of European trade is intra-industry trade.
Some U.S. Exports Quantity of Exports (\$ billions) Quantity of Imports (\$ billions)
Autos \$131 \$317
Food and beverages \$147 \$167
Capital goods \$474 \$695
Consumer goods \$201 \$699
Industrial supplies \$578 \$589
Other transportation \$63 \$113
Table 20.14 Some Intra-Industry U.S. Exports and Imports in 2021
Why do similar high-income economies engage in intra-industry trade? What can be the economic benefit of having workers of fairly similar skills making cars, computers, machinery and other products which are then shipped across the oceans to and from the United States, the European Union, and Japan? There are two reasons: (1) The division of labor leads to learning, innovation, and unique skills; and (2) economies of scale.
Gains from Specialization and Learning
Consider the category of machinery, where the U.S. economy has considerable intra-industry trade. Machinery comes in many varieties, so the United States may be exporting machinery for manufacturing with wood, but importing machinery for photographic processing. The underlying reason why a country like the United States, Japan, or Germany produces one kind of machinery rather than another is usually not related to U.S., German, or Japanese firms and workers having generally higher or lower skills. It is just that, in working on very specific and particular products, firms in certain countries develop unique and different skills.
Specialization in the world economy can be very finely split. In fact, recent years have seen a trend in international trade, which economists call splitting up the value chain. The value chain describes how a good is produced in stages. As indicated in the beginning of the chapter, producing the iPhone involves designing and engineering the phone in the United States, supplying parts from Korea, assembling the parts in China, and advertising and marketing in the United States. Thanks in large part to improvements in communication technology, sharing information, and transportation, it has become easier to split up the value chain. Instead of production in a single large factory, different firms operating in various places and even different countries can divide the value chain. Because firms split up the value chain, international trade often does not involve nations trading whole finished products like automobiles or refrigerators. Instead, it involves shipping more specialized goods like, say, automobile dashboards or the shelving that fits inside refrigerators. Intra-industry trade between similar countries produces economic gains because it allows workers and firms to learn and innovate on particular products—and often to focus on very particular parts of the value chain.
Link It Up
Visit this website for some interesting information about the assembly of the iPhone.
Economies of Scale, Competition, Variety
A second broad reason that intra-industry trade between similar nations produces economic gains involves economies of scale. The concept of economies of scale, as we introduced in Production, Costs and Industry Structure, means that as the scale of output goes up, average costs of production decline—at least up to a point. Figure 20.5 illustrates economies of scale for a plant producing toaster ovens. The horizontal axis of the figure shows the quantity of production by a certain firm or at a certain manufacturing plant. The vertical axis measures the average cost of production. Production plant S produces a small level of output at 30 units and has an average cost of production of \$30 per toaster oven. Plant M produces at a medium level of output at 50 units, and has an average cost of production of \$20 per toaster oven. Plant L produces 150 units of output with an average cost of production of only \$10 per toaster oven. Although plant V can produce 200 units of output, it still has the same unit cost as Plant L.
In this example, a small or medium plant, like S or M, will not be able to compete in the market with a large or a very large plant like L or V, because the firm that operates L or V will be able to produce and sell its output at a lower price. In this example, economies of scale operate up to point L, but beyond point L to V, the additional scale of production does not continue to reduce average costs of production.
Figure 20.5 Economies of Scale Production Plant S, has an average cost of production of \$30 per toaster oven. Production plant M has an average cost of production of \$20 per toaster oven. Production plant L has an average cost of production of only \$10 per toaster oven. Production plant V still has an average cost of production of \$10 per toaster oven. Thus, production plant M can produce toaster ovens more cheaply than plant S because of economies of scale, and plants L or V can produce more cheaply than S or M because of economies of scale. However, the economies of scale end at an output level of 150. Plant V, despite being larger, cannot produce more cheaply on average than plant L.
The concept of economies of scale becomes especially relevant to international trade when it enables one or two large producers to supply the entire country. For example, a single large automobile factory could probably supply all the cars consumers purchase in a smaller economy like the United Kingdom or Belgium in a given year. However, if a country has only one or two large factories producing cars, and no international trade, then consumers in that country would have relatively little choice between kinds of cars (other than the color of the paint and other nonessential options). Little or no competition will exist between different car manufacturers.
International trade provides a way to combine the lower average production costs that come from economies of scale and still have competition and variety for consumers. Large automobile factories in different countries can make and sell their products around the world. If General Motors, Ford, and Chrysler were the only players in the U.S. automobile market, the level of competition and consumer choice would be considerably lower than when U.S. carmakers must face competition from Toyota, Honda, Suzuki, Fiat, Mitsubishi, Nissan, Volkswagen, Kia, Hyundai, BMW, Subaru, and others. Greater competition brings with it innovation and responsiveness to what consumers want. America’s car producers make far better cars now than they did several decades ago, and much of the reason is competitive pressure, especially from East Asian and European carmakers.
Dynamic Comparative Advantage
The sources of gains from intra-industry trade between similar economies—namely, the learning that comes from a high degree of specialization and splitting up the value chain and from economies of scale—do not contradict the earlier theory of comparative advantage. Instead, they help to broaden the concept.
In intra-industry trade, climate or geography do not determine the level of worker productivity. Even the general level of education or skill does not determine it. Instead, how firms engage in specific learning about specialized products, including taking advantage of economies of scale determine the level of worker productivity. In this vision, comparative advantage can be dynamic—that is, it can evolve and change over time as one develops new skills and as manufacturers split the value chain in new ways. This line of thinking also suggests that countries are not destined to have the same comparative advantage forever, but must instead be flexible in response to ongoing changes in comparative advantage. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/20%3A_International_Trade/20.04%3A_Intra-industry_Trade_between_Similar_Economies.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain tariffs as barriers to trade
• Identify at least two benefits of reducing barriers to international trade
Tariffs are taxes that governments place on imported goods for a variety of reasons. Some of these reasons include protecting sensitive industries, for humanitarian reasons, and protecting against dumping. Traditionally, tariffs were used simply as a political tool to protect certain vested economic, social, and cultural interests. The World Trade Organization (WTO) is committed to lowering barriers to trade. The world’s nations meet through the WTO to negotiate how they can reduce barriers to trade, such as tariffs. WTO negotiations happen in “rounds,” where all countries negotiate one agreement to encourage trade, take a year or two off, and then start negotiating a new agreement. The current round of negotiations is called the Doha Round because it was officially launched in Doha, the capital city of Qatar, in November 2001. In 2010, the WTO noted that the Doha Round’s emphasis on market access and reforms of agricultural subsidies could add \$121–\$202 billion to the world economy.
In the context of a global economy that currently produces more than \$80 trillion of goods and services each year, this amount is not large: it is an increase of less than 1%. But before dismissing the gains from trade too quickly, it is worth remembering two points.
• First, a gain of a few hundred billion dollars is enough money to deserve attention! Moreover, remember that this increase is not a one-time event; it would persist each year into the future.
• Second, the estimate of gains may be on the low side because some of the gains from trade are not measured especially well in economic statistics. For example, it is difficult to measure the potential advantages to consumers of having a variety of products available and a greater degree of competition among producers. Perhaps the most important unmeasured factor is that trade between countries, especially when firms are splitting up the value chain of production, often involves a transfer of knowledge that can involve skills in production, technology, management, finance, and law.
Low-income countries benefit more from trade than high-income countries do. In some ways, the giant U.S. economy has less need for international trade, because it can already take advantage of internal trade within its economy. However, many smaller national economies around the world, in regions like Latin America, Africa, the Middle East, and Asia, have much more limited possibilities for trade inside their countries or their immediate regions. Without international trade, they may have little ability to benefit from comparative advantage, slicing up the value chain, or economies of scale. Moreover, smaller economies often have fewer competitive firms making goods within their economy, and thus firms have less pressure from other firms to provide the goods and prices that consumers want.
The economic gains from expanding international trade are measured in hundreds of billions of dollars, and the gains from international trade as a whole probably reach well into the trillions of dollars. The potential for gains from trade may be especially high among the smaller and lower-income countries of the world.
Link It Up
Visit this website for a list of some benefits of trade.
From Interpersonal to International Trade
Most people find it easy to believe that they, personally, would not be better off if they tried to grow and process all of their own food, to make all of their own clothes, to build their own cars and houses from scratch, and so on. Instead, we all benefit from living in economies where people and firms can specialize and trade with each other.
The benefits of trade do not stop at national boundaries, either. Earlier we explained that the division of labor could increase output for three reasons: (1) workers with different characteristics can specialize in the types of production where they have a comparative advantage; (2) firms and workers who specialize in a certain product become more productive with learning and practice; and (3) economies of scale. These three reasons apply from the individual and community level right up to the international level. If it makes sense to you that interpersonal, intercommunity, and interstate trade offer economic gains, it should make sense that international trade offers gains, too.
International trade currently involves about \$20 trillion worth of goods and services moving around the globe. Any economic force of that size, even if it confers overall benefits, is certain to cause disruption and controversy. This chapter has only made the case that trade brings economic benefits. Other chapters discuss, in detail, the public policy arguments over whether to restrict international trade.
Bring It Home
Just Whose iPhone Is It?
Apple Corporation uses a global platform to produce the iPhone. Now that you understand the concept of comparative advantage, you can see why the engineering and design of the iPhone is done in the United States. The United States has built up a comparative advantage over the years in designing and marketing products, and sacrifices fewer resources to design high-tech devices relative to other countries. China has a comparative advantage in assembling the phone due to its large skilled labor force. Korea has a comparative advantage in producing components. Korea focuses its production by increasing its scale, learning better ways to produce screens and computer chips, and uses innovation to lower average costs of production. Apple, in turn, benefits because it can purchase these quality products at lower prices. Put the global assembly line together and you have the device with which we are all so familiar. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/20%3A_International_Trade/20.05%3A_The_Benefits_of_Reducing_Barriers_to_International_Trade.txt |
absolute advantage
when one country can use fewer resources to produce a good compared to another country; when a country is more productive compared to another country
gain from trade
a country that can consume more than it can produce as a result of specialization and trade
intra-industry trade
international trade of goods within the same industry
splitting up the value chain
many of the different stages of producing a good happen in different geographic locations
tariffs
taxes that governments place on imported goods
value chain
how a good is produced in stages
20.07: Key Concepts and Summary
20.1 Absolute and Comparative Advantage
A country has an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product. A country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. Countries that specialize based on comparative advantage gain from trade.
20.2 What Happens When a Country Has an Absolute Advantage in All Goods
Even when a country has high levels of productivity in all goods, it can still benefit from trade. Gains from trade come about as a result of comparative advantage. By specializing in a good that it gives up the least to produce, a country can produce more and offer that additional output for sale. If other countries specialize in the area of their comparative advantage as well and trade, the highly productive country is able to benefit from a lower opportunity cost of production in other countries.
20.3 Intra-industry Trade between Similar Economies
A large share of global trade happens between high-income economies that are quite similar in having well-educated workers and advanced technology. These countries practice intra-industry trade, in which they import and export the same products at the same time, like cars, machinery, and computers. In the case of intra-industry trade between economies with similar income levels, the gains from trade come from specialized learning in very particular tasks and from economies of scale. Splitting up the value chain means that several stages of producing a good take place in different countries around the world.
20.4 The Benefits of Reducing Barriers to International Trade
Tariffs are placed on imported goods as a way of protecting sensitive industries, for humanitarian reasons, and for protection against dumping. Traditionally, tariffs were used as a political tool to protect certain vested economic, social, and cultural interests. The WTO has been, and continues to be, a way for nations to meet and negotiate in order to reduce barriers to trade. The gains of international trade are very large, especially for smaller countries, but are beneficial to all.
20.08: Self-Check Questions
1.
True or False: The source of comparative advantage must be natural elements like climate and mineral deposits. Explain.
2.
Brazil can produce 100 pounds of beef or 10 autos. In contrast the United States can produce 40 pounds of beef or 30 autos. Which country has the absolute advantage in beef? Which country has the absolute advantage in producing autos? What is the opportunity cost of producing one pound of beef in Brazil? What is the opportunity cost of producing one pound of beef in the United States?
3.
In France it takes one worker to produce one sweater, and one worker to produce one bottle of wine. In Tunisia it takes two workers to produce one sweater, and three workers to produce one bottle of wine. Who has the absolute advantage in production of sweaters? Who has the absolute advantage in the production of wine? How can you tell?
4.
In Germany it takes three workers to make one television and four workers to make one video camera. In Poland it takes six workers to make one television and 12 workers to make one video camera.
1. Who has the absolute advantage in the production of televisions? Who has the absolute advantage in the production of video cameras? How can you tell?
2. Calculate the opportunity cost of producing one additional television set in Germany and in Poland. (Your calculation may involve fractions, which is fine.) Which country has a comparative advantage in the production of televisions?
3. Calculate the opportunity cost of producing one video camera in Germany and in Poland. Which country has a comparative advantage in the production of video cameras?
4. In this example, is absolute advantage the same as comparative advantage, or not?
5. In what product should Germany specialize? In what product should Poland specialize?
5.
How can there be any economic gains for a country from both importing and exporting the same good, like cars?
6.
Table 20.15 shows how the average costs of production for semiconductors (the “chips” in computer memories) change as the quantity of semiconductors built at that factory increases.
1. Based on these data, sketch a curve with quantity produced on the horizontal axis and average cost of production on the vertical axis. How does the curve illustrate economies of scale?
2. If the equilibrium quantity of semiconductors demanded is 90,000, can this economy take full advantage of economies of scale? What about if quantity demanded is 70,000 semiconductors? 50,000 semiconductors? 30,000 semiconductors?
3. Explain how international trade could make it possible for even a small economy to take full advantage of economies of scale, while also benefiting from competition and the variety offered by several producers.
Quantity of Semiconductors Average Total Cost
10,000 \$8 each
20,000 \$5 each
30,000 \$3 each
40,000 \$2 each
100,000 \$2 each
Table 20.15
7.
If the removal of trade barriers is so beneficial to international economic growth, why would a nation continue to restrict trade on some imported or exported products? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/20%3A_International_Trade/20.06%3A_Key_Terms.txt |
8.
What is absolute advantage? What is comparative advantage?
9.
Under what conditions does comparative advantage lead to gains from trade?
10.
What factors does Paul Krugman identify that supported expanding international trade in the 1800s?
11.
Is it possible to have a comparative advantage in the production of a good but not to have an absolute advantage? Explain.
12.
How does comparative advantage lead to gains from trade?
13.
What is intra-industry trade?
14.
What are the two main sources of economic gains from intra-industry trade?
15.
What is splitting up the value chain?
16.
Are the gains from international trade more likely to be relatively more important to large or small countries?
20.10: Critical Thinking Questions
17.
Are differences in geography behind the differences in absolute advantages?
18.
Why does the United States not have an absolute advantage in coffee?
19.
Look at Exercise 20.2. Compute the opportunity costs of producing sweaters and wine in both France and Tunisia. Who has the lowest opportunity cost of producing sweaters and who has the lowest opportunity cost of producing wine? Explain what it means to have a lower opportunity cost.
20.
You just overheard your friend say the following: “Poor countries like Malawi have no absolute advantages. They have poor soil, low investments in formal education and hence low-skill workers, no capital, and no natural resources to speak of. Because they have no advantage, they cannot benefit from trade.” How would you respond?
21.
Look at Table 20.9. Is there a range of trades for which there will be no gains?
22.
You just got a job in Washington, D.C. You move into an apartment with some acquaintances. All your roommates, however, are slackers and do not clean up after themselves. You, on the other hand, can clean faster than each of them. You determine that you are 70% faster at dishes and 10% faster with vacuuming. All of these tasks have to be done daily. Which jobs should you assign to your roommates to get the most free time overall? Assume you have the same number of hours to devote to cleaning. Now, since you are faster, you seem to get done quicker than your roommate. What sorts of problems may this create? Can you imagine a trade-related analogy to this problem?
23.
Does intra-industry trade contradict the theory of comparative advantage?
24.
Do consumers benefit from intra-industry trade?
25.
Why might intra-industry trade seem surprising from the point of view of comparative advantage?
26.
In World Trade Organization meetings, what do you think low-income countries lobby for?
27.
Why might a low-income country put up barriers to trade, such as tariffs on imports?
28.
Can a nation’s comparative advantage change over time? What factors would make it change?
20.11: Problems
29.
France and Tunisia both have Mediterranean climates that are excellent for producing/harvesting green beans and tomatoes. In France it takes two hours for each worker to harvest green beans and two hours to harvest a tomato. Tunisian workers need only one hour to harvest the tomatoes but four hours to harvest green beans. Assume there are only two workers, one in each country, and each works 40 hours a week.
1. Draw a production possibilities frontier for each country. Hint: Remember the production possibility frontier is the maximum that all workers can produce at a unit of time which, in this problem, is a week.
2. Identify which country has the absolute advantage in green beans and which country has the absolute advantage in tomatoes.
3. Identify which country has the comparative advantage.
4. How much would France have to give up in terms of tomatoes to gain from trade? How much would it have to give up in terms of green beans?
30.
In Japan, one worker can make 5 tons of rubber or 80 radios. In Malaysia, one worker can make 10 tons of rubber or 40 radios.
1. Who has the absolute advantage in the production of rubber or radios? How can you tell?
2. Calculate the opportunity cost of producing 80 additional radios in Japan and in Malaysia. (Your calculation may involve fractions, which is fine.) Which country has a comparative advantage in the production of radios?
3. Calculate the opportunity cost of producing 10 additional tons of rubber in Japan and in Malaysia. Which country has a comparative advantage in producing rubber?
4. In this example, does each country have an absolute advantage and a comparative advantage in the same good?
5. In what product should Japan specialize? In what product should Malaysia specialize?
31.
Review the numbers for Canada and Venezuela from Table 20.12 which describes how many barrels of oil and tons of lumber the workers can produce. Use these numbers to answer the rest of this question.
1. Draw a production possibilities frontier for each country. Assume there are 100 workers in each country. Canadians and Venezuelans desire both oil and lumber. Canadians want at least 2,000 tons of lumber. Mark a point on their production possibilities where they can get at least 3,000 tons.
2. Assume that the Canadians specialize completely because they figured out they have a comparative advantage in lumber. They are willing to give up 1,000 tons of lumber. How much oil should they ask for in return for this lumber to be as well off as they were with no trade? How much should they ask for if they want to gain from trading with Venezuela? Note: We can think of this “ask” as the relative price or trade price of lumber.
3. Is the Canadian “ask” you identified in (b) also beneficial for Venezuelans? Use the production possibilities frontier graph for Venezuela to show that Venezuelans can gain from trade.
32.
In Exercise 20.31, is there an “ask” where Venezuelans may say “no thank you” to trading with Canada?
33.
From earlier chapters you will recall that technological change shifts the average cost curves. Draw a graph showing how technological change could influence intra-industry trade.
34.
Consider two countries: South Korea and Taiwan. Taiwan can produce one million mobile phones per day at the cost of \$10 per phone and South Korea can produce 50 million mobile phones at \$5 per phone. Assume these phones are the same type and quality and there is only one price. What is the minimum price at which both countries will engage in trade?
35.
If trade increases world GDP by 1% per year, what is the global impact of this increase over 10 years? How does this increase compare to the annual GDP of a country like Sri Lanka? Discuss. Hint: To answer this question, here are steps you may want to consider. Go to the World Development Indicators (online) published by the World Bank. Find the current level of World GDP in constant international dollars. Also, find the GDP of Sri Lanka in constant international dollars. Once you have these two numbers, compute the amount the additional increase in global incomes due to trade and compare that number to Sri Lanka’s GDP. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/20%3A_International_Trade/20.09%3A_Review_Questions.txt |
Figure 21.1 Flat Screen Competition The market for flat-panel displays in the United States is huge. The manufacturers of flat screens in the United States must compete against manufacturers from around the world. (Credit: modification of “IMG_4674” by “Jemimus”/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Protectionism: An Indirect Subsidy from Consumers to Producers
• International Trade and Its Effects on Jobs, Wages, and Working Conditions
• Arguments in Support of Restricting Imports
• How Trade Policy Is Enacted: Globally, Regionally, and Nationally
• The Tradeoffs of Trade Policy
Bring It Home
What’s the Downside of Protection?
Governments are motivated to limit and alter market outcomes for political or social ends. While governments can limit the rise in prices of some products, they cannot control how much people want to buy or how much firms are willing to sell. The laws of demand and supply still hold. Trade policy is an example where regulations can redirect economic forces, but it cannot stop them from manifesting themselves elsewhere.
Flat-panel displays, the displays for laptop computers, tablets, and flat screen televisions, are an example of such an enduring principle. In the early 1990s, the vast majority of flat-panel displays used in U.S.-manufactured laptops were imported, primarily from Japan. The small but politically powerful U.S. flat-panel-display industry filed a dumping complaint with the Commerce Department. They argued that Japanese firms were selling displays at “less than fair value,” which made it difficult for U.S. firms to compete. This argument for trade protection is referred to as anti-dumping. Other arguments for protection in this complaint included national security. After a preliminary determination by the Commerce Department that the Japanese firms were dumping, the U.S. International Trade Commission imposed a 63% dumping margin (or tax) on the import of flat-panel displays. Was this a successful exercise of U.S. trade policy? See what you think after reading the chapter.
The world has become more connected on multiple levels, especially economically. In 1970, imports and exports made up 11% of U.S. GDP, while now they make up 32%. However, the United States, due to its size, is less internationally connected than most countries. For example, according to the World Bank, 97% of Botswana’s economic activity is connected to trade. This chapter explores trade policy—the laws and strategies a country uses to regulate international trade. This topic is not without controversy.
As the world has become more globally connected, firms and workers in high-income countries like the United States, Japan, or the nations of the European Union, perceive a competitive threat from firms in medium-income countries like Mexico, China, or South Africa, that have lower costs of living and therefore pay lower wages. Firms and workers in low-income countries fear that they will suffer if they must compete against more productive workers and advanced technology in high-income countries.
On a different tack, some environmentalists worry that multinational firms may evade environmental protection laws by moving their production to countries with loose or nonexistent pollution standards, trading a clean environment for jobs. Some politicians worry that their country may become overly dependent on key imported products, like oil, which in a time of war could threaten national security. All of these fears influence governments to reach the same basic policy conclusion: to protect national interests, whether businesses, jobs, or security, imports of foreign products should be restricted. This chapter analyzes such arguments. First, however, it is essential to learn a few key concepts and understand how the demand and supply model applies to international trade. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.01%3A_Introduction_to_Globalization_and_Protectionism.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain protectionism and its three main forms
• Analyze protectionism through concepts of demand and supply, noting its effects on equilibrium
• Calculate the effects of trade barriers
When a government legislates policies to reduce or block international trade it is engaging in protectionism. Protectionist policies often seek to shield domestic producers and domestic workers from foreign competition. Protectionism takes three main forms: tariffs, import quotas, and nontariff barriers.
Recall from International Trade that tariffs are taxes that governments impose on imported goods and services. This makes imports more expensive for consumers, discouraging imports. For example, in 2018, President Trump increased tariffs on Chinese-manufactured goods by 2–25%, including TVs, monitors, desktop PCs, smartwatches, and many other consumer goods. The intention behind the policy was to shelter U.S. manufacturers from competition, helping companies that operate domestically. China responded with tariffs on American goods, launching a trade war. President Biden retained these tariffs and considered additional ones, but as of August 2022, the administration was considering changes designed to reduce inflation.
Another way to control trade is through import quotas, which are numerical limitations on the quantity of products that a country can import. For instance, during the early 1980s, the Reagan Administration imposed a quota on the import of Japanese automobiles. In the 1970s, many developed countries, including the United States, found themselves with declining textile industries. Textile production does not require highly skilled workers, so producers were able to set up lower-cost factories in developing countries. In order to “manage” this loss of jobs and income, the developed countries established an international Multifiber Agreement that essentially divided the market for textile exports between importers and the remaining domestic producers. The agreement, which ran from 1974 to 2004, specified the exact quota of textile imports that each developed country would accept from each low-income country. A similar story exists for sugar imports into the United States, which are still governed by quotas.
Nontariff barriers are all the other ways that a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products. A rule requiring certain safety standards can limit imports just as effectively as high tariffs or low import quotas, for instance. There are also nontariff barriers in the form of “rules-of-origin” regulations; these rules describe the “Made in Country X” label as the one in which the last substantial change in the product took place. A manufacturer wishing to evade import restrictions may try to change the production process so that the last big change in the product happens in their own country. For example, certain textiles are made in the United States, shipped to other countries, combined with textiles made in those other countries to make apparel—and then re-exported back to the United States for a final assembly, to escape paying tariffs or to obtain a “Made in the USA” label.
Despite import quotas, tariffs, and nontariff barriers, the share of apparel sold in the United States that is imported rose from about half in 1999 to about three-quarters today. According to the U.S. Bureau of Labor Statistics (BLS), estimated the number of U.S. jobs in textiles and apparel fell 44% from 2007 to 2014, and will fall by another 25% by 2024. Even more U.S. textile industry jobs would have been lost without tariffs. However, domestic jobs that are saved by import quotas come at a cost. Because textile and apparel protectionism adds to the costs of imports, consumers end up paying billions of dollars more for clothing each year.
When the United States eliminates trade barriers in one area, consumers spend the money they save on that product elsewhere in the economy. Thus, while eliminating trade barriers in one sector of the economy will likely result in some job loss in that sector, consumers will spend the resulting savings in other sectors of the economy and hence increase the number of jobs in those other sectors. Of course, workers in some of the poorest countries of the world who would otherwise have jobs producing textiles, would gain considerably if the United States reduced its barriers to trade in textiles. That said, there are good reasons to be wary about reducing barriers to trade. The 2012 and 2013 Bangladeshi fires in textile factories, which resulted in a horrific loss of life, present complications that our simplified analysis in the chapter will not capture.
Realizing the compromises between nations that come about due to trade policy, many countries came together in 1947 to form the General Agreement on Tariffs and Trade (GATT). (We’ll cover the GATT in more detail later in the chapter.) This agreement has since been superseded by the World Trade Organization (WTO), whose membership includes about 150 nations and most of the world's economies. It is the primary international mechanism through which nations negotiate their trade rules—including rules about tariffs, quotas, and nontariff barriers. The next section examines the results of such protectionism and develops a simple model to show the impact of trade policy.
Demand and Supply Analysis of Protectionism
To the non-economist, restricting imports may appear to be nothing more than taking sales from foreign producers and giving them to domestic producers. Other factors are at work, however, because firms do not operate in a vacuum. Instead, firms sell their products either to consumers or to other firms (if they are business suppliers), who are also affected by the trade barriers. A demand and supply analysis of protectionism shows that it is not just a matter of domestic gains and foreign losses, but a policy that imposes substantial domestic costs as well.
Consider two countries, Brazil and the United States, who produce sugar. Each country has a domestic supply and demand for sugar, as Table 21.1 details and Figure 21.2 illustrates. In Brazil, without trade, the equilibrium price of sugar is 12 cents per pound and the equilibrium output is 30 tons. When there is no trade in the United States, the equilibrium price of sugar is 24 cents per pound and the equilibrium quantity is 80 tons. We label these equilibrium points as point E in each part of the figure.
Figure 21.2 The Sugar Trade between Brazil and the United States Before trade, the equilibrium price of sugar in Brazil is 12 cents a pound and it is 24 cents per pound in the United States. When trade is allowed, businesses will buy cheap sugar in Brazil and sell it in the United States. This will result in higher prices in Brazil and lower prices in the United States. Ignoring transaction costs, prices should converge to 16 cents per pound, with Brazil exporting 15 tons of sugar and the United States importing 15 tons of sugar. If trade is only partly open between the countries, it will lead to an outcome between the free-trade and no-trade possibilities.
Price Brazil: Quantity Supplied (tons) Brazil: Quantity Demanded (tons) U.S.: Quantity Supplied (tons) U.S.: Quantity Demanded (tons)
8 cents 20 35 60 100
12 cents 30 30 66 93
14 cents 35 28 69 90
16 cents 40 25 72 87
20 cents 45 21 76 83
24 cents 50 18 80 80
28 cents 55 15 82 78
Table 21.1 The Sugar Trade between Brazil and the United States
If international trade between Brazil and the United States now becomes possible, profit-seeking firms will spot an opportunity: buy sugar cheaply in Brazil, and sell it at a higher price in the United States. As sugar is shipped from Brazil to the United States, the quantity of sugar produced in Brazil will be greater than Brazilian consumption (with the extra production exported), and the amount produced in the United States will be less than the amount of U.S. consumption (with the extra consumption imported). Exports to the United States will reduce the sugar supply in Brazil, raising its price. Imports into the United States will increase the sugar supply, lowering its price. When the sugar price is the same in both countries, there is no incentive to trade further. As Figure 21.2 shows, the equilibrium with trade occurs at a price of 16 cents per pound. At that price, the sugar farmers of Brazil supply a quantity of 40 tons, while the consumers of Brazil buy only 25 tons.
The extra 15 tons of sugar production, shown by the horizontal gap between the demand curve and the supply curve in Brazil, is exported to the United States. In the United States, at a price of 16 cents, the farmers produce a quantity of 72 tons and consumers demand a quantity of 87 tons. The excess demand of 15 tons by American consumers, shown by the horizontal gap between demand and domestic supply at the price of 16 cents, is supplied by imported sugar. Free trade typically results in income distribution effects, but the key is to recognize the overall gains from trade, as Figure 21.3 shows. Building on the concepts that we outlined in Demand and Supply and Demand, Supply, and Efficiency in terms of consumer and producer surplus, Figure 21.3 (a) shows that producers in Brazil gain by selling more sugar at a higher price, while Figure 21.3 (b) shows consumers in the United States benefit from the lower price and greater availability of sugar. Consumers in Brazil are worse off (compare their no-trade consumer surplus with the free-trade consumer surplus) and U.S. producers of sugar are worse off. There are gains from trade—an increase in social surplus in each country. That is, both the United States and Brazil are better off than they would be without trade. The following Clear It Up feature explains how trade policy can influence low-income countries.
Figure 21.3 Free Trade of Sugar Free trade results in gains from trade. Total surplus increases in both countries, as the two blue-shaded areas show. However, there are clear income distribution effects. Producers gain in the exporting country, while consumers lose; and in the importing country, consumers gain and producers lose.
Link It Up
Visit this website to read more about the global sugar trade.
Clear It Up
Why are there low-income countries?
Why are the poor countries of the world poor? There are a number of reasons, but one of them will surprise you: the trade policies of the high-income countries. Following is a stark review of social priorities which the international aid organization, Oxfam International has widely publicized.
High-income countries of the world—primarily the United States, countries of the European Union, and Japan—subsidize their domestic farmers collectively by about \$200 billion per year. Why does this matter?
It matters because the support of farmers in high-income countries is devastating to the livelihoods of farmers in low-income countries. Even when their climate and land are well-suited to products like cotton, rice, sugar, or milk, farmers in low-income countries find it difficult to compete. Farm subsidies in the high-income countries cause farmers in those countries to increase the amount they produce. This increase in supply drives down world prices of farm products below the costs of production. As Michael Gerson of the Washington Post describes it: “[T]he effects in the cotton-growing regions of West Africa are dramatic . . . keep[ing] millions of Africans on the edge of malnutrition. In some of the poorest countries on Earth, cotton farmers are some of the poorest people, earning about a dollar a day. . . . Who benefits from the current system of subsidies? About 20,000 American cotton producers, with an average annual income of more than \$125,000.”
As if subsidies were not enough, often, the high-income countries block agricultural exports from low-income countries. In some cases, the situation gets even worse when the governments of high-income countries, having bought and paid for an excess supply of farm products, give away those products in poor countries and drive local farmers out of business altogether.
For example, shipments of excess milk from the European Union to Jamaica have caused great hardship for Jamaican dairy farmers. Shipments of excess rice from the United States to Haiti drove thousands of low-income rice farmers in Haiti out of business. The opportunity costs of protectionism are not paid just by domestic consumers, but also by foreign producers—and for many agricultural products, those foreign producers are the world’s poor.
Now, let’s look at what happens with protectionism. U.S. sugar farmers are likely to argue that, if only they could be protected from sugar imported from Brazil, the United States would have higher domestic sugar production, more jobs in the sugar industry, and American sugar farmers would receive a higher price. If the United States government sets a high-enough tariff on imported sugar, or sets an import quota at zero, the result will be that the quantity of sugar traded between countries could be reduced to zero, and the prices in each country will return to the levels before trade was allowed.
Blocking only some trade is also possible. Suppose that the United States passed a sugar import quota of seven tons. The United States will import no more than seven tons of sugar, which means that Brazil can export no more than seven tons of sugar to the United States. As a result, the price of sugar in the United States will be 20 cents, which is the price where the quantity demanded is seven tons greater than the domestic quantity supplied. Conversely, if Brazil can export only seven tons of sugar, then the price of sugar in Brazil will be 14 cents per pound, which is the price where the domestic quantity supplied in Brazil is seven tons greater than domestic demand.
In general, when a country sets a low or medium tariff or import quota, the equilibrium price and quantity will be somewhere between those that prevail with no trade and those with completely free trade. The following Work It Out explores the impact of these trade barriers.
Work It Out
Effects of Trade Barriers
Let’s look carefully at the effects of tariffs or quotas. If the U.S. government imposes a tariff or quota sufficient to eliminate trade with Brazil, two things occur: U.S. consumers pay a higher price and therefore buy a smaller quantity of sugar. U.S. producers obtain a higher price and they sell a larger quantity of sugar. We can measure the effects of a tariff on producers and consumers in the United States using two concepts that we developed in Demand, Supply, and Efficiency: consumer surplus and producer surplus.
Figure 21.4 U.S. Sugar Supply and Demand When there is free trade, the equilibrium is at point A. When there is no trade, the equilibrium is at point E.
Step 1. Look at Figure 21.4, which shows a hypothetical version of the demand and supply of sugar in the United States.
Step 2. Note that when there is free trade the sugar market is in equilibrium at point A where Domestic Quantity Demanded (Qd) = Quantity Supplied (Domestic Qs + Imports from Brazil) at a price of PTrade.
Step 3. Note, also, that imports are equal to the distance between points C and A.
Step 4. Recall that consumer surplus is the value that consumers get beyond what they paid for when they buy a product. Graphically, it is the area under a demand curve but above the price. In this case, the consumer surplus in the United States is the area of the triangle formed by the points PTrade, A, and B.
Step 5. Recall, also, that producer surplus is another name for profit—it is the income producers get above the cost of production, which is shown by the supply curve here. In this case, the producer surplus with trade is the area of the triangle formed by the points Ptrade, C, and D.
Step 6. Suppose that the barriers to trade are imposed, imports are excluded, and the price rises to PNoTrade. Look what happens to producer surplus and consumer surplus. At the higher price, the domestic quantity supplied increases from Qs to Q at point E. Because producers are selling more quantity at a higher price, the producer surplus increases to the area of the triangle PNoTrade, E, and D.
Step 7. Compare the areas of the two triangles and you will see the increase in the producer surplus.
Step 8. Examine the consumer surplus. Consumers are now paying a higher price to get a lower quantity (Q instead of Qd). Their consumer surplus shrinks to the area of the triangle PNoTrade, E, and B.
Step 9. Determine the net effect. The producer surplus increases by the area Ptrade, C, E, PNoTrade. The loss of consumer surplus, however, is larger. It is the area Ptrade, A, E, PNoTrade. In other words, consumers lose more than producers gain as a result of the trade barriers and the United States has a lower social surplus.
Who Benefits and Who Pays?
Using the demand and supply model, consider the impact of protectionism on producers and consumers in each of the two countries. For protected producers like U.S. sugar farmers, restricting imports is clearly positive. Without a need to face imported products, these producers are able to sell more, at a higher price. For consumers in the country with the protected good, in this case U.S. sugar consumers, restricting imports is clearly negative. They end up buying a lower quantity of the good and paying a higher price for what they do buy, compared to the equilibrium price and quantity with trade. The following Clear It Up feature considers why a country might outsource jobs even for a domestic product.
Clear It Up
Why are Life Savers, an American product, not made in America?
In 1912, Clarence Crane invented Life Savers, the hard candy with the hole in the middle, in Cleveland, Ohio. Starting in the late 1960s and for 35 years afterward, a plant in Holland, Michigan produced 46 billion Life Savers a year, in 200 million rolls. However, in 2002, the Kraft Company announced that it would close the Michigan plant and move Life Saver production across the border to Montreal, Canada.
One reason is that Canadian workers are paid slightly less, especially in healthcare and insurance costs that are not linked to employment there. Another main reason is that the United States government keeps the sugar price high for the benefit of sugar farmers, with a combination of a government price floor program and strict quotas on imported sugar. In recent years, the price of U.S. sugar has been about double the price of sugar produced by the rest of the world. Life Saver production uses over 100 tons of sugar each day, because the candies are 95% sugar.
A number of other candy companies have also reduced U.S. production and expanded foreign production. Sugar-using industries have eliminated over 100,000 jobs over the last 20 years, more than seven times the total employment in sugar production. While the candy industry is especially affected by the cost of sugar, the costs are spread more broadly. U.S. consumers pay roughly \$1 billion per year in higher food prices because of elevated sugar costs. Meanwhile, sugar producers in low-income countries are driven out of business. Because of the sugar subsidies to domestic producers and the quotas on imports, they cannot sell their output profitably, or at all, in the United States market.
The fact that protectionism pushes up prices for consumers in the country enacting such protectionism is not always acknowledged openly, but it is not disputed. After all, if protectionism did not benefit domestic producers, there would not be much point in enacting such policies in the first place. Protectionism is simply a method of requiring consumers to subsidize producers. The subsidy is indirect, since consumers pay for it through higher prices, rather than a direct government subsidy paid with money collected from taxpayers. However, protectionism works like a subsidy, nonetheless. The American satirist Ambrose Bierce defined “tariff” this way in his 1911 book, The Devil’s Dictionary: “Tariff, n. A scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer.”
The effect of protectionism on producers and consumers in the foreign country is complex. When a government uses an import quota to impose partial protectionism, Brazilian sugar producers receive a lower price for the sugar they sell in Brazil—but a higher price for the sugar they are allowed to export to the United States. Notice that some of the burden of protectionism, paid by domestic consumers, ends up in the hands of foreign producers in this case. Brazilian sugar consumers seem to benefit from U.S. protectionism, because it reduces the price of sugar that they pay (compared to the free-trade situation). On the other hand, at least some of these Brazilian sugar consumers also work as sugar farmers, so protectionism reduces their incomes and jobs. Moreover, if trade between the countries vanishes, Brazilian consumers would miss out on better prices for imported goods—which do not appear in our single-market example of sugar protectionism.
The effects of protectionism on foreign countries notwithstanding, protectionism requires domestic consumers of a product (consumers may include either households or other firms) to pay higher prices to benefit domestic producers of that product. In addition, when a country enacts protectionism, it loses the economic gains it would have been able to achieve through a combination of comparative advantage, specialized learning, and economies of scale, concepts that we discuss in International Trade. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.02%3A_Protectionism-_An_Indirect_Subsidy_from_Consumers_to_Producers.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss how international trade influences the job market
• Analyze the opportunity cost of protectionism
• Explain how international trade impacts wages, labor standards, and working conditions
In theory at least, imports might injure workers in several different ways: fewer jobs, lower wages, or poor working conditions. Let’s consider these in turn.
Fewer Jobs?
In the early 1990s, the United States was negotiating the North American Free Trade Agreement (NAFTA)1 with Mexico, an agreement that reduced tariffs, import quotas, and nontariff barriers to trade between the United States, Mexico, and Canada. H. Ross Perot, a 1992 candidate for U.S. president, claimed, in prominent campaign arguments, that if the United States expanded trade with Mexico, there would be a “giant sucking sound” as U.S. employers relocated to Mexico to take advantage of lower wages. After all, average wages in Mexico were, at that time, about one-eighth of those in the United States. NAFTA passed Congress, President Bill Clinton signed it into law, and it took effect in 1995. For the next six years, the United States economy had some of the most rapid job growth and low unemployment in its history. Those who feared that open trade with Mexico would lead to a dramatic decrease in jobs were proven wrong.
This result was no surprise to economists. After all, the trend toward globalization has been going on for decades, not just since NAFTA. If trade reduced the number of available jobs, then the United States should have been seeing a steady loss of jobs for decades. While the United States economy does experience rises and falls in unemployment rates, the number of jobs is not falling over extended periods of time. The number of U.S. jobs rose from 71 million in 1970 to 150 million in 2021.
Protectionism certainly saves jobs in the specific industry being protected but, for two reasons, it costs jobs in other unprotected industries. First, if consumers are paying higher prices to the protected industry, they inevitably have less money to spend on goods from other industries, and so jobs are lost in those other industries. Second, if a firm sells the protected product to other firms, so that other firms must now pay a higher price for a key input, then those firms will lose sales to foreign producers who do not need to pay the higher price. Lost sales translate into lost jobs. The hidden opportunity cost of using protectionism to save jobs in one industry is jobs sacrificed in other industries. This is why the United States International Trade Commission, in its study of barriers to trade, predicts that reducing trade barriers would not lead to an overall loss of jobs. Protectionism reshuffles jobs from industries without import protections to industries that are protected from imports, but it does not create more jobs.
Moreover, the costs of saving jobs through protectionism can be very high. A number of different studies have attempted to estimate the cost to consumers in higher prices per job saved through protectionism. Table 21.2 shows a sample of results, compiled by economists at the Federal Reserve Bank of Dallas. Saving a job through protectionism typically costs much more than the actual worker’s salary. For example, a study published in 2002 compiled evidence that using protectionism to save an average job in the textile and apparel industry would cost \$199,000 per job saved. In other words, those workers could have been paid \$100,000 per year to be unemployed and the cost would only be half of what it is to keep them working in the textile and apparel industry. This result is not unique to textiles and apparel.
Industry Protected with Import Tariffs or Quotas Annual Cost per Job Saved
Sugar \$826,000
Polyethylene resins \$812,000
Dairy products \$685,000
Frozen concentrated orange juice \$635,000
Ball bearings \$603,000
Machine tools \$479,000
Women’s handbags \$263,000
Glassware \$247,000
Apparel and textiles \$199,000
Rubber footwear \$168,000
Women’s nonathletic footwear \$139,000
Table 21.2 Cost to U.S. Consumers of Saving a Job through Protectionism (Source: Federal Reserve Bank of Dallas)
Why does it cost so much to save jobs through protectionism? The basic reason is that not all of the extra money that consumers pay because of tariffs or quotas goes to save jobs. For example, if the government imposes tariffs on steel imports so that steel buyers pay a higher price, U.S. steel companies earn greater profits, buy more equipment, pay bigger bonuses to managers, give pay raises to existing employees—and also avoid firing some additional workers. Only part of the higher price of protected steel goes toward saving jobs. Also, when an industry is protected, the economy as a whole loses the benefits of playing to its comparative advantage—in other words, producing what it is best at. Therefore, part of the higher price that consumers pay for protected goods is lost economic efficiency, which we can measure as another deadweight loss, like what we discussed in Labor and Financial Markets.
There’s a bumper sticker that speaks to the threat some U.S. workers feel from imported products: “Buy American—Save U.S. Jobs.” If an economist were driving the car, the sticker might declare: “Block Imports—Save Jobs for Some Americans, Lose Jobs for Other Americans, and Also Pay High Prices.”
Trade and Wages
Even if trade does not reduce the number of jobs, it could affect wages. Here, it is important to separate issues about the average level of wages from issues about whether the wages of certain workers may be helped or hurt by trade.
Because trade raises the amount that an economy can produce by letting firms and workers play to their comparative advantage, trade will also cause the average level of wages in an economy to rise. Workers who can produce more will be more desirable to employers, which will shift the demand for their labor out to the right, and increase wages in the labor market. By contrast, barriers to trade will reduce the average level of wages in an economy.
However, even if trade increases the overall wage level, it will still benefit some workers and hurt others. Workers in industries that are confronted by competition from imported products may find that demand for their labor decreases and shifts back to the left, so that their wages decline with a rise in international trade. Conversely, workers in industries that benefit from selling in global markets may find that demand for their labor shifts out to the right, so that trade raises their wages.
Link It Up
View this website to read an article on the issues surrounding fair trade coffee.
One concern is that while globalization may be benefiting high-skilled, high-wage workers in the United States, it may also impose costs on low-skilled, low-wage workers. After all, high-skilled U.S. workers presumably benefit from increased sales of sophisticated products like computers, machinery, and pharmaceuticals in which the United States has a comparative advantage. Meanwhile, low-skilled U.S. workers must now compete against extremely low-wage workers worldwide for making simpler products like toys and clothing. As a result, the wages of low-skilled U.S. workers are likely to fall. There are, however, a number of reasons to believe that while globalization has helped some U.S. industries and hurt others, it has not focused its negative impact on the wages of low-skilled Americans. First, about half of U.S. trade is intra-industry trade. That means the U.S. trades similar goods with other high-wage economies like Canada, Japan, Germany, and the United Kingdom. For instance, in 2014 the U.S. exported over 2 million cars, from all the major automakers, and also imported several million cars from other countries.
Most U.S. workers in these industries have above-average skills and wages—and many of them do quite well in the world of globalization. Some evidence suggested that intra-industry trade between similar countries had a small impact on domestic workers but later evidence indicates that it all depends on how flexible the labor market is. In other words, the key is how flexible workers are in finding jobs in different industries. The effect of trade on low-wage workers depends considerably on the structure of labor markets and indirect effects felt in other parts of the economy. For example, in the United States and the United Kingdom, because labor market frictions are low, the impact of trade on low income workers is small.
Second, many low-skilled U.S. workers hold service jobs that imports from low-wage countries cannot replace. For example, we cannot import lawn care services or moving and hauling services or hotel maids from countries long distances away like China or Bangladesh. Competition from imported products is not the primary determinant of their wages.
Finally, while the focus of the discussion here is on wages, it is worth pointing out that low-wage U.S. workers suffer due to protectionism in all the industries—even those in which they do not work. For example, food and clothing are protected industries. These low-wage workers therefore pay higher prices for these basic necessities and as such their dollar stretches over fewer goods.
The benefits and costs of increased trade in terms of its effect on wages are not distributed evenly across the economy. However, the growth of international trade has helped to raise the productivity of U.S. workers as a whole—and thus helped to raise the average level of wages.
Labor Standards and Working Conditions
Workers in many low-income countries around the world labor under conditions that would be illegal for a worker in the United States. Workers in countries like China, Thailand, Brazil, South Africa, and Poland are often paid less than the United States minimum wage. For example, in the United States, the national minimum wage is \$7.25 per hour. A typical wage in many low-income countries might be more like \$7.25 per day, or often much less. Moreover, working conditions in low-income countries may be extremely unpleasant, or even unsafe. In the worst cases, production may involve the child labor or even workers who are mistreated, abused, or entrapped in their jobs. These concerns over foreign labor standards do not affect most of U.S. trade, which is intra-industry and carried out with other high-income countries that have labor standards similar to the United States, but it is, nonetheless, morally and economically important.
In thinking about labor standards in other countries, it is important to draw some distinctions between what is truly unacceptable and what is painful to think about. Most people, economists included, have little difficulty with the idea that production by six-year-olds confined in factories, by people who are abused or mistreated, or by slave labor is morally unacceptable. They would support aggressive efforts to eliminate such practices—including shutting out imported products made with such labor. Many cases, however, are less clear-cut. An opinion article in the New York Times several years ago described the case of Ahmed Zia, a 14-year-old boy from Pakistan. He earned \$2 per day working in a carpet factory. He dropped out of school in second grade. Should the United States and other countries refuse to purchase rugs made by Ahmed and his co-workers? If the carpet factories were to close, the likely alternative job for Ahmed is farm work, and as Ahmed says of his carpet-weaving job: “This makes much more money and is more comfortable.”
Other workers may have even less attractive alternative jobs, perhaps scavenging garbage or prostitution. The real problem for Ahmed and many others in low-income countries is not that globalization has made their lives worse, but rather that they have so few good life alternatives. The United States went through similar situations during the nineteenth and early twentieth centuries.
In closing, there is some irony when the United States government or U.S. citizens take issue with labor standards in low-income countries, because the United States is not a world leader in government laws to protect employees. According to a recent study by the Organization for Economic Cooperation and Development (OECD), the U.S. is the only one of 41 countries that does not provide mandated paid leave for new parents, and among the 40 countries that do mandate paid leave, the minimum duration is about two months. Many European workers receive six weeks or more of paid vacation per year. In the United States, vacations are often one to three weeks per year. If European countries accused the United States of using unfair labor standards to make U.S. products cheaply, and announced that they would shut out all U.S. imports until the United States adopted paid parental leave, added more national holidays, and doubled vacation time, Americans would be outraged. Yet when U.S. protectionists start talking about restricting imports from poor countries because of low wage levels and poor working conditions, they are making a very similar argument. This is not to say that labor conditions in low-income countries are not an important issue. They are. However, linking labor conditions in low-income countries to trade deflects the emphasis from the real question to ask: “What are acceptable and enforceable minimum labor standards and protections to have the world over?”
Footnotes
• 1As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.03%3A_International_Trade_and_Its_Effects_on_Jobs_Wages_and_Working_Conditions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain and analyze various arguments that are in support of restricting imports, including the infant industry argument, the anti-dumping argument, the environmental protection argument, the unsafe consumer products argument, and the national interest argument
• Explain dumping and race to the bottom
• Evaluate the significance of countries’ perceptions on the benefits of growing trade
As we previously noted, protectionism requires domestic consumers of a product to pay higher prices to benefit domestic producers of that product. Countries that institute protectionist policies lose the economic gains achieved through a combination of comparative advantage, specialized learning, and economies of scale. With these overall costs in mind, let us now consider, one by one, a number of arguments that support restricting imports.
The Infant Industry Argument
Imagine Bhutan wants to start its own computer industry, but it has no computer firms that can produce at a low enough price and high enough quality to compete in world markets. However, Bhutanese politicians, business leaders, and workers hope that if the local industry had a chance to get established, before it needed to face international competition, then a domestic company or group of companies could develop the skills, management, technology, and economies of scale that it needs to become a successful profit-earning domestic industry. Thus, the infant industry argument for protectionism is to block imports for a limited time, to give the infant industry time to mature, before it starts competing on equal terms in the global economy. (Revisit Macroeconomic Policy Around the World for more information on the infant industry argument.)
The infant industry argument is theoretically possible, even sensible: give an industry a short-term indirect subsidy through protection, and then reap the long-term economic benefits of having a vibrant, healthy industry. Implementation, however, is tricky. In many countries, infant industries have gone from babyhood to senility and obsolescence without ever having reached the profitable maturity stage. Meanwhile, the protectionism that was supposed to be short-term often took a very long time to be repealed.
As one example, Brazil treated its computer industry as an infant industry from the late 1970s until about 1990. In an attempt to establish its computer industry in the global economy, Brazil largely barred imports of computer products for several decades. This policy guaranteed increased sales for Brazilian computers. However, by the mid-1980s, due to lack of international competition, Brazil had a backward and out-of-date industry, typically lagging behind world standards for price and performance by three to five years—a long time in this fast-moving industry. After more than a decade, during which Brazilian consumers and industries that would have benefited from up-to-date computers paid the costs and Brazil’s computer industry never competed effectively on world markets, Brazil phased out its infant industry policy for the computer industry.
Protectionism for infant industries always imposes costs on domestic users of the product, and typically has provided little benefit in the form of stronger, competitive industries. However, several countries in East Asia offer an exception. Japan, Korea, Thailand, and other countries in this region have sometimes provided a package of indirect and direct subsidies targeted at certain industries, including protection from foreign competition and government loans at interest rates below the market equilibrium. In Japan and Korea, for example, subsidies helped get their domestic steel and auto industries up and running.
Why did the infant industry policy of protectionism and other subsidies work fairly well in East Asia? An early 1990 World Bank study offered three guidelines to countries thinking about infant industry protection:
1. Do not hand out protectionism and other subsidies to all industries, but focus on a few industries where your country has a realistic chance to be a world-class producer.
2. Be very hesitant about using protectionism in areas like computers, where many other industries rely on having the best products available, because it is not useful to help one industry by imposing high costs on many other industries.
3. Have clear guidelines for when the infant industry policy will end.
In Korea in the 1970s and 1980s, a common practice was to link protectionism and subsidies to export sales in global markets. If export sales rose, then the infant industry had succeeded and the government could phase out protectionism. If export sales did not rise, then the infant industry policy had failed and the government could phase out protectionism. Either way, the protectionism would be temporary.
Following these rules is easier said than done. Politics often intrudes, both in choosing which industries will receive the benefits of treatment as “infants” and when to phase out import restrictions and other subsidies. Also, if the country's government wishes to impose costs on its citizens so that it can provide subsidies to a few key industries, it has many tools for doing such as direct government payments, loans, targeted tax reductions, and government support of research and development of new technologies. In other words, protectionism is not the only or even the best way to support key industries.
Link It Up
Visit this website to view a presentation by Pankaj Ghemawat questioning how integrated the world really is.
The Anti-Dumping Argument
Dumping refers to selling goods below their cost of production. Anti-dumping laws block imports that are sold below the cost of production by imposing tariffs that increase the price of these imports to reflect their cost of production. Since dumping is not allowed under World Trade Organization (WTO) rules, nations that believe they are on the receiving end of dumped goods can file a complaint with the WTO. According to the WTO, between 1995 and 2020, it oversaw 137 anti-dumping disputes. Note that dumping cases are countercyclical. During recessions, case filings increase. During economic booms, case filings go down. Individual countries have also frequently started their own anti-dumping investigations. The U.S. government has dozens of anti-dumping orders in place from past investigations. In 2022, for example, some U.S. imports that were under anti-dumping orders included olives from Spain, steel from South Korea, coated paper from Indonesia, light commercial vehicles from Germany and Italy, fish fillets from Vietnam, and cellulose pulp from Canada.
Why Might Dumping Occur?
Why would foreign firms export a product at less than its cost of production—which presumably means taking a loss? This question has two possible answers, one innocent and one more sinister.
The innocent explanation is that demand and supply set market prices, not the cost of production. Perhaps demand for a product shifts back to the left or supply shifts out to the right, which drives the market price to low levels—even below the cost of production. When a local store has a going-out-of-business sale, for example, it may sell goods at below the cost of production. If international companies find that there is excess supply of steel or computer chips or machine tools that is driving the market price down below their cost of production—this may be the market in action.
The sinister explanation is that dumping is part of a long-term strategy. Foreign firms sell goods at prices below the cost of production for a short period of time, and when they have driven out the domestic U.S. competition, they then raise prices. Economists sometimes call this scenario predatory pricing, which we discuss in the Monopoly chapter.
Should Anti-Dumping Cases Be Limited?
Anti-dumping cases pose two questions. How much sense do they make in economic theory? How much sense do they make as practical policy?
In terms of economic theory, the case for anti-dumping laws is weak. In a market governed by demand and supply, the government does not guarantee that firms will be able to make a profit. After all, low prices are difficult for producers, but benefit consumers. Moreover, although there are plenty of cases in which foreign producers have driven out domestic firms, there are zero documented cases in which the foreign producers then jacked up prices. Instead, foreign producers typically continue competing hard against each other and providing low prices to consumers. In short, it is difficult to find evidence of predatory pricing by foreign firms exporting to the United States.
Even if one could make a case that the government should sometimes enact anti-dumping rules in the short term, and then allow free trade to resume shortly thereafter, there is a growing concern that anti-dumping investigations often involve more politics than careful analysis. The U.S. Commerce Department is charged with calculating the appropriate “cost of production,” which can be as much an art as a science.
For example, if a company built a new factory two years ago, should it count part of the factory’s cost in this year’s cost of production? When a company is in a country where the government controls prices, like China for example, how can one measure the true cost of production? When a domestic industry complains loudly enough, government regulators seem very likely to find that unfair dumping has occurred. A common pattern has arisen where a domestic industry files an anti-dumping complaint, the governments meet and negotiate a reduction in imports, and then the domestic producers drop the anti-dumping suit. In such cases, anti-dumping cases often appear to be little more than a cover story for imposing tariffs or import quotas.
In the 1980s, the United States, Canada, the European Union, Australia, and New Zealand implemented almost all the anti-dumping cases. By the 2000s, countries like Argentina, Brazil, South Korea, South Africa, Mexico, and India were filing the majority of the anti-dumping cases before the WTO. As the number of anti-dumping cases has increased, and as countries such as the United States and the European Union feel targeted by the anti-dumping actions of others, the WTO may well propose some additional guidelines to limit the reach of anti-dumping laws.
The Environmental Protection Argument
The potential for global trade to affect the environment has become controversial. A president of the Sierra Club, an environmental lobbying organization, once wrote: “The consequences of globalization for the environment are not good. … Globalization, if we are lucky, will raise average incomes enough to pay for cleaning up some of the mess that we have made. But before we get there, globalization could also destroy enough of the planet’s basic biological and physical systems that prospects for life itself will be radically compromised.”
If free trade meant the destruction of life itself, then even economists would convert to protectionism! While globalization—and economic activity of all kinds—can pose environmental dangers, it seems quite possible that, with the appropriate safeguards in place, we can minimize the environmental impacts of trade. In some cases, trade may even bring environmental benefits.
In general, high-income countries such as the United States, Canada, Japan, the United Kingdom, and the nations of the European Union have relatively strict environmental standards. In contrast, middle- and low-income countries like Brazil, Nigeria, India, and China have lower environmental standards. The general view of the governments of such countries is that environmental protection is a luxury: as soon as their people have enough to eat, decent healthcare, and longer life expectancies, then they will spend more money on items such as sewage treatment plants, scrubbers to reduce air pollution from factory smokestacks, and national parks to protect wildlife.
This gap in environmental standards between high-income and low-income countries raises two worrisome possibilities in a world of increasing global trade: the “race to the bottom” scenario and the question of how quickly environmental standards will improve in low-income countries.
The Race to the Bottom Scenario
The race to the bottom scenario of global environmental degradation runs like this. Profit-seeking multinational companies shift their production from countries with strong environmental standards to countries with weak standards, thus reducing their costs and increasing their profits. Faced with such behavior, countries reduce their environmental standards to attract multinational firms, which, after all, provide jobs and economic clout. As a result, global production becomes concentrated in countries where firms can pollute the most and environmental laws everywhere “race to the bottom.”
Although the race-to-the-bottom scenario sounds plausible, it does not appear to describe reality. In fact, the financial incentive for firms to shift production to poor countries to take advantage of their weaker environmental rules does not seem especially powerful. When firms decide where to locate a new factory, they look at many different factors: the costs of labor and financial capital; whether the location is close to a reliable suppliers of the inputs that they need; whether the location is close to customers; the quality of transportation, communications, and electrical power networks; the level of taxes; and the competence and honesty of the local government. The cost of environmental regulations is a factor, too, but typically environmental costs are no more than 1 to 2% of the costs that a large industrial plant faces. The other factors that determine location are much more important to these companies than trying to skimp on environmental protection costs.
When an international company does choose to build a plant in a low-income country with lax environmental laws, it typically builds a plant similar to those that it operates in high-income countries with stricter environmental standards. Part of the reason for this decision is that designing an industrial plant is a complex and costly task, and so if a plant works well in a high-income country, companies prefer to use the same design everywhere. Also, companies realize that if they create an environmental disaster in a low-income country, it is likely to cost them a substantial amount of money in paying for damages, lost trust, and reduced sales—by building up-to-date plants everywhere they minimize such risks. As a result of these factors, foreign-owned plants in low-income countries often have a better record of compliance with environmental laws than do locally-owned plants.
Pressuring Low-Income Countries for Higher Environmental Standards
In some cases, the issue is not so much whether globalization will pressure low-income countries to reduce their environmental standards, but instead whether the threat of blocking international trade can pressure these countries into adopting stronger standards. For example, restrictions on ivory imports in high-income countries, along with stronger government efforts to catch elephant poachers, have been credited with helping to reduce the illegal poaching of elephants in certain African countries.
However, it would be highly undemocratic for the well-fed citizens of high-income countries to attempt to dictate to the ill-fed citizens of low-income countries what domestic policies and priorities they must adopt, or how they should balance environmental goals against other priorities for their citizens. Furthermore, if high-income countries want stronger environmental standards in low-income countries, they have many options other than the threat of protectionism. For example, high-income countries could pay for anti-pollution equipment in low-income countries, or could help to pay for national parks. High-income countries could help pay for and carry out the scientific and economic studies that would help environmentalists in low-income countries to make a more persuasive case for the economic benefits of protecting the environment.
After all, environmental protection is vital to two industries of key importance in many low-income countries—agriculture and tourism. Environmental advocates can set up standards for labeling products, like “this tuna caught in a net that kept dolphins safe” or “this product made only with wood not taken from rainforests,” so that consumer pressure can reinforce environmentalist values. The United Nations also reinforces these values, by sponsoring treaties to address issues such as climate change and global warming, the preservation of biodiversity, the spread of deserts, and the environmental health of the seabed. Countries that share a national border or are within a region often sign environmental agreements about air and water rights, too. The WTO is also becoming more aware of environmental issues and more careful about ensuring that increases in trade do not inflict environmental damage.
Finally, note that these concerns about the race to the bottom or pressuring low-income countries for more strict environmental standards do not apply very well to the roughly half of all U.S. trade that occurs with other high-income countries. Many European countries have stricter environmental standards in certain industries than the United States.
The Unsafe Consumer Products Argument
One argument for shutting out certain imported products is that they are unsafe for consumers. Consumer rights groups have sometimes warned that the World Trade Organization would require nations to reduce their health and safety standards for imported products. However, the WTO explains its current agreement on the subject in this way: “It allows countries to set their own standards.” It also says “regulations must be based on science. . . . And they should not arbitrarily or unjustifiably discriminate between countries where identical or similar conditions prevail.” Thus, for example, under WTO rules it is perfectly legitimate for the United States to pass laws requiring that all food products or cars sold in the United States meet certain safety standards approved by the United States government, whether or not other countries choose to pass similar standards. However, such standards must have some scientific basis. It is improper to impose one set of health and safety standards for domestically produced goods but a different set of standards for imports, or one set of standards for imports from Europe and a different set of standards for imports from Latin America.
In 2007, Mattel recalled nearly two million toys imported from China due to concerns about high levels of lead in the paint, as well as some loose parts. It is unclear if other toys were subject to similar standards. In 2013, Japan blocked imports of U.S. wheat because of concerns that genetically modified (GMO) wheat might be included in the shipments. The science on the impact of GMOs on health is still developing.
The National Interest Argument
Some argue that a nation should not depend too heavily on other countries for supplies of certain key products, such as oil, or for special materials or technologies that might have national security applications. On closer consideration, this argument for protectionism proves rather weak.
As an example, in the United States, oil provides about 36% of all the energy and 21% of the oil used in the United States economy is imported. Several times in the last few decades, when disruptions in the Middle East have shifted the supply curve of oil back to the left and sharply raised the price, the effects have been felt across the United States economy. This is not, however, a very convincing argument for restricting oil imports. If the United States needs to be protected from a possible cutoff of foreign oil, then a more reasonable strategy would be to import 100% of the petroleum supply now, and save U.S. domestic oil resources for when or if the foreign supply is cut off. It might also be useful to import extra oil and put it into a stockpile for use in an emergency, as the United States government did by starting a Strategic Petroleum Reserve in 1977. Moreover, it may be necessary to discourage people from using oil, and to start a high-powered program to seek out alternatives to oil. A straightforward way to do this would be to raise taxes on oil. Additionally, it makes no sense to argue that because oil is highly important to the United States economy, then the United States should shut out oil imports and use up its domestic supplies more quickly. U.S. domestic oil production is increasing. Shale oil is adding to domestic supply using fracking extraction techniques.
Whether or not to limit certain kinds of imports of key technologies or materials that might be important to national security and weapons systems is a slightly different issue. If weapons’ builders are not confident that they can continue to obtain a key product in wartime, they might decide to avoid designing weapons that use this key product, or they can go ahead and design the weapons and stockpile enough of the key high-tech components or materials to last through an armed conflict. There is a U.S. Defense National Stockpile Center that has built up reserves of many materials, from aluminum oxides, antimony, and bauxite to tungsten, vegetable tannin extracts, and zinc (although many of these stockpiles have been reduced and sold in recent years). Think every country is pro-trade? How about the U.S.? The following Clear It Up might surprise you.
Clear It Up
How does the United States really feel about expanding trade?
How do people around the world feel about expanding trade between nations? In summer 2007, the Pew Foundation surveyed 45,000 people in 47 countries. One of the questions asked about opinions on growing trade ties between countries. Table 21.3 shows the percentages who answered either “very good” or “somewhat good” for some of countries surveyed.
For those who think of the United States as the world’s leading supporter of expanding trade, the survey results may be perplexing. When adding up the shares of those who say that growing trade ties between countries is “very good” or “somewhat good,” Americans had the least favorable attitude toward increasing globalization, while the Chinese and South Africans ranked highest. In fact, among the 47 countries surveyed, the United States ranked by far the lowest on this measure, followed by Egypt, Italy, and Argentina.
Country Very Good Somewhat Good Total
China 38% 53% 91%
South Africa 42% 43% 87%
South Korea 24% 62% 86%
Germany 30% 55% 85%
Canada 29% 53% 82%
United Kingdom 28% 50% 78%
Mexico 22% 55% 77%
Brazil 13% 59% 72%
Japan 17% 55% 72%
United States 14% 45% 59%
Table 21.3 The Status of Growing Trade Ties between Countries (Source: www.pewglobal.org/files/pdf/258.pdf)
One final reason why economists often treat the national interest argument skeptically is that lobbyists and politicians can tout almost any product as vital to national security. In 1954, the United States became worried that it was importing half of the wool required for military uniforms, so it declared wool and mohair to be “strategic materials” and began to give subsidies to wool and mohair farmers. Although the government removed wool from the official list of “strategic” materials in 1960, the subsidies for mohair continued for almost 40 years until the government repealed them in 1993, and then reinstated them in 2002. All too often, the national interest argument has become an excuse for handing out the indirect subsidy of protectionism to certain industries or companies. After all, politicians, not nonpartisan analysts make decisions about what constitutes a key strategic material. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.04%3A_Arguments_in_Support_of_Restricting_Imports.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the origin and role of the World Trade Organization (WTO) and General Agreement on Tariffs and Trade (GATT)
• Discuss the significance and provide examples of regional trading agreements
• Analyze trade policy at the national level
• Evaluate long-term trends in barriers to trade
These public policy arguments about how nations should react to globalization and trade are fought out at several levels: at the global level through the World Trade Organization and through regional trade agreements between pairs or groups of countries.
The World Trade Organization
The World Trade Organization (WTO) was officially born in 1995, but its history is much longer. In the years after the Great Depression and World War II, there was a worldwide push to build institutions that would tie the nations of the world together. The United Nations officially came into existence in 1945. The World Bank, which assists the poorest people in the world, and the International Monetary Fund, which addresses issues raised by international financial transactions, were both created in 1946. The third planned organization was to be an International Trade Organization, which would manage international trade. The United Nations was unable to agree to this. Instead, 27 nations signed the General Agreement on Tariffs and Trade (GATT) in Geneva, Switzerland on October 30, 1947 to provide a forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade. In 1995, the GATT transformed into the WTO.
The GATT process was to negotiate an agreement to reduce barriers to trade, sign that agreement, pause for a while, and then start negotiating the next agreement. Table 21.4 shows rounds of talks in the GATT, and now the WTO. Notice that the early rounds of GATT talks took a relatively short time, included a small number of countries, and focused almost entirely on reducing tariffs. Since the mid-1960s, however, rounds of trade talks have taken years, included a large number of countries, and have included an ever-broadening range of issues.
Year Place or Name of Round Main Subjects Number of Countries Involved
1947 Geneva Tariff reduction 23
1949 Annecy Tariff reduction 13
1951 Torquay Tariff reduction 38
1956 Geneva Tariff reduction 26
1960–61 Dillon round Tariff reduction 26
1964–67 Kennedy round Tariffs, anti-dumping measures 62
1973–79 Tokyo round Tariffs, nontariff barriers 102
1986–94 Uruguay round Tariffs, nontariff barriers, services, intellectual property, dispute settlement, textiles, agriculture, creation of WTO 123
2001– Doha round Agriculture, services, intellectual property, competition, investment, environment, dispute settlement 147
Table 21.4 The Negotiating Rounds of GATT and the World Trade Organization
The sluggish pace of GATT negotiations led to an old joke that GATT really stood for Gentleman’s Agreement to Talk and Talk. The slow pace of international trade talks, however, is understandable, even sensible. Having dozens of nations agree to any treaty is a lengthy process. GATT often set up separate trading rules for certain industries, like agriculture, and separate trading rules for certain countries, like the low-income countries. There were rules, exceptions to rules, opportunities to opt out of rules, and precise wording to be fought over in every case. Like the GATT before it, the WTO is not a world government, with power to impose its decisions on others. The total staff of the WTO Secretariat in 2021 is 625 people and its annual budget (as of 2020) is \$197 million, which makes it smaller in size than many large universities.
Regional Trading Agreements
There are different types of economic integration across the globe, ranging from free trade agreements, in which participants allow each other’s imports without tariffs or quotas, to common markets, in which participants have a common external trade policy as well as free trade within the group, to full economic unions, in which, in addition to a common market, monetary and fiscal policies are coordinated. Many nations belong both to the World Trade Organization and to regional trading agreements.
The best known of these regional trading agreements is the European Union. In the years after World War II, leaders of several European nations reasoned that if they could tie their economies together more closely, they might be more likely to avoid another devastating war. Their efforts began with a free trade association, evolved into a common market, and then transformed into what is now a full economic union, known as the European Union. The EU, as it is often called, has a number of goals. For example, in the early 2000s it introduced a common currency for Europe, the euro, and phased out most of the former national forms of money like the German mark and the French franc, though a few have retained their own currency. Another key element of the union is to eliminate barriers to the mobility of goods, labor, and capital across Europe. In 2016, Britain voted to leave the European Union—a move that was completed in January 2020.
For the United States, perhaps the best-known regional trading agreement is the North American Free Trade Agreement (NAFTA). 2 The United States also participates in some less-prominent regional trading agreements, like the Caribbean Basin Initiative, which offers reduced tariffs for imports from these countries, and a free trade agreement with Israel.
The world has seen a flood of regional trading agreements in recent years. About 100 such agreements are now in place. Table 21.5 lists a few of the more prominent ones. Some are just agreements to continue talking. Others set specific goals for reducing tariffs, import quotas, and nontariff barriers. One economist described the current trade treaties as a “spaghetti bowl,” which is what a map with lines connecting all the countries with trade treaties looks like.
There is concern among economists who favor free trade that some of these regional agreements may promise free trade, but actually act as a way for the countries within the regional agreement to try to limit trade from anywhere else. In some cases, the regional trade agreements may even conflict with the broader agreements of the World Trade Organization.
Trade Agreements Participating Countries
Asia Pacific Economic Cooperation (APEC) Australia, Brunei, Canada, Chile, People’s Republic of China, Hong Kong, China, Indonesia, Japan, Republic of Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Chinese Taipei, Thailand, United States, Vietnam
European Union (EU) Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom*
North America Free Trade Agreement (NAFTA) Canada, Mexico, United States
Latin American Integration Association (LAIA) Argentina, Bolivia, Brazil, Chile, Columbia, Ecuador, Mexico, Paraguay, Peru, Uruguay, Venezuela, Panama
Association of Southeast Asian Nations (ASEAN) Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam
Southern African Development Community (SADC) Angola, Botswana, Comoros, Congo, Lesotho, Madagascar, Malawi, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia, Zimbabwe
Table 21.5 Some Regional Trade Agreements * Following the 2016 referendum vote to leave the European Union, the UK government triggered the withdrawal process on March 29, 2017, setting the date for the UK to leave by April 2019. In January 2020, the withdrawal was complete and the United Kingdom is now no longer part of the EU trading bloc. Also, as of 2020, NAFTA has been replaced by the United States-Mexico-Canada (USMCA) free trade agreement.
Trade Policy at the National Level
Yet another dimension of trade policy, along with international and regional trade agreements, happens at the national level. The United States, for example, imposes import quotas on sugar, because of a fear that such imports would drive down the price of sugar and thus injure domestic sugar producers. One of the jobs of the United States Department of Commerce is to determine if there is import dumping from other countries. The United States International Trade Commission—a government agency—determines whether the dumping has substantially injured domestic industries, and if so, the president can impose tariffs that are intended to offset the unfairly low price.
In the arena of trade policy, the battle often seems to be between national laws that increase protectionism and international agreements that try to reduce protectionism, like the WTO. Why would a country pass laws or negotiate agreements to shut out certain foreign products, like sugar or textiles, while simultaneously negotiating to reduce trade barriers in general? One plausible answer is that international trade agreements offer a method for countries to restrain their own special interests. A member of Congress can say to an industry lobbying for tariffs or quotas on imports: “Sure would like to help you, but that pesky WTO agreement just won’t let me.”
Link It Up
If consumers are the biggest losers from trade, why do they not fight back? The quick answer is because it is easier to organize a small group of people around a narrow interest (producers) versus a large group that has diffuse interests (consumers). This is a question about trade policy theory. Visit this website and read the article by Jonathan Rauch.
Long-Term Trends in Barriers to Trade
In newspaper headlines, trade policy appears mostly as disputes and acrimony. Countries are almost constantly threatening to challenge other nations' “unfair” trading practices. Cases are brought to the dispute settlement procedures of the WTO, the European Union, NAFTA, and other regional trading agreements. Politicians in national legislatures, goaded on by lobbyists, often threaten to pass bills that will “establish a fair playing field” or “prevent unfair trade”—although most such bills seek to accomplish these high-sounding goals by placing more restrictions on trade. Protesters in the streets may object to specific trade rules or to the entire practice of international trade.
Through all the controversy, the general trend in the last 60 years is clearly toward lower barriers to trade. The average level of tariffs on imported products charged by industrialized countries was 40% in 1946. By 1990, after decades of GATT negotiations, it was down to less than 5%. One of the reasons that GATT negotiations shifted from focusing on tariff reduction in the early rounds to a broader agenda was that tariffs had been reduced so dramatically there was not much more to do in that area. U.S. tariffs have followed this general pattern: After rising sharply during the Great Depression, tariffs dropped off to less than 2% by the end of the century. Although measures of import quotas and nontariff barriers are less exact than those for tariffs, they generally appear to be at lower levels than they had been previously, too.
Thus, the last half-century has seen both a dramatic reduction in government-created barriers to trade, such as tariffs, import quotas, and nontariff barriers, and also a number of technological developments that have made international trade easier, like advances in transportation, communication, and information management. The result has been the powerful surge of international trade.
These trends were altered by two important events in 2016: the UK vote to leave the EU and the election of President Trump in the United States, whose administration pursued a policy of raising trade barriers. In 2018, tariffs on a broad range of imports from China were raised by around 25%. As of 2022, the UK has been out of the EU for two years, and it remains unclear if President Biden’s administration will adjust or remove President Trump’s trade barriers.
Footnotes
• 2As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.05%3A_How_Governments_Enact_Trade_Policy-_Globally_Regionally_and_Nationally.txt |
Learning Objectives
By the end of this section, you will be able to:
• Asses the complexity of international trade
• Discuss why a market-oriented economy is so affected by international trade
• Explain disruptive market change
Economists readily acknowledge that international trade is not all sunshine, roses, and happy endings. Over time, the average person gains from international trade, both as a worker who has greater productivity and higher wages because of the benefits of specialization and comparative advantage, and as a consumer who can benefit from shopping all over the world for a greater variety of quality products at attractive prices. The “average person,” however, is hypothetical, not real—representing a mix of those who have done very well, those who have done all right, and those who have done poorly. It is a legitimate concern of public policy to focus not just on the average or on the success stories, but also on those who have not been so fortunate. Workers in other countries, the environment, and prospects for new industries and materials that might be of key importance to the national economy are also all legitimate issues.
The common belief among economists is that it is better to embrace the gains from trade, and then deal with the costs and tradeoffs with other policy tools, than it is to cut off trade to avoid the costs and tradeoffs.
To gain a better intuitive understanding for this argument, consider a hypothetical American company called Technotron. Technotron invents a new scientific technology that allows the firm to increase the output and quality of its goods with a smaller number of workers at a lower cost. As a result of this technology, other U.S. firms in this industry will lose money and will also have to lay off workers—and some of the competing firms will even go bankrupt. Should the United States government protect the existing firms and their employees by making it illegal for Technotron to use its new technology? Most people who live in market-oriented economies would oppose trying to block better products that lower the cost of services. Certainly, there is a case for society providing temporary support and assistance for those who find themselves without work. Many would argue for government support of programs that encourage retraining and acquiring additional skills. Government might also support research and development efforts, so that other firms may find ways of outdoing Technotron. Blocking the new technology altogether, however, seems like a mistake. After all, few people would advocate giving up electricity because it caused so much disruption to the kerosene and candle business. Few would suggest holding back on improvements in medical technology because they might cause companies selling leeches and snake oil to lose money. In short, most people view disruptions due to technological change as a necessary cost that is worth bearing.
Now, imagine that Technotron’s new “technology” is as simple as this: the company imports what it sells from another country. In other words, think of foreign trade as a type of innovative technology. The objective situation is now exactly the same as before. Because of Technotron’s new technology—which in this case is importing goods from another county—other firms in this industry will lose money and lay off workers. Just as it would have been inappropriate and ultimately foolish to respond to the disruptions of new scientific technology by trying to shut it down, it would be inappropriate and ultimately foolish to respond to the disruptions of international trade by trying to restrict trade.
Some workers and firms will suffer because of international trade. In a living, breathing market-oriented economy, some workers and firms will always be experiencing disruptions, for a wide variety of reasons. Corporate management can be better or worse. Workers for a certain firm can be more or less productive. Tough domestic competitors can create just as much disruption as tough foreign competitors. Sometimes a new product is a hit with consumers; sometimes it is a flop. Sometimes a company is blessed by a run of good luck or stricken with a run of bad luck. For some firms, international trade will offer great opportunities for expanding productivity and jobs; for other firms, trade will impose stress and pain. The disruption caused by international trade is not fundamentally different from all the other disruptions caused by the other workings of a market economy.
In other words, the economic analysis of free trade does not rely on a belief that foreign trade is not disruptive or does not pose tradeoffs; indeed, the story of Technotron begins with a particular disruptive market change—a new technology—that causes real tradeoffs. In thinking about the disruptions of foreign trade, or any of the other possible costs and tradeoffs of foreign trade discussed in this chapter, the best public policy solutions typically do not involve protectionism, but instead involve finding ways for public policy to address the particular issues resulting from these disruptions, costs, and tradeoffs, while still allowing the benefits of international trade to occur.
Bring It Home
What’s the Downside of Protection?
The domestic flat-panel display industry employed many workers before the ITC imposed the dumping margin tax. Flat-panel displays make up a significant portion of the cost of producing laptop computers—as much as 50%. Therefore, the antidumping tax would substantially increase the cost, and thus the price, of U.S.-manufactured laptops. As a result of the ITC’s decision, Apple moved its domestic manufacturing plant for Macintosh computers to Ireland (where it had an existing plant). Toshiba shut down its U.S. manufacturing plant for laptops. And IBM cancelled plans to open a laptop manufacturing plant in North Carolina, instead deciding to expand production at its plant in Japan. In this case, rather than having the desired effect of protecting U.S. interests and giving domestic manufacturing an advantage over items manufactured elsewhere, it had the unintended effect of driving the manufacturing completely out of the country. Many people lost their jobs and most flat-panel display production now occurs in countries other than the United States. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.06%3A_The_Tradeoffs_of_Trade_Policy.txt |
anti-dumping laws
laws that block imports sold below the cost of production and impose tariffs that would increase the price of these imports to reflect their cost of production
common market
economic agreement between countries to allow free trade in goods, services, labor, and financial capital between members while having a common external trade policy
disruptive market change
innovative new product or production technology which disrupts the status quo in a market, leading the innovators to earn more income and profits and the other firms to lose income and profits, unless they can come up with their own innovations
dumping
selling internationally traded goods below their cost of production
economic union
economic agreement between countries to allow free trade between members, a common external trade policy, and coordinated monetary and fiscal policies
free trade agreement
economic agreement between countries to allow free trade between members
General Agreement on Tariffs and Trade (GATT)
forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade; the precursor to the World Trade Organization
import quotas
numerical limits on the quantity of products that a country can import
national interest argument
the argument that there are compelling national interests against depending on key imports from other nations
nontariff barriers
ways a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products
protectionism
government policies to reduce or block imports
race to the bottom
when production locates in countries with the lowest environmental (or other) standards, putting pressure on all countries to reduce their environmental standards
World Trade Organization (WTO)
organization that seeks to negotiate reductions in barriers to trade and to adjudicate complaints about violations of international trade policy; successor to the General Agreement on Tariffs and Trade (GATT)
21.08: Key Concepts and Summary
21.1 Protectionism: An Indirect Subsidy from Consumers to Producers
There are three tools for restricting the flow of trade: tariffs, import quotas, and nontariff barriers. When a country places limitations on imports from abroad, regardless of whether it uses tariffs, quotas, or nontariff barriers, it is said to be practicing protectionism. Protectionism will raise the price of the protected good in the domestic market, which causes domestic consumers to pay more, but domestic producers to earn more.
21.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
As international trade increases, it contributes to a shift in jobs away from industries where that economy does not have a comparative advantage and toward industries where it does have a comparative advantage. The degree to which trade affects labor markets has much to do with the structure of the labor market in that country and the adjustment process in other industries. Global trade should raise the average level of wages by increasing productivity. However, this increase in average wages may include both gains to workers in certain jobs and industries and losses to others.
In thinking about labor practices in low-income countries, it is useful to draw a line between what is unpleasant to think about and what is morally objectionable. For example, low wages and long working hours in poor countries are unpleasant to think about, but for people in low-income parts of the world, it may well be the best option open to them. Practices like child labor and forced labor are morally objectionable and many countries refuse to import products made using these practices.
21.3 Arguments in Support of Restricting Imports
There are a number of arguments that support restricting imports. These arguments are based around industry and competition, environmental concerns, and issues of safety and security.
The infant industry argument for protectionism is that small domestic industries need to be temporarily nurtured and protected from foreign competition for a time so that they can grow into strong competitors. In some cases, notably in East Asia, this approach has worked. Often, however, the infant industries never grow up. On the other hand, arguments against dumping (which is setting prices below the cost of production to drive competitors out of the market), often simply seem to be a convenient excuse for imposing protectionism.
Low-income countries typically have lower environmental standards than high-income countries because they are more worried about immediate basics such as food, education, and healthcare. However, except for a small number of extreme cases, shutting off trade seems unlikely to be an effective method of pursuing a cleaner environment.
Finally, there are arguments involving safety and security. Under the rules of the World Trade Organization, countries are allowed to set whatever standards for product safety they wish, but the standards must be the same for domestic products as for imported products and there must be a scientific basis for the standard. The national interest argument for protectionism holds that it is unwise to import certain key products because if the nation becomes dependent on key imported supplies, it could be vulnerable to a cutoff. However, it is often wiser to stockpile resources and to use foreign supplies when available, rather than preemptively restricting foreign supplies so as not to become dependent on them.
21.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally
Governments determine trade policy at many different levels: administrative agencies within government, laws passed by the legislature, regional negotiations between a small group of nations (sometimes just two), and global negotiations through the World Trade Organization. During the second half of the twentieth century, trade barriers have, in general, declined quite substantially in the United States economy and in the global economy. One reason why countries sign international trade agreements to commit themselves to free trade is to give themselves protection against their own special interests. When an industry lobbies for protection from foreign producers, politicians can point out that, because of the trade treaty, their hands are tied.
21.5 The Tradeoffs of Trade Policy
International trade certainly has income distribution effects. This is hardly surprising. All domestic or international competitive market forces are disruptive. They cause companies and industries to rise and fall. Government has a role to play in cushioning workers against the disruptions of the market. However, just as it would be unwise in the long term to clamp down on new technology and other causes of disruption in domestic markets, it would be unwise to clamp down on foreign trade. In both cases, the disruption brings with it economic benefits. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.07%3A_Key_Terms.txt |
1.
Explain how a tariff reduction causes an increase in the equilibrium quantity of imports and a decrease in the equilibrium price. Hint: Consider the Work It Out "Effects of Trade Barriers."
2.
Explain how a subsidy on agricultural goods like sugar adversely affects the income of foreign producers of imported sugar.
3.
Explain how trade barriers save jobs in protected industries, but only by costing jobs in other industries.
4.
Explain how trade barriers raise wages in protected industries by reducing average wages economy-wide.
5.
How does international trade affect working conditions of low-income countries?
6.
Do the jobs for workers in low-income countries that involve making products for export to high-income countries typically pay these workers more or less than their next-best alternative?
7.
How do trade barriers affect the average income level in an economy?
8.
How does the cost of “saving” jobs in protected industries compare to the workers’ wages and salaries?
9.
Explain how predatory pricing could be a motivation for dumping.
10.
Why do low-income countries like Brazil, Egypt, or Vietnam have lower environmental standards than high-income countries like the Germany, Japan, or the United States?
11.
Explain the logic behind the “race to the bottom” argument and the likely reason it has not occurred.
12.
What are the conditions under which a country may use the unsafe products argument to block imports?
13.
Why is the national security argument not convincing?
14.
Assume a perfectly competitive market and the exporting country is small. Using a demand and supply diagram, show the impact of increasing standards on a low-income exporter of toys. Show the tariff's impact. Is the effect on toy prices the same or different? Why is a standards policy preferred to tariffs?
15.
What is the difference between a free trade association, a common market, and an economic union?
16.
Why would countries promote protectionist laws, while also negotiate for freer trade internationally?
17.
What might account for the dramatic increase in international trade over the past 50 years?
18.
How does competition, whether domestic or foreign, harm businesses?
19.
What are the gains from competition?
21.10: Review Questions
20.
Who does protectionism protect? From what does it protect them?
21.
Name and define three policy tools for enacting protectionism.
22.
How does protectionism affect the price of the protected good in the domestic market?
23.
Does international trade, taken as a whole, increase the total number of jobs, decrease the total number of jobs, or leave the total number of jobs about the same?
24.
Is international trade likely to have roughly the same effect on the number of jobs in each individual industry?
25.
How is international trade, taken as a whole, likely to affect the average level of wages?
26.
Is international trade likely to have about the same effect on everyone’s wages?
27.
What are main reasons for protecting “infant industries”? Why is it difficult to stop protecting them?
28.
What is dumping? Why does prohibiting it often work better in theory than in practice?
29.
What is the “race to the bottom” scenario?
30.
Do the rules of international trade require that all nations impose the same consumer safety standards?
31.
What is the national interest argument for protectionism with regard to certain products?
32.
Name several of the international treaties where countries negotiate with each other over trade policy.
33.
What is the general trend of trade barriers over recent decades: higher, lower, or about the same?
34.
If opening up to free trade would benefit a nation, then why do nations not just eliminate their trade barriers, and not bother with international trade negotiations?
35.
Who gains and who loses from trade?
36.
Why is trade a good thing if some people lose?
37.
What are some ways that governments can help people who lose from trade? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.09%3A_Self-Check_Questions.txt |
38.
Show graphically that for any tariff, there is an equivalent quota that would give the same result. What would be the difference, then, between the two types of trade barriers? Hint: It is not something you can see from the graph.
39.
From the Work It Out "Effects of Trade Barriers," you can see that a tariff raises the price of imports. What is interesting is that the price rises by less than the amount of the tariff. Who pays the rest of the tariff amount? Can you show this graphically?
40.
If trade barriers hurt the average worker in an economy (due to lower wages), why does government create trade barriers?
41.
Why do you think labor standards and working conditions are lower in the low-income countries of the world than in countries like the United States?
42.
How would direct subsidies to key industries be preferable to tariffs or quotas?
43.
How can governments identify good candidates for infant industry protection? Can you suggest some key characteristics of good candidates? Why are industries like computers not good candidates for infant industry protection?
44.
Microeconomic theory argues that it is economically rationale (and profitable) to sell additional output as long as the price covers the variable costs of production. How is this relevant to the determination of whether dumping has occurred?
45.
How do you think Americans would feel if other countries began to urge the United States to increase environmental standards?
46.
Is it legitimate to impose higher safety standards on imported goods that exist in the foreign country where the goods were produced?
47.
Why might the unsafe consumer products argument be a more effective strategy (from the perspective of the importing country) than using tariffs or quotas to restrict imports?
48.
Why might a tax on domestic consumption of resources critical for national security be a more efficient approach than barriers to imports?
49.
Why do you think that the GATT rounds and, more recently, WTO negotiations have become longer and more difficult to resolve?
50.
An economic union requires giving up some political autonomy to succeed. What are some examples of political power countries must give up to be members of an economic union?
51.
What are some examples of innovative products that have disrupted their industries for the better?
52.
In principle, the benefits of international trade to a country exceed the costs, no matter whether the country is importing or exporting. In practice, it is not always possible to compensate the losers in a country, for example, workers who lose their jobs due to foreign imports. In your opinion, does that mean that trade should be inhibited to prevent the losses?
53.
Economists sometimes say that protectionism is the “second-best” choice for dealing with any particular problem. What they mean is that there is often a policy choice that is more direct or effective for dealing with the problem—a choice that would still allow the benefits of trade to occur. Explain why protectionism is a “second-best” choice for:
1. helping workers as a group
2. helping industries stay strong
3. protecting the environment
4. advancing national defense
54.
Trade has income distribution effects. For example, suppose that because of a government-negotiated reduction in trade barriers, trade between Germany and the Czech Republic increases. Germany sells house paint to the Czech Republic. The Czech Republic sells alarm clocks to Germany. Would you expect this pattern of trade to increase or decrease jobs and wages in the paint industry in Germany? The alarm clock industry in Germany? The paint industry in Czech Republic? The alarm clock industry in Czech Republic? What has to happen for there to be no increase in total unemployment in both countries?
21.12: Problems
55.
Assume two countries, Thailand (T) and Japan (J), have one good: cameras. The demand (d) and supply (s) for cameras in Thailand and Japan is described by the following functions:
$QdT = 60 – PQdT = 60 – P$ $QsT = –5 + 14PQsT = –5 + 14P$ $QdJ = 80 – PQdJ = 80 – P$ $QsJ = –10 + 12PQsJ = –10 + 12P$
P is the price measured in a common currency used in both countries, such as the Thai Baht.
1. Compute the equilibrium price (P) and quantities (Q) in each country without trade.
2. Now assume that free trade occurs. The free-trade price goes to 56.36 Baht. Who exports and imports cameras and in what quantities?
56.
You have just been put in charge of trade policy for Malawi. Coffee is a recent crop that is growing well and the Malawian export market is developing. As such, Malawi coffee is an infant industry. Malawi coffee producers come to you and ask for tariff protection from cheap Tanzanian coffee. What sorts of policies will you enact? Explain.
57.
The country of Pepperland exports steel to the Land of Submarines. Information for the quantity demanded (Qd) and quantity supplied (Qs) in each country, in a world without trade, are given in Table 21.6 and Table 21.7.
Price (\$) Qd Qs
60 230 180
70 200 200
80 170 220
90 150 240
100 140 250
Table 21.6 Pepperland
Price (\$) Qd Qs
60 430 310
70 420 330
80 410 360
90 400 400
100 390 440
Table 21.7 Land of Submarines
1. What would be the equilibrium price and quantity in each country in a world without trade? How can you tell?
2. What would be the equilibrium price and quantity in each country if trade is allowed to occur? How can you tell?
3. Sketch two supply and demand diagrams, one for each country, in the situation before trade.
4. On those diagrams, show the equilibrium price and the levels of exports and imports in the world after trade.
5. If the Land of Submarines imposes an anti-dumping import quota of 30, explain in general terms whether it will benefit or injure consumers and producers in each country.
6. Does your general answer change if the Land of Submarines imposes an import quota of 70? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/21%3A_Globalization_and_Protectionism/21.11%3A_Critical_Thinking_Questions.txt |
(This appendix should be consulted after first reading Welcome to Economics!) Economics is not math. There is no important concept in this course that cannot be explained without mathematics. That said, math is a tool that can be used to illustrate economic concepts. Remember the saying a picture is worth a thousand words? Instead of a picture, think of a graph. It is the same thing. Economists use models as the primary tool to derive insights about economic issues and problems. Math is one way of working with (or manipulating) economic models.
There are other ways of representing models, such as text or narrative. But why would you use your fist to bang a nail, if you had a hammer? Math has certain advantages over text. It disciplines your thinking by making you specify exactly what you mean. You can get away with fuzzy thinking in your head, but you cannot when you reduce a model to algebraic equations. At the same time, math also has disadvantages. Mathematical models are necessarily based on simplifying assumptions, so they are not likely to be perfectly realistic. Mathematical models also lack the nuances which can be found in narrative models. The point is that math is one tool, but it is not the only tool or even always the best tool economists can use. So what math will you need for this book? The answer is: little more than high school algebra and graphs. You will need to know:
• What a function is
• How to interpret the equation of a line (i.e., slope and intercept)
• How to manipulate a line (i.e., changing the slope or the intercept)
• How to compute and interpret a growth rate (i.e., percentage change)
• How to read and manipulate a graph
In this text, we will use the easiest math possible, and we will introduce it in this appendix. So if you find some math in the book that you cannot follow, come back to this appendix to review. Like most things, math has diminishing returns. A little math ability goes a long way; the more advanced math you bring in, the less additional knowledge that will get you. That said, if you are going to major in economics, you should consider learning a little calculus. It will be worth your while in terms of helping you learn advanced economics more quickly.
Algebraic Models
Often economic models (or parts of models) are expressed in terms of mathematical functions. What is a function? A function describes a relationship. Sometimes the relationship is a definition. For example (using words), your professor is Adam Smith. This could be expressed as Professor = Adam Smith. Or Friends = Bob + Shawn + Margaret.
Often in economics, functions describe cause and effect. The variable on the left-hand side is what is being explained (“the effect”). On the right-hand side is what is doing the explaining (“the causes”). For example, suppose your GPA was determined as follows:
$GPA = 0.25 × combined_SAT + 0.25 × class_attendance + 0.50 × hours_spent_studyingGPA = 0.25 × combined_SAT + 0.25 × class_attendance + 0.50 × hours_spent_studying$
This equation states that your GPA depends on three things: your combined SAT score, your class attendance, and the number of hours you spend studying. It also says that study time is twice as important (0.50) as either combined_SAT score (0.25) or class_attendance (0.25). If this relationship is true, how could you raise your GPA? By not skipping class and studying more. Note that you cannot do anything about your SAT score, since if you are in college, you have (presumably) already taken the SATs.
Of course, economic models express relationships using economic variables, like Budget = money_spent_on_econ_books + money_spent_on_music, assuming that the only things you buy are economics books and music.
Most of the relationships we use in this course are expressed as linear equations of the form:
$y = b + mxy = b + mx$
Expressing Equations Graphically
Graphs are useful for two purposes. The first is to express equations visually, and the second is to display statistics or data. This section will discuss expressing equations visually.
To a mathematician or an economist, a variable is the name given to a quantity that may assume a range of values. In the equation of a line presented above, x and y are the variables, with x on the horizontal axis and y on the vertical axis, and b and m representing factors that determine the shape of the line. To see how this equation works, consider a numerical example:
$y = 9 + 3xy = 9 + 3x$
In this equation for a specific line, the b term has been set equal to 9 and the m term has been set equal to 3. Table A1 shows the values of x and y for this given equation. Figure A1 shows this equation, and these values, in a graph. To construct the table, just plug in a series of different values for x, and then calculate what value of y results. In the figure, these points are plotted and a line is drawn through them.
x y
0 9
1 12
2 15
3 18
4 21
5 24
6 27
Table A1 Values for the Slope Intercept Equation
Figure A1 Slope and the Algebra of Straight Lines This line graph has x on the horizontal axis and y on the vertical axis. The y-intercept—that is, the point where the line intersects the y-axis—is 9. The slope of the line is 3; that is, there is a rise of 3 on the vertical axis for every increase of 1 on the horizontal axis. The slope is the same all along a straight line.
This example illustrates how the b and m terms in an equation for a straight line determine the shape of the line. The b term is called the y-intercept. The reason for this name is that, if x = 0, then the b term will reveal where the line intercepts, or crosses, the y-axis. In this example, the line hits the vertical axis at 9. The m term in the equation for the line is the slope. Remember that slope is defined as rise over run; more specifically, the slope of a line from one point to another is the change in the vertical axis divided by the change in the horizontal axis. In this example, each time the x term increases by one (the run), the y term rises by three. Thus, the slope of this line is three. Specifying a y-intercept and a slope—that is, specifying b and m in the equation for a line—will identify a specific line. Although it is rare for real-world data points to arrange themselves as an exact straight line, it often turns out that a straight line can offer a reasonable approximation of actual data.
Interpreting the Slope
The concept of slope is very useful in economics, because it measures the relationship between two variables. A positive slope means that two variables are positively related; that is, when x increases, so does y, or when x decreases, y decreases also. Graphically, a positive slope means that as a line on the line graph moves from left to right, the line rises. The length-weight relationship, shown in Figure A3 later in this Appendix, has a positive slope. We will learn in other chapters that price and quantity supplied have a positive relationship; that is, firms will supply more when the price is higher.
A negative slope means that two variables are negatively related; that is, when x increases, y decreases, or when x decreases, y increases. Graphically, a negative slope means that, as the line on the line graph moves from left to right, the line falls. The altitude-air density relationship, shown in Figure A4 later in this appendix, has a negative slope. We will learn that price and quantity demanded have a negative relationship; that is, consumers will purchase less when the price is higher.
A slope of zero means that there is no relationship between x and y. Graphically, the line is flat; that is, zero rise over the run. Figure A5 of the unemployment rate, shown later in this appendix, illustrates a common pattern of many line graphs: some segments where the slope is positive, other segments where the slope is negative, and still other segments where the slope is close to zero.
The slope of a straight line between two points can be calculated in numerical terms. To calculate slope, begin by designating one point as the “starting point” and the other point as the “end point” and then calculating the rise over run between these two points. As an example, consider the slope of the air density graph between the points representing an altitude of 4,000 meters and an altitude of 6,000 meters:
Rise: Change in variable on vertical axis (end point minus original point)
$= 0.100 – 0.307 = –0.207 = 0.100 – 0.307 = –0.207$
Run: Change in variable on horizontal axis (end point minus original point)
$= 6,000 – 4,000= 2,000= 6,000 – 4,000= 2,000$
Thus, the slope of a straight line between these two points would be that from the altitude of 4,000 meters up to 6,000 meters, the density of the air decreases by approximately 0.1 kilograms/cubic meter for each of the next 1,000 meters.
Suppose the slope of a line were to increase. Graphically, that means it would get steeper. Suppose the slope of a line were to decrease. Then it would get flatter. These conditions are true whether or not the slope was positive or negative to begin with. A higher positive slope means a steeper upward tilt to the line, while a smaller positive slope means a flatter upward tilt to the line. A negative slope that is larger in absolute value (that is, more negative) means a steeper downward tilt to the line. A slope of zero is a horizontal flat line. A vertical line has an infinite slope.
Suppose a line has a larger intercept. Graphically, that means it would shift out (or up) from the old origin, parallel to the old line. If a line has a smaller intercept, it would shift in (or down), parallel to the old line.
Solving Models with Algebra
Economists often use models to answer a specific question, like: What will the unemployment rate be if the economy grows at 3% per year? Answering specific questions requires solving the “system” of equations that represent the model.
Suppose the demand for personal pizzas is given by the following equation:
$Qd = 16 – 2PQd = 16 – 2P$
where Qd is the amount of personal pizzas consumers want to buy (i.e., quantity demanded), and P is the price of pizzas. Suppose the supply of personal pizzas is:
$Qs = 2 + 5PQs = 2 + 5P$
where Qs is the amount of pizza producers will supply (i.e., quantity supplied).
Finally, suppose that the personal pizza market operates where supply equals demand, or
$Qd = QsQd = Qs$
We now have a system of three equations and three unknowns (Qd, Qs, and P), which we can solve with algebra:
Since Qd = Qs, we can set the demand and supply equation equal to each other:
$Qd = Qs16 – 2P = 2 + 5PQd = Qs16 – 2P = 2 + 5P$
Subtracting 2 from both sides and adding 2P to both sides yields:
$16 – 2P – 2 = 2 + 5P – 214 – 2P = 5P14 – 2P + 2P = 5P + 2P14 = 7P147 = 7P72 = P16 – 2P – 2 = 2 + 5P – 214 – 2P = 5P14 – 2P + 2P = 5P + 2P14 = 7P147 = 7P72 = P$
In other words, the price of each personal pizza will be \$2. How much will consumers buy?
Taking the price of \$2, and plugging it into the demand equation, we get:
$Qd = 16 – 2P = 16 – 2(2) = 16 – 4 = 12Qd = 16 – 2P = 16 – 2(2) = 16 – 4 = 12$
So if the price is \$2 each, consumers will purchase 12. How much will producers supply? Taking the price of \$2, and plugging it into the supply equation, we get:
$Qs = 2 + 5P = 2 + 5(2) = 2 + 10 = 12Qs = 2 + 5P = 2 + 5(2) = 2 + 10 = 12$
So if the price is \$2 each, producers will supply 12 personal pizzas. This means we did our math correctly, since Qd = Qs.
Solving Models with Graphs
If algebra is not your forte, you can get the same answer by using graphs. Take the equations for Qd and Qs and graph them on the same set of axes as shown in Figure A2. Since P is on the vertical axis, it is easiest if you solve each equation for P. The demand curve is then P = 8 – 0.5Qd and the supply curve is P = –0.4 + 0.2Qs. Note that the vertical intercepts are 8 and –0.4, and the slopes are –0.5 for demand and 0.2 for supply. If you draw the graphs carefully, you will see that where they cross (Qs = Qd), the price is \$2 and the quantity is 12, just like the algebra predicted.
Figure A2 Supply and Demand Graph The equations for Qd and Qs are displayed graphically by the sloped lines.
We will use graphs more frequently in this book than algebra, but now you know the math behind the graphs.
Growth Rates
Growth rates are frequently encountered in real world economics. A growth rate is simply the percentage change in some quantity. It could be your income. It could be a business’s sales. It could be a nation’s GDP. The formula for computing a growth rate is straightforward:
$Percentage change = Change in quantityQuantityPercentage change = Change in quantityQuantity$
Suppose your job pays \$10 per hour. Your boss, however, is so impressed with your work that he gives you a \$2 per hour raise. The percentage change (or growth rate) in your pay is \$2/\$10 = 0.20 or 20%.
To compute the growth rate for data over an extended period of time, for example, the average annual growth in GDP over a decade or more, the denominator is commonly defined a little differently. In the previous example, we defined the quantity as the initial quantity—or the quantity when we started. This is fine for a one-time calculation, but when we compute the growth over and over, it makes more sense to define the quantity as the average quantity over the period in question, which is defined as the quantity halfway between the initial quantity and the next quantity. This is harder to explain in words than to show with an example. Suppose a nation’s GDP was \$1 trillion in 2005 and \$1.03 trillion in 2006. The growth rate between 2005 and 2006 would be the change in GDP (\$1.03 trillion – \$1.00 trillion) divided by the average GDP between 2005 and 2006 (\$1.03 trillion + \$1.00 trillion)/2. In other words:
$= 1.03 trillion – 1.00 trillion(1.03 trillion + 1.00 trillion) / 2 = 0.031.015 = 0.0296 = 2.96% growth = 1.03 trillion – 1.00 trillion(1.03 trillion + 1.00 trillion) / 2 = 0.031.015 = 0.0296 = 2.96% growth$
Note that if we used the first method, the calculation would be (\$1.03 trillion – \$1.00 trillion) / \$1.00 trillion = 3% growth, which is approximately the same as the second, more complicated method. If you need a rough approximation, use the first method. If you need accuracy, use the second method.
A few things to remember: A positive growth rate means the quantity is growing. A smaller growth rate means the quantity is growing more slowly. A larger growth rate means the quantity is growing more quickly. A negative growth rate means the quantity is decreasing.
The same change over times yields a smaller growth rate. If you got a \$2 raise each year, in the first year the growth rate would be \$2/\$10 = 20%, as shown above. But in the second year, the growth rate would be \$2/\$12 = 0.167 or 16.7% growth. In the third year, the same \$2 raise would correspond to a \$2/\$14 = 14.2%. The moral of the story is this: To keep the growth rate the same, the change must increase each period.
Displaying Data Graphically and Interpreting the Graph
Graphs are also used to display data or evidence. Graphs are a method of presenting numerical patterns. They condense detailed numerical information into a visual form in which relationships and numerical patterns can be seen more easily. For example, which countries have larger or smaller populations? A careful reader could examine a long list of numbers representing the populations of many countries, but with over 200 nations in the world, searching through such a list would take concentration and time. Putting these same numbers on a graph can quickly reveal population patterns. Economists use graphs both for a compact and readable presentation of groups of numbers and for building an intuitive grasp of relationships and connections.
Three types of graphs are used in this book: line graphs, pie graphs, and bar graphs. Each is discussed below. We also provide warnings about how graphs can be manipulated to alter viewers’ perceptions of the relationships in the data.
Line Graphs
The graphs we have discussed so far are called line graphs, because they show a relationship between two variables: one measured on the horizontal axis and the other measured on the vertical axis.
Sometimes it is useful to show more than one set of data on the same axes. The data in Table A2 is displayed in Figure A3 which shows the relationship between two variables: length and median weight for American baby boys and girls during the first three years of life. (The median means that half of all babies weigh more than this and half weigh less.) The line graph measures length in inches on the horizontal axis and weight in pounds on the vertical axis. For example, point A on the figure shows that a boy who is 28 inches long will have a median weight of about 19 pounds. One line on the graph shows the length-weight relationship for boys and the other line shows the relationship for girls. This kind of graph is widely used by healthcare providers to check whether a child’s physical development is roughly on track.
Figure A3 The Length-Weight Relationship for American Boys and Girls The line graph shows the relationship between height and weight for boys and girls from birth to 3 years. Point A, for example, shows that a boy of 28 inches in height (measured on the horizontal axis) is typically 19 pounds in weight (measured on the vertical axis). These data apply only to children in the first three years of life.
Boys from Birth to 36 Months Girls from Birth to 36 Months
Length (inches) Weight (pounds) Length (inches) Weight (pounds)
20.0 8.0 20.0 7.9
22.0 10.5 22.0 10.5
24.0 13.5 24.0 13.2
26.0 16.4 26.0 16.0
28.0 19.0 28.0 18.8
30.0 21.8 30.0 21.2
32.0 24.3 32.0 24.0
34.0 27.0 34.0 26.2
36.0 29.3 36.0 28.9
38.0 32.0 38.0 31.3
Table A2 Length to Weight Relationship for American Boys and Girls
Not all relationships in economics are linear. Sometimes they are curves. Figure A4 presents another example of a line graph, representing the data from Table A3. In this case, the line graph shows how thin the air becomes when you climb a mountain. The horizontal axis of the figure shows altitude, measured in meters above sea level. The vertical axis measures the density of the air at each altitude. Air density is measured by the weight of the air in a cubic meter of space (that is, a box measuring one meter in height, width, and depth). As the graph shows, air pressure is heaviest at ground level and becomes lighter as you climb. Figure A4 shows that a cubic meter of air at an altitude of 500 meters weighs approximately one kilogram (about 2.2 pounds). However, as the altitude increases, air density decreases. A cubic meter of air at the top of Mount Everest, at about 8,828 meters, would weigh only 0.023 kilograms. The thin air at high altitudes explains why many mountain climbers need to use oxygen tanks as they reach the top of a mountain.
Figure A4 Altitude-Air Density Relationship This line graph shows the relationship between altitude, measured in meters above sea level, and air density, measured in kilograms of air per cubic meter. As altitude rises, air density declines. The point at the top of Mount Everest has an altitude of approximately 8,828 meters above sea level (the horizontal axis) and air density of 0.023 kilograms per cubic meter (the vertical axis).
Altitude (meters) Air Density (kg/cubic meters)
0 1.200
500 1.093
1,000 0.831
1,500 0.678
2,000 0.569
2,500 0.484
3,000 0.415
3,500 0.357
4,000 0.307
4,500 0.231
5,000 0.182
5,500 0.142
6,000 0.100
6,500 0.085
7,000 0.066
7,500 0.051
8,000 0.041
8,500 0.025
9,000 0.022
9,500 0.019
10,000 0.014
Table A3 Altitude to Air Density Relationship
The length-weight relationship and the altitude-air density relationships in these two figures represent averages. If you were to collect actual data on air pressure at different altitudes, the same altitude in different geographic locations will have slightly different air density, depending on factors like how far you are from the equator, local weather conditions, and the humidity in the air. Similarly, in measuring the height and weight of children for the previous line graph, children of a particular height would have a range of different weights, some above average and some below. In the real world, this sort of variation in data is common. The task of a researcher is to organize that data in a way that helps to understand typical patterns. The study of statistics, especially when combined with computer statistics and spreadsheet programs, is a great help in organizing this kind of data, plotting line graphs, and looking for typical underlying relationships. For most economics and social science majors, a statistics course will be required at some point.
One common line graph is called a time series, in which the horizontal axis shows time and the vertical axis displays another variable. Thus, a time series graph shows how a variable changes over time. Figure A5 shows the unemployment rate in the United States since 1975, where unemployment is defined as the percentage of adults who want jobs and are looking for a job, but cannot find one. The points for the unemployment rate in each year are plotted on the graph, and a line then connects the points, showing how the unemployment rate has moved up and down since 1975. The line graph makes it easy to see, for example, that the highest unemployment rate during this time period was slightly less than 10% in the early 1980s and 2010, while the unemployment rate declined from the early 1990s to the end of the 1990s, before rising and then falling back in the early 2000s, and then rising sharply during the recession from 2008–2009.
Figure A5 U.S. Unemployment Rate, 1975–2014 This graph provides a quick visual summary of unemployment data. With a graph like this, it is easy to spot the times of high unemployment and of low unemployment.
Pie Graphs
A pie graph (sometimes called a pie chart) is used to show how an overall total is divided into parts. A circle represents a group as a whole. The slices of this circular “pie” show the relative sizes of subgroups.
Figure A6 shows how the U.S. population was divided among children, working age adults, and the elderly in 1970, 2000, and what is projected for 2030. The information is first conveyed with numbers in Table A4, and then in three pie charts. The first column of Table A4 shows the total U.S. population for each of the three years. Columns 2–4 categorize the total in terms of age groups—from birth to 18 years, from 19 to 64 years, and 65 years and above. In columns 2–4, the first number shows the actual number of people in each age category, while the number in parentheses shows the percentage of the total population comprised by that age group.
Year Total Population 19 and Under 20–64 years Over 65
1970 205.0 million 77.2 (37.6%) 107.7 (52.5%) 20.1 (9.8%)
2000 275.4 million 78.4 (28.5%) 162.2 (58.9%) 34.8 (12.6%)
2030 351.1 million 92.6 (26.4%) 188.2 (53.6%) 70.3 (20.0%)
Table A4 U.S. Age Distribution, 1970, 2000, and 2030 (projected)
Figure A6 Pie Graphs of the U.S. Age Distribution (numbers in millions) The three pie graphs illustrate the division of total population into three age groups for the three different years.
In a pie graph, each slice of the pie represents a share of the total, or a percentage. For example, 50% would be half of the pie and 20% would be one-fifth of the pie. The three pie graphs in Figure A6 show that the share of the U.S. population 65 and over is growing. The pie graphs allow you to get a feel for the relative size of the different age groups from 1970 to 2000 to 2030, without requiring you to slog through the specific numbers and percentages in the table. Some common examples of how pie graphs are used include dividing the population into groups by age, income level, ethnicity, religion, occupation; dividing different firms into categories by size, industry, number of employees; and dividing up government spending or taxes into its main categories.
Bar Graphs
A bar graph uses the height of different bars to compare quantities. Table A5 lists the 12 most populous countries in the world. Figure A7 provides this same data in a bar graph. The height of the bars corresponds to the population of each country. Although you may know that China and India are the most populous countries in the world, seeing how the bars on the graph tower over the other countries helps illustrate the magnitude of the difference between the sizes of national populations.
Figure A7 Leading Countries of the World by Population, 2015 (in millions) The graph shows the 12 countries of the world with the largest populations. The height of the bars in the bar graph shows the size of the population for each country.
Country Population
China 1,369
India 1,270
United States 321
Indonesia 255
Brazil 204
Pakistan 190
Nigeria 184
Bangladesh 158
Russia 146
Japan 127
Mexico 121
Philippines 101
Table A5 Leading 12 Countries of the World by Population
Bar graphs can be subdivided in a way that reveals information similar to that we can get from pie charts. Figure A8 offers three bar graphs based on the information from Figure A6 about the U.S. age distribution in 1970, 2000, and 2030. Figure A8 (a) shows three bars for each year, representing the total number of persons in each age bracket for each year. Figure A8 (b) shows just one bar for each year, but the different age groups are now shaded inside the bar. In Figure A8 (c), still based on the same data, the vertical axis measures percentages rather than the number of persons. In this case, all three bar graphs are the same height, representing 100% of the population, with each bar divided according to the percentage of population in each age group. It is sometimes easier for a reader to run their eyes across several bar graphs, comparing the shaded areas, rather than trying to compare several pie graphs.
Figure A8 U.S. Population with Bar Graphs Population data can be represented in different ways. (a) Shows three bars for each year, representing the total number of persons in each age bracket for each year. (b) Shows just one bar for each year, but the different age groups are now shaded inside the bar. (c) Sets the vertical axis as a measure of percentages rather than the number of persons. All three bar graphs are the same height and each bar is divided according to the percentage of population in each age group.
Figure A7 and Figure A8 show how the bars can represent countries or years, and how the vertical axis can represent a numerical or a percentage value. Bar graphs can also compare size, quantity, rates, distances, and other quantitative categories.
Comparing Line Graphs with Pie Charts and Bar Graphs
Now that you are familiar with pie graphs, bar graphs, and line graphs, how do you know which graph to use for your data? Pie graphs are often better than line graphs at showing how an overall group is divided. However, if a pie graph has too many slices, it can become difficult to interpret.
Bar graphs are especially useful when comparing quantities. For example, if you are studying the populations of different countries, as in Figure A7, bar graphs can show the relationships between the population sizes of multiple countries. Not only can it show these relationships, but it can also show breakdowns of different groups within the population.
A line graph is often the most effective format for illustrating a relationship between two variables that are both changing. For example, time series graphs can show patterns as time changes, like the unemployment rate over time. Line graphs are widely used in economics to present continuous data about prices, wages, quantities bought and sold, the size of the economy.
How Graphs Can Be Misleading
Graphs not only reveal patterns; they can also alter how patterns are perceived. To see some of the ways this can be done, consider the line graphs of Figure A9, Figure A10, and Figure A11. These graphs all illustrate the unemployment rate—but from different perspectives.
Figure A9
Figure A10 Presenting Unemployment Rates in Different Ways, All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data.
Figure A11 Presenting Unemployment Rates in Different Ways, All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data.
Suppose you wanted a graph which gives the impression that the rise in unemployment in 2009 was not all that large, or all that extraordinary by historical standards. You might choose to present your data as in Figure A9 (a). Figure A9 (a) includes much of the same data presented earlier in Figure A5, but stretches the horizontal axis out longer relative to the vertical axis. By spreading the graph wide and flat, the visual appearance is that the rise in unemployment is not so large, and is similar to some past rises in unemployment. Now imagine you wanted to emphasize how unemployment spiked substantially higher in 2009. In this case, using the same data, you can stretch the vertical axis out relative to the horizontal axis, as in Figure A9 (b), which makes all rises and falls in unemployment appear larger.
A similar effect can be accomplished without changing the length of the axes, but by changing the scale on the vertical axis. In Figure A10 (c), the scale on the vertical axis runs from 0% to 30%, while in Figure A10 (d), the vertical axis runs from 3% to 10%. Compared to Figure A5, where the vertical scale runs from 0% to 12%, Figure A10 (c) makes the fluctuation in unemployment look smaller, while Figure A10 (d) makes it look larger.
Another way to alter the perception of the graph is to reduce the amount of variation by changing the number of points plotted on the graph. Figure A10 (e) shows the unemployment rate according to five-year averages. By averaging out some of the year-to-year changes, the line appears smoother and with fewer highs and lows. In reality, the unemployment rate is reported monthly, and Figure A11 (f) shows the monthly figures since 1960, which fluctuate more than the five-year average. Figure A11 (f) is also a vivid illustration of how graphs can compress lots of data. The graph includes monthly data since 1960, which over almost 50 years, works out to nearly 600 data points. Reading that list of 600 data points in numerical form would be hypnotic. You can, however, get a good intuitive sense of these 600 data points very quickly from the graph.
A final trick in manipulating the perception of graphical information is that, by choosing the starting and ending points carefully, you can influence the perception of whether the variable is rising or falling. The original data show a general pattern with unemployment low in the 1960s, but spiking up in the mid-1970s, early 1980s, early 1990s, early 2000s, and late 2000s. Figure A11 (g), however, shows a graph that goes back only to 1975, which gives an impression that unemployment was more-or-less gradually falling over time until the 2009 recession pushed it back up to its “original” level—which is a plausible interpretation if one starts at the high point around 1975.
These kinds of tricks—or shall we just call them “presentation choices”— are not limited to line graphs. In a pie chart with many small slices and one large slice, someone must decide what categories should be used to produce these slices in the first place, thus making some slices appear bigger than others. If you are making a bar graph, you can make the vertical axis either taller or shorter, which will tend to make variations in the height of the bars appear more or less.
Being able to read graphs is an essential skill, both in economics and in life. A graph is just one perspective or point of view, shaped by choices such as those discussed in this section. Do not always believe the first quick impression from a graph. View with caution.
Key Concepts and Summary
Math is a tool for understanding economics and economic relationships can be expressed mathematically using algebra or graphs. The algebraic equation for a line is y = b + mx, where x is the variable on the horizontal axis and y is the variable on the vertical axis, the b term is the y-intercept and the m term is the slope. The slope of a line is the same at any point on the line and it indicates the relationship (positive, negative, or zero) between two economic variables.
Economic models can be solved algebraically or graphically. Graphs allow you to illustrate data visually. They can illustrate patterns, comparisons, trends, and apportionment by condensing the numerical data and providing an intuitive sense of relationships in the data. A line graph shows the relationship between two variables: one is shown on the horizontal axis and one on the vertical axis. A pie graph shows how something is allotted, such as a sum of money or a group of people. The size of each slice of the pie is drawn to represent the corresponding percentage of the whole. A bar graph uses the height of bars to show a relationship, where each bar represents a certain entity, like a country or a group of people. The bars on a bar graph can also be divided into segments to show subgroups.
Any graph is a single visual perspective on a subject. The impression it leaves will be based on many choices, such as what data or time frame is included, how data or groups are divided up, the relative size of vertical and horizontal axes, whether the scale used on a vertical starts at zero. Thus, any graph should be regarded somewhat skeptically, remembering that the underlying relationship can be open to different interpretations.
Review Questions
Exercise A1
Name three kinds of graphs and briefly state when is most appropriate to use each type of graph.
Exercise A2
What is slope on a line graph?
Exercise A3
What do the slices of a pie chart represent?
Exercise A4
Why is a bar chart the best way to illustrate comparisons?
Exercise A5
How does the appearance of positive slope differ from negative slope and from zero slope? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.01%3A_Appendix_A-_The_Use_of_Mathematics_in_Principles_of_Economics.txt |
(This appendix should be consulted after first reading The Aggregate Demand/Aggregate Supply Model and The Keynesian Perspective.) The fundamental ideas of Keynesian economics were developed before the AD/AS model was popularized. From the 1930s until the 1970s, Keynesian economics was usually explained with a different model, known as the expenditure-output approach. This approach is strongly rooted in the fundamental assumptions of Keynesian economics: it focuses on the total amount of spending in the economy, with no explicit mention of aggregate supply or of the price level (although as you will see, it is possible to draw some inferences about aggregate supply and price levels based on the diagram).
The Axes of the Expenditure-Output Diagram
The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy are equal to the amount of output produced. The axes of the Keynesian cross diagram presented in Figure B1 show real GDP on the horizontal axis as a measure of output and aggregate expenditures on the vertical axis as a measure of spending.
Figure B1 The Expenditure-Output Diagram The aggregate expenditure-output model shows aggregate expenditures on the vertical axis and real GDP on the horizontal axis. A vertical line shows potential GDP where full employment occurs. The 45-degree line shows all points where aggregate expenditures and output are equal. The aggregate expenditure schedule shows how total spending or aggregate expenditure increases as output or real GDP rises. The intersection of the aggregate expenditure schedule and the 45-degree line will be the equilibrium. Equilibrium occurs at E0, where aggregate expenditure AE0 is equal to the output level Y0.
Remember that GDP can be thought of in several equivalent ways: it measures both the value of spending on final goods and also the value of the production of final goods. All sales of the final goods and services that make up GDP will eventually end up as income for workers, for managers, and for investors and owners of firms. The sum of all the income received for contributing resources to GDP is called national income (Y). At some points in the discussion that follows, it will be useful to refer to real GDP as “national income.” Both axes are measured in real (inflation-adjusted) terms.
The Potential GDP Line and the 45-degree Line
The Keynesian cross diagram contains two lines that serve as conceptual guideposts to orient the discussion. The first is a vertical line showing the level of potential GDP. Potential GDP means the same thing here that it means in the AD/AS diagrams: it refers to the quantity of output that the economy can produce with full employment of its labor and physical capital.
The second conceptual line on the Keynesian cross diagram is the 45-degree line, which starts at the origin and reaches up and to the right. A line that stretches up at a 45-degree angle represents the set of points (1, 1), (2, 2), (3, 3) and so on, where the measurement on the vertical axis is equal to the measurement on the horizontal axis. In this diagram, the 45-degree line shows the set of points where the level of aggregate expenditure in the economy, measured on the vertical axis, is equal to the level of output or national income in the economy, measured by GDP on the horizontal axis.
When the macroeconomy is in equilibrium, it must be true that the aggregate expenditures in the economy are equal to the real GDP—because by definition, GDP is the measure of what is spent on final sales of goods and services in the economy. Thus, the equilibrium calculated with a Keynesian cross diagram will always end up where aggregate expenditure and output are equal—which will only occur along the 45-degree line.
The Aggregate Expenditure Schedule
The final ingredient of the Keynesian cross or expenditure-output diagram is the aggregate expenditure schedule, which will show the total expenditures in the economy for each level of real GDP. The intersection of the aggregate expenditure line with the 45-degree line—at point E0 in Figure B1—will show the equilibrium for the economy, because it is the point where aggregate expenditure is equal to output or real GDP. After developing an understanding of what the aggregate expenditures schedule means, we will return to this equilibrium and how to interpret it.
Building the Aggregate Expenditure Schedule
Aggregate expenditure is the key to the expenditure-income model. The aggregate expenditure schedule shows, either in the form of a table or a graph, how aggregate expenditures in the economy rise as real GDP or national income rises. Thus, in thinking about the components of the aggregate expenditure line—consumption, investment, government spending, exports and imports—the key question is how expenditures in each category will adjust as national income rises.
Consumption as a Function of National Income
How do consumption expenditures increase as national income rises? People can do two things with their income: consume it or save it (for the moment, let’s ignore the need to pay taxes with some of it). Each person who receives an additional dollar faces this choice. The marginal propensity to consume (MPC), is the share of the additional dollar of income a person decides to devote to consumption expenditures. The marginal propensity to save (MPS) is the share of the additional dollar a person decides to save. It must always hold true that:
$MPC + MPS = 1MPC + MPS = 1$
For example, if the marginal propensity to consume out of the marginal amount of income earned is 0.9, then the marginal propensity to save is 0.1.
With this relationship in mind, consider the relationship among income, consumption, and savings shown in Figure B2. (Note that we use “Aggregate Expenditure” on the vertical axis in this and the following figures, because all consumption expenditures are parts of aggregate expenditures.)
An assumption commonly made in this model is that even if income were zero, people would have to consume something. In this example, consumption would be \$600 even if income were zero. Then, the MPC is 0.8 and the MPS is 0.2. Thus, when income increases by \$1,000, consumption rises by \$800 and savings rises by \$200. At an income of \$4,000, total consumption will be the \$600 that would be consumed even without any income, plus \$4,000 multiplied by the marginal propensity to consume of 0.8, or \$ 3,200, for a total of \$ 3,800. The total amount of consumption and saving must always add up to the total amount of income. (Exactly how a situation of zero income and negative savings would work in practice is not important, because even low-income societies are not literally at zero income, so the point is hypothetical.) This relationship between income and consumption, illustrated in Figure B2 and Table B1, is called the consumption function.
Figure B2 The Consumption Function In the expenditure-output model, how does consumption increase with the level of national income? Output on the horizontal axis is conceptually the same as national income, since the value of all final output that is produced and sold must be income to someone, somewhere in the economy. At a national income level of zero, \$600 is consumed. Then, each time income rises by \$1,000, consumption rises by \$800, because in this example, the marginal propensity to consume is 0.8.
The pattern of consumption shown in Table B1 is plotted in Figure B2. To calculate consumption, multiply the income level by 0.8, for the marginal propensity to consume, and add \$600, for the amount that would be consumed even if income was zero. Consumption plus savings must be equal to income.
Income Consumption Savings
\$0 \$600 –\$600
\$1,000 \$1,400 –\$400
\$2,000 \$2,200 –\$200
\$3,000 \$3,000 \$0
\$4,000 \$3,800 \$200
\$5,000 \$4,600 \$400
\$6,000 \$5,400 \$600
\$7,000 \$6,200 \$800
\$8,000 \$7,000 \$1,000
\$9,000 \$7,800 \$1,200
Table B1 The Consumption Function
However, a number of factors other than income can also cause the entire consumption function to shift. These factors were summarized in the earlier discussion of consumption, and listed in Table B1. When the consumption function moves, it can shift in two ways: either the entire consumption function can move up or down in a parallel manner, or the slope of the consumption function can shift so that it becomes steeper or flatter. For example, if a tax cut leads consumers to spend more, but does not affect their marginal propensity to consume, it would cause an upward shift to a new consumption function that is parallel to the original one. However, a change in household preferences for saving that reduced the marginal propensity to save would cause the slope of the consumption function to become steeper: that is, if the savings rate is lower, then every increase in income leads to a larger rise in consumption.
Investment as a Function of National Income
Investment decisions are forward-looking, based on expected rates of return. Precisely because investment decisions depend primarily on perceptions about future economic conditions, they do not depend primarily on the level of GDP in the current year. Thus, on a Keynesian cross diagram, the investment function can be drawn as a horizontal line, at a fixed level of expenditure. Figure B3 shows an investment function where the level of investment is, for the sake of concreteness, set at the specific level of 500. Just as a consumption function shows the relationship between consumption levels and real GDP (or national income), the investment function shows the relationship between investment levels and real GDP.
Figure B3 The Investment Function The investment function is drawn as a flat line because investment is based on interest rates and expectations about the future, and so it does not change with the level of current national income. In this example, investment expenditures are at a level of 500. However, changes in factors like technological opportunities, expectations about near-term economic growth, and interest rates would all cause the investment function to shift up or down.
The appearance of the investment function as a horizontal line does not mean that the level of investment never moves. It means only that in the context of this two-dimensional diagram, the level of investment on the vertical aggregate expenditure axis does not vary according to the current level of real GDP on the horizontal axis. However, all the other factors that vary investment—new technological opportunities, expectations about near-term economic growth, interest rates, the price of key inputs, and tax incentives for investment—can cause the horizontal investment function to shift up or down.
Government Spending and Taxes as a Function of National Income
In the Keynesian cross diagram, government spending appears as a horizontal line, as in Figure B4, where government spending is set at a level of 1,300. As in the case of investment spending, this horizontal line does not mean that government spending is unchanging. It means only that government spending changes when Congress decides on a change in the budget, rather than shifting in a predictable way with the current size of the real GDP shown on the horizontal axis.
Figure B4 The Government Spending Function The level of government spending is determined by political factors, not by the level of real GDP in a given year. Thus, government spending is drawn as a horizontal line. In this example, government spending is at a level of 1,300. Congressional decisions to increase government spending will cause this horizontal line to shift up, while decisions to reduce spending would cause it to shift down.
The situation of taxes is different because taxes often rise or fall with the volume of economic activity. For example, income taxes are based on the level of income earned and sales taxes are based on the amount of sales made, and both income and sales tend to be higher when the economy is growing and lower when the economy is in a recession. For the purposes of constructing the basic Keynesian cross diagram, it is helpful to view taxes as a proportionate share of GDP. In the United States, for example, taking federal, state, and local taxes together, government typically collects about 30–35 % of income as taxes.
Table B2 revises the earlier table on the consumption function so that it takes taxes into account. The first column shows national income. The second column calculates taxes, which in this example are set at a rate of 30%, or 0.3. The third column shows after-tax income; that is, total income minus taxes. The fourth column then calculates consumption in the same manner as before: multiply after-tax income by 0.8, representing the marginal propensity to consume, and then add \$600, for the amount that would be consumed even if income was zero. When taxes are included, the marginal propensity to consume is reduced by the amount of the tax rate, so each additional dollar of income results in a smaller increase in consumption than before taxes. For this reason, the consumption function, with taxes included, is flatter than the consumption function without taxes, as Figure B5 shows.
Figure B5 The Consumption Function Before and After Taxes The upper line repeats the consumption function from Figure B2. The lower line shows the consumption function if taxes must first be paid on income, and then consumption is based on after-tax income.
Income Taxes After-Tax Income Consumption Savings
\$0 \$0 \$0 \$600 –\$600
\$1,000 \$300 \$700 \$1,160 –\$460
\$2,000 \$600 \$1,400 \$1,720 –\$320
\$3,000 \$900 \$2,100 \$2,280 –\$180
\$4,000 \$1,200 \$2,800 \$2,840 –\$40
\$5,000 \$1,500 \$3,500 \$3,400 \$100
\$6,000 \$1,800 \$4,200 \$3,960 \$240
\$7,000 \$2,100 \$4,900 \$4,520 \$380
\$8,000 \$2,400 \$5,600 \$5,080 \$520
\$9,000 \$2,700 \$6,300 \$5,640 \$660
Table B2 The Consumption Function Before and After Taxes
Exports and Imports as a Function of National Income
The export function, which shows how exports change with the level of a country’s own real GDP, is drawn as a horizontal line, as in the example in Figure B6 (a) where exports are drawn at a level of \$840. Again, as in the case of investment spending and government spending, drawing the export function as horizontal does not imply that exports never change. It just means that they do not change because of what is on the horizontal axis—that is, a country’s own level of domestic production—and instead are shaped by the level of aggregate demand in other countries. More demand for exports from other countries would cause the export function to shift up; less demand for exports from other countries would cause it to shift down.
Figure B6 The Export and Import Functions (a) The export function is drawn as a horizontal line because exports are determined by the buying power of other countries and thus do not change with the size of the domestic economy. In this example, exports are set at 840. However, exports can shift up or down, depending on buying patterns in other countries. (b) The import function is drawn in negative territory because expenditures on imported products are a subtraction from expenditures in the domestic economy. In this example, the marginal propensity to import is 0.1, so imports are calculated by multiplying the level of income by –0.1.
Imports are drawn in the Keynesian cross diagram as a downward-sloping line, with the downward slope determined by the marginal propensity to import (MPI), out of national income. In Figure B6 (b), the marginal propensity to import is 0.1. Thus, if real GDP is \$5,000, imports are \$500; if national income is \$6,000, imports are \$600, and so on. The import function is drawn as downward sloping and negative, because it represents a subtraction from the aggregate expenditures in the domestic economy. A change in the marginal propensity to import, perhaps as a result of changes in preferences, would alter the slope of the import function.
Work It Out
Using an Algebraic Approach to the Expenditure-Output Model
In the expenditure-output or Keynesian cross model, the equilibrium occurs where the aggregate expenditure line (AE line) crosses the 45-degree line. Given algebraic equations for two lines, the point where they cross can be readily calculated. Imagine an economy with the following characteristics.
Y = Real GDP or national income
T = Taxes = 0.3Y
C = Consumption = 140 + 0.9(Y – T)
I = Investment = 400
G = Government spending = 800
X = Exports = 600
M = Imports = 0.15Y
Step 1. Determine the aggregate expenditure function. In this case, it is:
$AE = C + I + G + X – MAE = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15YAE = C + I + G + X – MAE = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15Y$
Step 2. The equation for the 45-degree line is the set of points where GDP or national income on the horizontal axis is equal to aggregate expenditure on the vertical axis. Thus, the equation for the 45-degree line is: AE = Y.
Step 3. The next step is to solve these two equations for Y (or AE, since they will be equal to each other). Substitute Y for AE:
$Y = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15YY = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15Y$
Step 4. Insert the term 0.3Y for the tax rate T. This produces an equation with only one variable, Y.
Step 5. Work through the algebra and solve for Y.
$Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.15YY = 140 + 0.9Y – 0.27Y + 1800 – 0.15YY = 1940 + 0.48YY – 0.48Y = 19400.52Y = 19400.52Y0.52 = 19400.52Y = 3730Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.15YY = 140 + 0.9Y – 0.27Y + 1800 – 0.15YY = 1940 + 0.48YY – 0.48Y = 19400.52Y = 19400.52Y0.52 = 19400.52Y = 3730$
This algebraic framework is flexible and useful in predicting how economic events and policy actions will affect real GDP.
Step 6. Say, for example, that because of changes in the relative prices of domestic and foreign goods, the marginal propensity to import falls to 0.1. Calculate the equilibrium output when the marginal propensity to import is changed to 0.1.
$Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.1YY = 1940 – 0.53Y0.47Y = 1940Y = 4127Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.1YY = 1940 – 0.53Y0.47Y = 1940Y = 4127$
Step 7. Because of a surge of business confidence, investment rises to 500. Calculate the equilibrium output.
$Y = 140 + 0.9(Y – 0.3Y) + 500 + 800 + 600 – 0.15Y Y = 2040 + 0.48YY – 0.48Y = 20400.52Y = 2040Y = 3923Y = 140 + 0.9(Y – 0.3Y) + 500 + 800 + 600 – 0.15Y Y = 2040 + 0.48YY – 0.48Y = 20400.52Y = 2040Y = 3923$
For issues of policy, the key questions would be how to adjust government spending levels or tax rates so that the equilibrium level of output is the full employment level. In this case, let the economic parameters be:
Y = National income
T = Taxes = 0.3Y
C = Consumption = 200 + 0.9(Y – T)
I = Investment = 600
G = Government spending = 1,000
X = Exports = 600
Y = Imports = 0.1(Y – T)
Step 8. Calculate the equilibrium for this economy (remember Y = AE).
$Y = 200 + 0.9(Y – 0.3Y) + 600 + 1000 + 600 – 0.1(Y – 0.3Y)Y – 0.63Y + 0.07Y = 24000.44Y = 2400Y = 5454Y = 200 + 0.9(Y – 0.3Y) + 600 + 1000 + 600 – 0.1(Y – 0.3Y)Y – 0.63Y + 0.07Y = 24000.44Y = 2400Y = 5454$
Step 9. Assume that the full employment level of output is 6,000. What level of government spending would be necessary to reach that level? To answer this question, plug in 6,000 as equal to Y, but leave G as a variable, and solve for G. Thus:
$6000 = 200 + 0.9(6000 – 0.3(6000)) + 600 + G + 600 – 0.1(6000 – 0.3(6000))6000 = 200 + 0.9(6000 – 0.3(6000)) + 600 + G + 600 – 0.1(6000 – 0.3(6000))$
Step 10. Solve this problem arithmetically. The answer is: G = 1,240. In other words, increasing government spending by 240, from its original level of 1,000, to 1,240, would raise output to the full employment level of GDP.
Indeed, the question of how much to increase government spending so that equilibrium output will rise from 5,454 to 6,000 can be answered without working through the algebra, just by using the multiplier formula. The multiplier equation in this case is:
$11 – 0.56 = 2.2711 – 0.56 = 2.27$
Thus, to raise output by 546 would require an increase in government spending of 546/2.27=240, which is the same as the answer derived from the algebraic calculation.
This algebraic framework is highly flexible. For example, taxes can be treated as a total set by political considerations (like government spending) and not dependent on national income. Imports might be based on before-tax income, not after-tax income. For certain purposes, it may be helpful to analyze the economy without exports and imports. A more complicated approach could divide up consumption, investment, government, exports and imports into smaller categories, or to build in some variability in the rates of taxes, savings, and imports. A wise economist will shape the model to fit the specific question under investigation.
Building the Combined Aggregate Expenditure Function
All the components of aggregate demand—consumption, investment, government spending, and the trade balance—are now in place to build the Keynesian cross diagram. Figure B7 builds up an aggregate expenditure function, based on the numerical illustrations of C, I, G, X, and M that have been used throughout this text. The first three columns in Table B3 are lifted from the earlier Table B2, which showed how to bring taxes into the consumption function. The first column is real GDP or national income, which is what appears on the horizontal axis of the income-expenditure diagram. The second column calculates after-tax income, based on the assumption, in this case, that 30% of real GDP is collected in taxes. The third column is based on an MPC of 0.8, so that as after-tax income rises by \$700 from one row to the next, consumption rises by \$560 (700 × 0.8) from one row to the next. Investment, government spending, and exports do not change with the level of current national income. In the previous discussion, investment was \$500, government spending was \$1,300, and exports were \$840, for a total of \$2,640. This total is shown in the fourth column. Imports are 0.1 of real GDP in this example, and the level of imports is calculated in the fifth column. The final column, aggregate expenditures, sums up C + I + G + X – M. This aggregate expenditure line is illustrated in Figure B7.
Figure B7 A Keynesian Cross Diagram Each combination of national income and aggregate expenditure (after-tax consumption, government spending, investment, exports, and imports) is graphed. The equilibrium occurs where aggregate expenditure is equal to national income; this occurs where the aggregate expenditure schedule crosses the 45-degree line, at a real GDP of \$6,000. Potential GDP in this example is \$7,000, so the equilibrium is occurring at a level of output or real GDP below the potential GDP level.
National Income After-Tax Income Consumption Government Spending + Investment + Exports Imports Aggregate Expenditure
\$3,000 \$2,100 \$2,280 \$2,640 \$300 \$4,620
\$4,000 \$2,800 \$2,840 \$2,640 \$400 \$5,080
\$5,000 \$3,500 \$3,400 \$2,640 \$500 \$5,540
\$6,000 \$4,200 \$3,960 \$2,640 \$600 \$6,000
\$7,000 \$4,900 \$4,520 \$2,640 \$700 \$6,460
\$8,000 \$5,600 \$5,080 \$2,640 \$800 \$6,920
\$9,000 \$6,300 \$5,640 \$2,640 \$900 \$7,380
Table B3 National Income-Aggregate Expenditure Equilibrium
The aggregate expenditure function is formed by stacking on top of each other the consumption function (after taxes), the investment function, the government spending function, the export function, and the import function. The point at which the aggregate expenditure function intersects the vertical axis will be determined by the levels of investment, government, and export expenditures—which do not vary with national income. The upward slope of the aggregate expenditure function will be determined by the marginal propensity to save, the tax rate, and the marginal propensity to import. A higher marginal propensity to save, a higher tax rate, and a higher marginal propensity to import will all make the slope of the aggregate expenditure function flatter—because out of any extra income, more is going to savings or taxes or imports and less to spending on domestic goods and services.
The equilibrium occurs where national income is equal to aggregate expenditure, which is shown on the graph as the point where the aggregate expenditure schedule crosses the 45-degree line. In this example, the equilibrium occurs at 6,000. This equilibrium can also be read off the table under the figure; it is the level of national income where aggregate expenditure is equal to national income.
Equilibrium in the Keynesian Cross Model
With the aggregate expenditure line in place, the next step is to relate it to the two other elements of the Keynesian cross diagram. Thus, the first subsection interprets the intersection of the aggregate expenditure function and the 45-degree line, while the next subsection relates this point of intersection to the potential GDP line.
Where Equilibrium Occurs
The point where the aggregate expenditure line that is constructed from C + I + G + X – M crosses the 45-degree line will be the equilibrium for the economy. It is the only point on the aggregate expenditure line where the total amount being spent on aggregate demand equals the total level of production. In Figure B7, this point of equilibrium (E0) happens at 6,000, which can also be read off Table B3.
The meaning of “equilibrium” remains the same; that is, equilibrium is a point of balance where no incentive exists to shift away from that outcome. To understand why the point of intersection between the aggregate expenditure function and the 45-degree line is a macroeconomic equilibrium, consider what would happen if an economy found itself to the right of the equilibrium point E, say point H in Figure B8, where output is higher than the equilibrium. At point H, the level of aggregate expenditure is below the 45-degree line, so that the level of aggregate expenditure in the economy is less than the level of output. As a result, at point H, output is piling up unsold—not a sustainable state of affairs.
Figure B8 Equilibrium in the Keynesian Cross Diagram If output was above the equilibrium level, at H, then the real output is greater than the aggregate expenditure in the economy. This pattern cannot hold, because it would mean that goods are produced but piling up unsold. If output was below the equilibrium level at L, then aggregate expenditure would be greater than output. This pattern cannot hold either, because it would mean that spending exceeds the number of goods being produced. Only point E can be at equilibrium, where output, or national income and aggregate expenditure, are equal. The equilibrium (E) must lie on the 45-degree line, which is the set of points where national income and aggregate expenditure are equal.
Conversely, consider the situation where the level of output is at point L—where real output is lower than the equilibrium. In that case, the level of aggregate demand in the economy is above the 45-degree line, indicating that the level of aggregate expenditure in the economy is greater than the level of output. When the level of aggregate demand has emptied the store shelves, it cannot be sustained, either. Firms will respond by increasing their level of production. Thus, the equilibrium must be the point where the amount produced and the amount spent are in balance, at the intersection of the aggregate expenditure function and the 45-degree line.
Work It Out
Finding Equilibrium
Table B4 gives some information on an economy. The Keynesian model assumes that there is some level of consumption even without income. That amount is \$236 – \$216 = \$20. \$20 will be consumed when national income equals zero. Assume that taxes are 0.2 of real GDP. Let the marginal propensity to save of after-tax income be 0.1. The level of investment is \$70, the level of government spending is \$80, and the level of exports is \$50. Imports are 0.2 of after-tax income. Given these values, you need to complete Table B4 and then answer these questions:
• What is the consumption function?
• What is the equilibrium?
• Why is a national income of \$300 not at equilibrium?
• How do expenditures and output compare at this point?
National Income Taxes After-tax income Consumption I + G + X Imports Aggregate Expenditures
\$300 \$236
\$400
\$500
\$600
\$700
Table B4
Step 1. Calculate the amount of taxes for each level of national income(reminder: GDP = national income) for each level of national income using the following as an example:
$National Income (Y)300Taxes = 0.2 or 20%× 0.2Tax amount (T)60National Income (Y)300Taxes = 0.2 or 20%× 0.2Tax amount (T)60$
Step 2. Calculate after-tax income by subtracting the tax amount from national income for each level of national income using the following as an example:
$National income minus taxes300–60After-tax income240National income minus taxes300–60After-tax income240$
Step 3. Calculate consumption. The marginal propensity to save is given as 0.1. This means that the marginal propensity to consume is 0.9, since MPS + MPC = 1. Therefore, multiply 0.9 by the after-tax income amount using the following as an example:
$After-tax Income240MPC× 0.9Consumption216After-tax Income240MPC× 0.9Consumption216$
Step 4. Consider why the table shows consumption of \$236 in the first row. As mentioned earlier, the Keynesian model assumes that there is some level of consumption even without income. That amount is \$236 – \$216 = \$20.
Step 5. There is now enough information to write the consumption function. The consumption function is found by figuring out the level of consumption that will happen when income is zero. Remember that:
$C = Consumption when national income is zero + MPC (after-tax income)C = Consumption when national income is zero + MPC (after-tax income)$
Let C represent the consumption function, Y represent national income, and T represent taxes.
$C = 20 + 0.9(Y – T) = 20 + 0.9(300 – 60) = 236C = 20 + 0.9(Y – T) = 20 + 0.9(300 – 60) = 236$
Step 6. Use the consumption function to find consumption at each level of national income.
Step 7. Add investment (I), government spending (G), and exports (X). Remember that these do not change as national income changes:
Step 8. Find imports, which are 0.2 of after-tax income at each level of national income. For example:
$After-tax income240Imports of 0.2 or 20% of Y – T× 0.2Imports48After-tax income240Imports of 0.2 or 20% of Y – T× 0.2Imports48$
Step 9. Find aggregate expenditure by adding C + I + G + X – I for each level of national income. Your completed table should look like Table B5.
National Income (Y) Tax = 0.2 × Y (T) After-tax income (Y – T) Consumption C = \$20 + 0.9(Y – T) I + G + X Minus Imports (M) Aggregate Expenditures AE = C + I + G + X – M
\$300 \$60 \$240 \$236 \$200 \$48 \$388
\$400 \$80 \$320 \$308 \$200 \$64 \$444
\$500 \$100 \$400 \$380 \$200 \$80 \$500
\$600 \$120 \$480 \$452 \$200 \$96 \$556
\$700 \$140 \$560 \$524 \$200 \$112 \$612
Table B5
Step 10. Answer the question: What is equilibrium? Equilibrium occurs where AE = Y. Table B5 shows that equilibrium occurs where national income equals aggregate expenditure at \$500.
Step 11. Find equilibrium mathematically, knowing that national income is equal to aggregate expenditure.
$Y = AE = C + I + G + X – M = 20 + 0.9(Y – T) + 70 + 80 + 50 – 0.2(Y – T) = 220 + 0.9(Y – T) – 0.2(Y – T)Y = AE = C + I + G + X – M = 20 + 0.9(Y – T) + 70 + 80 + 50 – 0.2(Y – T) = 220 + 0.9(Y – T) – 0.2(Y – T)$
Since T is 0.2 of national income, substitute T with 0.2 Y so that:
$Y = 220 + 0.9(Y – 0.2Y) – 0.2(Y – 0.2Y) = 220 + 0.9Y – 0.18Y – 0.2Y + 0.04Y = 220 + 0.56YY = 220 + 0.9(Y – 0.2Y) – 0.2(Y – 0.2Y) = 220 + 0.9Y – 0.18Y – 0.2Y + 0.04Y = 220 + 0.56Y$
Solve for Y.
$Y = 220 + 0.56YY – 0.56Y = 2200.44Y = 2200.44Y0.44 = 2200.44Y = 500Y = 220 + 0.56YY – 0.56Y = 2200.44Y = 2200.44Y0.44 = 2200.44Y = 500$
Step 12. Answer this question: Why is a national income of \$300 not an equilibrium? At national income of \$300, aggregate expenditures are \$388.
Step 13. Answer this question: How do expenditures and output compare at this point? Aggregate expenditures cannot exceed output (GDP) in the long run, since there would not be enough goods to be bought.
Recessionary and Inflationary Gaps
In the Keynesian cross diagram, if the aggregate expenditure line intersects the 45-degree line at the level of potential GDP, then the economy is in sound shape. There is no recession, and unemployment is low. But there is no guarantee that the equilibrium will occur at the potential GDP level of output. The equilibrium might be higher or lower.
For example, Figure B9 (a) illustrates a situation where the aggregate expenditure line intersects the 45-degree line at point E0, which is a real GDP of \$6,000, and which is below the potential GDP of \$7,000. In this situation, the level of aggregate expenditure is too low for GDP to reach its full employment level, and unemployment will occur. The distance between an output level like E0 that is below potential GDP and the level of potential GDP is called a recessionary gap. Because the equilibrium level of real GDP is so low, firms will not wish to hire the full employment number of workers, and unemployment will be high.
Figure B9 Addressing Recessionary and Inflationary Gaps (a) If the equilibrium occurs at an output below potential GDP, then a recessionary gap exists. The policy solution to a recessionary gap is to shift the aggregate expenditure schedule up from AE0 to AE1, using policies like tax cuts or government spending increases. Then the new equilibrium E1 occurs at potential GDP. (b) If the equilibrium occurs at an output above potential GDP, then an inflationary gap exists. The policy solution to an inflationary gap is to shift the aggregate expenditure schedule down from AE0 to AE1, using policies like tax increases or spending cuts. Then, the new equilibrium E1 occurs at potential GDP.
What might cause a recessionary gap? Anything that shifts the aggregate expenditure line down is a potential cause of recession, including a decline in consumption, a rise in savings, a fall in investment, a drop in government spending or a rise in taxes, or a fall in exports or a rise in imports. Moreover, an economy that is at equilibrium with a recessionary gap may just stay there and suffer high unemployment for a long time; remember, the meaning of equilibrium is that there is no particular adjustment of prices or quantities in the economy to chase the recession away.
The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AE0 to AE1. When this shift occurs, the new equilibrium E1 now occurs at potential GDP as shown in Figure B9 (a).
Conversely, Figure B9 (b) shows a situation where the aggregate expenditure schedule (AE0) intersects the 45-degree line above potential GDP. The gap between the level of real GDP at the equilibrium E0 and potential GDP is called an inflationary gap. The inflationary gap also requires a bit of interpreting. After all, a naïve reading of the Keynesian cross diagram might suggest that if the aggregate expenditure function is just pushed up high enough, real GDP can be as large as desired—even doubling or tripling the potential GDP level of the economy. This implication is clearly wrong. An economy faces some supply-side limits on how much it can produce at a given time with its existing quantities of workers, physical and human capital, technology, and market institutions.
The inflationary gap should be interpreted, not as a literal prediction of how large real GDP will be, but as a statement of how much extra aggregate expenditure is in the economy beyond what is needed to reach potential GDP. An inflationary gap suggests that because the economy cannot produce enough goods and services to absorb this level of aggregate expenditures, the spending will instead cause an inflationary increase in the price level. In this way, even though changes in the price level do not appear explicitly in the Keynesian cross equation, the notion of inflation is implicit in the concept of the inflationary gap.
The appropriate Keynesian response to an inflationary gap is shown in Figure B9 (b). The original intersection of aggregate expenditure line AE0 and the 45-degree line occurs at \$8,000, which is above the level of potential GDP at \$7,000. If AE0 shifts down to AE1, so that the new equilibrium is at E1, then the economy will be at potential GDP without pressures for inflationary price increases. The government can achieve a downward shift in aggregate expenditure by increasing taxes on consumers or firms, or by reducing government expenditures.
The Multiplier Effect
The Keynesian policy prescription has one final twist. Assume that for a certain economy, the intersection of the aggregate expenditure function and the 45-degree line is at a GDP of 700, while the level of potential GDP for this economy is \$800. By how much does government spending need to be increased so that the economy reaches the full employment GDP? The obvious answer might seem to be \$800 – \$700 = \$100; so raise government spending by \$100. But that answer is incorrect. A change of, for example, \$100 in government expenditures will have an effect of more than \$100 on the equilibrium level of real GDP. The reason is that a change in aggregate expenditures circles through the economy: households buy from firms, firms pay workers and suppliers, workers and suppliers buy goods from other firms, those firms pay their workers and suppliers, and so on. In this way, the original change in aggregate expenditures is actually spent more than once. This is called the multiplier effect: An initial increase in spending, cycles repeatedly through the economy and has a larger impact than the initial dollar amount spent.
How Does the Multiplier Work?
To understand how the multiplier effect works, return to the example in which the current equilibrium in the Keynesian cross diagram is a real GDP of \$700, or \$100 short of the \$800 needed to be at full employment, potential GDP. If the government spends \$100 to close this gap, someone in the economy receives that spending and can treat it as income. Assume that those who receive this income pay 30% in taxes, save 10% of after-tax income, spend 10% of total income on imports, and then spend the rest on domestically produced goods and services.
As shown in the calculations in Figure B10 and Table B6, out of the original \$100 in government spending, \$53 is left to spend on domestically produced goods and services. That \$53 which was spent, becomes income to someone, somewhere in the economy. Those who receive that income also pay 30% in taxes, save 10% of after-tax income, and spend 10% of total income on imports, as shown in Figure B10, so that an additional \$28.09 (that is, 0.53 × \$53) is spent in the third round. The people who receive that income then pay taxes, save, and buy imports, and the amount spent in the fourth round is \$14.89 (that is, 0.53 × \$28.09).
Figure B10 The Multiplier Effect An original increase of government spending of \$100 causes a rise in aggregate expenditure of \$100. But that \$100 is income to others in the economy, and after they save, pay taxes, and buy imports, they spend \$53 of that \$100 in a second round. In turn, that \$53 is income to others. Thus, the original government spending of \$100 is multiplied by these cycles of spending, but the impact of each successive cycle gets smaller and smaller. Given the numbers in this example, the original government spending increase of \$100 raises aggregate expenditure by \$213; therefore, the multiplier in this example is \$213/\$100 = 2.13.
Original increase in aggregate expenditure from government spending 100
Which is income to people throughout the economy: Pay 30% in taxes. Save 10% of after-tax income. Spend 10% of income on imports. Second-round increase of… 70 – 7 – 10 = 53
Which is \$53 of income to people through the economy: Pay 30% in taxes. Save 10% of after-tax income. Spend 10% of income on imports. Third-round increase of… 37.1 – 3.71 – 5.3 = 28.09
Which is \$28.09 of income to people through the economy: Pay 30% in taxes. Save 10% of after-tax income. Spend 10% of income on imports. Fourth-round increase of… 19.663 – 1.96633 – 2.809 = 14.89
Table B6 Calculating the Multiplier Effect
Thus, over the first four rounds of aggregate expenditures, the impact of the original increase in government spending of \$100 creates a rise in aggregate expenditures of \$100 + \$53 + \$28.09 + \$14.89 = \$195.98. Figure B10 shows these total aggregate expenditures after these first four rounds, and then the figure shows the total aggregate expenditures after 30 rounds. The additional boost to aggregate expenditures is shrinking in each round of consumption. After about 10 rounds, the additional increments are very small indeed—nearly invisible to the naked eye. After 30 rounds, the additional increments in each round are so small that they have no practical consequence. After 30 rounds, the cumulative value of the initial boost in aggregate expenditure is approximately \$213. Thus, the government spending increase of \$100 eventually, after many cycles, produced an increase of \$213 in aggregate expenditure and real GDP. In this example, the multiplier is \$213/\$100 = 2.13.
Calculating the Multiplier
Fortunately for everyone who is not carrying around a computer with a spreadsheet program to project the impact of an original increase in expenditures over 20, 50, or 100 rounds of spending, there is a formula for calculating the multiplier.
$Spending Multiplier = 1/1 – (0.7 x (1 – .1) + 0.10) = 1/.63 + .1 = 1/.73 = 1.369 Spending Multiplier = 1/1 – (0.7 x (1 – .1) + 0.10) = 1/.63 + .1 = 1/.73 = 1.369$
The data from Figure B10 and Table B6 is:
• Marginal Propensity to Save (MPS) = 30%
• Tax rate = 10%
• Marginal Propensity to Import (MPI) = 10%
The MPC is equal to 1 – MPS, or 0.7. Therefore, the spending multiplier is:
$Spending Multiplier = 11 – (0.7 – (0.10)(0.7) – 0.10) = 10.47 = 2.13Spending Multiplier = 11 – (0.7 – (0.10)(0.7) – 0.10) = 10.47 = 2.13$
A change in spending of \$100 multiplied by the spending multiplier of 2.13 is equal to a change in GDP of \$213. Not coincidentally, this result is exactly what was calculated in Figure B10 after many rounds of expenditures cycling through the economy.
The size of the multiplier is determined by what proportion of the marginal dollar of income goes into taxes, saving, and imports. These three factors are known as “leakages,” because they determine how much demand “leaks out” in each round of the multiplier effect. If the leakages are relatively small, then each successive round of the multiplier effect will have larger amounts of demand, and the multiplier will be high. Conversely, if the leakages are relatively large, then any initial change in demand will diminish more quickly in the second, third, and later rounds, and the multiplier will be small. Changes in the size of the leakages—a change in the marginal propensity to save, the tax rate, or the marginal propensity to import—will change the size of the multiplier.
Calculating Keynesian Policy Interventions
Returning to the original question: How much should government spending be increased to produce a total increase in real GDP of \$100? If the goal is to increase aggregate demand by \$100, and the multiplier is 2.13, then the increase in government spending to achieve that goal would be \$100/2.13 = \$47. Government spending of approximately \$47, when combined with a multiplier of 2.13 (which is, remember, based on the specific assumptions about tax, saving, and import rates), produces an overall increase in real GDP of \$100, restoring the economy to potential GDP of \$800, as Figure B11 shows.
Figure B11 The Multiplier Effect in an Expenditure-Output Model The power of the multiplier effect is that an increase in expenditure has a larger increase on the equilibrium output. The increase in expenditure is the vertical increase from AE0 to AE1. However, the increase in equilibrium output, shown on the horizontal axis, is clearly larger.
The multiplier effect is also visible on the Keynesian cross diagram. Figure B11 shows the example we have been discussing: a recessionary gap with an equilibrium of \$700, potential GDP of \$800, the slope of the aggregate expenditure function (AE0) determined by the assumptions that taxes are 30% of income, savings are 0.1 of after-tax income, and imports are 0.1 of before-tax income. At AE1, the aggregate expenditure function is moved up to reach potential GDP.
Now, compare the vertical shift upward in the aggregate expenditure function, which is \$47, with the horizontal shift outward in real GDP, which is \$100 (as these numbers were calculated earlier). The rise in real GDP is more than double the rise in the aggregate expenditure function. (Similarly, if you look back at Figure B9, you will see that the vertical movements in the aggregate expenditure functions are smaller than the change in equilibrium output that is produced on the horizontal axis. Again, this is the multiplier effect at work.) In this way, the power of the multiplier is apparent in the income–expenditure graph, as well as in the arithmetic calculation.
The multiplier does not just affect government spending, but applies to any change in the economy. Say that business confidence declines and investment falls off, or that the economy of a leading trading partner slows down so that export sales decline. These changes will reduce aggregate expenditures, and then will have an even larger effect on real GDP because of the multiplier effect. Read the following Clear It Up feature to learn how the multiplier effect can be applied to analyze the economic impact of professional sports.
Clear It Up
How can the multiplier be used to analyze the economic impact of professional sports?
Attracting professional sports teams and building sports stadiums to create jobs and stimulate business growth is an economic development strategy adopted by many communities throughout the United States. In his recent article, “Public Financing of Private Sports Stadiums,” James Joyner of Outside the Beltway looked at public financing for NFL teams. Joyner’s findings confirm the earlier work of John Siegfried of Vanderbilt University and Andrew Zimbalist of Smith College.
Siegfried and Zimbalist used the multiplier to analyze this issue. They considered the amount of taxes paid and dollars spent locally to see if there was a positive multiplier effect. Since most professional athletes and owners of sports teams are rich enough to owe a lot of taxes, let’s say that 40% of any marginal income they earn is paid in taxes. Because athletes are often high earners with short careers, let’s assume that they save one-third of their after-tax income.
However, many professional athletes do not live year-round in the city in which they play, so let’s say that one-half of the money that they do spend is spent outside the local area. One can think of spending outside a local economy, in this example, as the equivalent of imported goods for the national economy.
Now, consider the impact of money spent at local entertainment venues other than professional sports. While the owners of these other businesses may be comfortably middle-income, few of them are in the economic stratosphere of professional athletes. Because their incomes are lower, so are their taxes; say that they pay only 35% of their marginal income in taxes. They do not have the same ability, or need, to save as much as professional athletes, so let’s assume their MPC is just 0.8. Finally, because more of them live locally, they will spend a higher proportion of their income on local goods—say, 65%.
If these general assumptions hold true, then money spent on professional sports will have less local economic impact than money spent on other forms of entertainment. For professional athletes, out of a dollar earned, 40 cents goes to taxes, leaving 60 cents. Of that 60 cents, one-third is saved, leaving 40 cents, and half is spent outside the area, leaving 20 cents. Only 20 cents of each dollar is cycled into the local economy in the first round. For locally-owned entertainment, out of a dollar earned, 35 cents goes to taxes, leaving 65 cents. Of the rest, 20% is saved, leaving 52 cents, and of that amount, 65% is spent in the local area, so that 33.8 cents of each dollar of income is recycled into the local economy.
Siegfried and Zimbalist make the plausible argument that, within their household budgets, people have a fixed amount to spend on entertainment. If this assumption holds true, then money spent attending professional sports events is money that was not spent on other entertainment options in a given metropolitan area. Since the multiplier is lower for professional sports than for other local entertainment options, the arrival of professional sports to a city would reallocate entertainment spending in a way that causes the local economy to shrink, rather than to grow. Thus, their findings seem to confirm what Joyner reports and what newspapers across the country are reporting. A quick Internet search for “economic impact of sports” will yield numerous reports questioning this economic development strategy.
Multiplier Tradeoffs: Stability versus the Power of Macroeconomic Policy
Is an economy healthier with a high multiplier or a low one? With a high multiplier, any change in aggregate demand will tend to be substantially magnified, and so the economy will be more unstable. With a low multiplier, by contrast, changes in aggregate demand will not be multiplied much, so the economy will tend to be more stable.
However, with a low multiplier, government policy changes in taxes or spending will tend to have less impact on the equilibrium level of real output. With a higher multiplier, government policies to raise or reduce aggregate expenditures will have a larger effect. Thus, a low multiplier means a more stable economy, but also weaker government macroeconomic policy, while a high multiplier means a more volatile economy, but also an economy in which government macroeconomic policy is more powerful.
Key Concepts and Summary
The expenditure-output model or Keynesian cross diagram shows how the level of aggregate expenditure (on the vertical axis) varies with the level of economic output (shown on the horizontal axis). Since the value of all macroeconomic output also represents income to someone somewhere else in the economy, the horizontal axis can also be interpreted as national income. The equilibrium in the diagram will occur where the aggregate expenditure line crosses the 45-degree line, which represents the set of points where aggregate expenditure in the economy is equal to output (or national income). Equilibrium in a Keynesian cross diagram can happen at potential GDP, or below or above that level.
The consumption function shows the upward-sloping relationship between national income and consumption. The marginal propensity to consume (MPC) is the amount consumed out of an additional dollar of income. A higher marginal propensity to consume means a steeper consumption function; a lower marginal propensity to consume means a flatter consumption function. The marginal propensity to save (MPS) is the amount saved out of an additional dollar of income. It is necessarily true that MPC + MPS = 1. The investment function is drawn as a flat line, showing that investment in the current year does not change with regard to the current level of national income. However, the investment function will move up and down based on the expected rate of return in the future. Government spending is drawn as a horizontal line in the Keynesian cross diagram, because its level is determined by political considerations, not by the current level of income in the economy. Taxes in the basic Keynesian cross diagram are taken into account by adjusting the consumption function. The export function is drawn as a horizontal line in the Keynesian cross diagram, because exports do not change as a result of changes in domestic income, but they move as a result of changes in foreign income, as well as changes in exchange rates. The import function is drawn as a downward-sloping line, because imports rise with national income, but imports are a subtraction from aggregate demand. Thus, a higher level of imports means a lower level of expenditure on domestic goods.
In a Keynesian cross diagram, the equilibrium may be at a level below potential GDP, which is called a recessionary gap, or at a level above potential GDP, which is called an inflationary gap.
The multiplier effect describes how an initial change in aggregate demand generated several times as much as cumulative GDP. The size of the spending multiplier is determined by three leakages: spending on savings, taxes, and imports. The formula for the multiplier is:
$Multiplier = 11 – (MPC × (1 – tax rate) + MPI)Multiplier = 11 – (MPC × (1 – tax rate) + MPI)$
An economy with a lower multiplier is more stable—it is less affected either by economic events or by government policy than an economy with a higher multiplier.
Self-Check Questions
Exercise B1
Sketch the aggregate expenditure-output diagram with the recessionary gap.
Answer
Exercise B2
Sketch the aggregate expenditure-output diagram with an inflationary gap.
Answer
Exercise B3
An economy has the following characteristics:
Y = National income
Taxes = T = 0.25Y
C = Consumption = 400 + 0.85(Y – T)
I = 300
G = 200
X = 500
M = 0.1(Y – T)
Find the equilibrium for this economy. If potential GDP is 3,500, then what change in government spending is needed to achieve this level? Do this problem two ways. First, plug 3,500 into the equations and solve for G. Second, calculate the multiplier and figure it out that way.
Answer
Exercise B4
Table B7 represents the data behind a Keynesian cross diagram. Assume that the tax rate is 0.4 of national income; the MPC out of the after-tax income is 0.8; investment is \$2,000; government spending is \$1,000; exports are \$2,000 and imports are 0.05 of after-tax income. What is the equilibrium level of output for this economy?
National Income After-tax Income Consumption I + G + X Minus Imports Aggregate Expenditures
\$8,000 \$4,340
\$9,000
\$10,000
\$11,000
\$12,000
\$13,000
Table B7
Answer
Exercise B5
Explain how the multiplier works. Use an MPC of 80% in an example.
Answer
Review Questions
Exercise B6
What is on the axes of an expenditure-output diagram?
Exercise B7
What does the 45-degree line show?
Exercise B8
What determines the slope of a consumption function?
Exercise B9
What is the marginal propensity to consume, and how is it related to the marginal propensity to import?
Exercise B10
Why are the investment function, the government spending function, and the export function all drawn as flat lines?
Exercise B11
Why does the import function slope down? What is the marginal propensity to import?
Exercise B12
What are the components on which the aggregate expenditure function is based?
Exercise B13
Is the equilibrium in a Keynesian cross diagram usually expected to be at or near potential GDP?
Exercise B14
What is an inflationary gap? A recessionary gap?
Exercise B15
What is the multiplier effect?
Exercise B16
Why are savings, taxes, and imports referred to as “leakages” in calculating the multiplier effect?
Exercise B17
Will an economy with a high multiplier be more stable or less stable than an economy with a low multiplier in response to changes in the economy or in government policy?
Exercise B18
How do economists use the multiplier?
Critical Thinking Questions
Exercise B19
What does it mean when the aggregate expenditure line crosses the 45-degree line? In other words, how would you explain the intersection in words?
Exercise B20
Which model, the AD/AS or the AE model better explains the relationship between rising price levels and GDP? Why?
Exercise B21
What are some reasons that the economy might be in a recession, and what is the appropriate government action to alleviate the recession?
Exercise B22
What should the government do to relieve inflationary pressures if the aggregate expenditure is greater than potential GDP?
Exercise B23
Two countries are in a recession. Country A has an MPC of 0.8 and Country B has an MPC of 0.6. In which country will government spending have the greatest impact?
Exercise B24
Compare two policies: a tax cut on income or an increase in government spending on roads and bridges. What are both the short-term and long-term impacts of such policies on the economy?
Exercise B25
What role does government play in stabilizing the economy and what are the tradeoffs that must be considered?
Exercise B26
If there is a recessionary gap of \$100 billion, should the government increase spending by \$100 billion to close the gap? Why? Why not?
Exercise B27
What other changes in the economy can be evaluated by using the multiplier? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.02%3A_Appendix_B-_The_Expenditure-Output_Model.txt |
1.
Scarcity means human wants for goods and services exceed the available supply. Supply is limited because resources are limited. Demand, however, is virtually unlimited. Whatever the supply, it seems human nature to want more.
2.
100 people / 10 people per ham = a maximum of 10 hams per month if all residents produce ham. Since consumption is limited by production, the maximum number of hams residents could consume per month is 10.
3.
She is very productive at her consulting job, but not very productive growing vegetables. Time spent consulting would produce far more income than it what she could save growing her vegetables using the same amount of time. So on purely economic grounds, it makes more sense for her to maximize her income by applying her labor to what she does best (i.e. specialization of labor).
4.
The engineer is better at computer science than at painting. Thus, his time is better spent working for pay at his job and paying a painter to paint his house. Of course, this assumes he does not paint his house for fun!
5.
There are many physical systems that would work, for example, the study of planets (micro) in the solar system (macro), or solar systems (micro) in the galaxy (macro).
6.
Draw a box outside the original circular flow to represent the foreign country. Draw an arrow from the foreign country to firms, to represents imports. Draw an arrow in the reverse direction representing payments for imports. Draw an arrow from firms to the foreign country to represent exports. Draw an arrow in the reverse direction to represent payments for imports.
7.
There are many such problems. Consider the AIDS epidemic. Why are so few AIDS patients in Africa and Southeast Asia treated with the same drugs that are effective in the United States and Europe? It is because neither those patients nor the countries in which they live have the resources to purchase the same drugs.
8.
Public enterprise means the factors of production (resources and businesses) are owned and operated by the government.
9.
The United States is a large country economically speaking, so it has less need to trade internationally than the other countries mentioned. (This is the same reason that France and Italy have lower ratios than Belgium or Sweden.) One additional reason is that each of the other countries is a member of the European Union, where trade between members occurs without barriers to trade, like tariffs and quotas.
22.3.02: Chapter 2
1.
The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket. Originally, when the price of bus tickets was 50 cents per trip, this opportunity cost was 0.50/2 = .25 burgers. The reason for this is that at the original prices, one burger (\$2) costs the same as four bus tickets (\$0.50), so the opportunity cost of a burger is four bus tickets, and the opportunity cost of a bus ticket is .25 burgers (the inverse of the opportunity cost of a burger). With the new, higher price of bus tickets, the opportunity cost rises to \$1/\$2 or 0.50 burgers. You can see this graphically since the slope of the new budget constraint is steeper than the original one. If Alphonso spends all of his budget on burgers, the higher price of bus tickets has no impact so the vertical intercept of the budget constraint is the same. If he spends his entire budget on bus tickets, he can now afford only half as many, so the horizontal intercept is half as much. In short, the budget constraint rotates clockwise around the vertical intercept, steepening as it goes and the opportunity cost of bus tickets increases.
2.
Because of the improvement in technology, the vertical intercept of the PPF would be at a higher level of healthcare. In other words, the PPF would rotate clockwise around the horizontal intercept. This would make the PPF steeper, corresponding to an increase in the opportunity cost of education, since resources devoted to education would now mean forgoing a greater quantity of healthcare.
3.
No. Allocative efficiency requires productive efficiency, because it pertains to choices along the production possibilities frontier.
4.
Both the budget constraint and the PPF show the constraint that each operates under. Both show a tradeoff between having more of one good but less of the other. Both show the opportunity cost graphically as the slope of the constraint (budget or PPF).
5.
When individuals compare cost per unit in the grocery store, or characteristics of one product versus another, they are behaving approximately like the model describes.
6.
Since an op-ed makes a case for what should be, it is considered normative.
7.
Assuming that the study is not taking an explicit position about whether soft drink consumption is good or bad, but just reporting the science, it would be considered positive. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.01%3A_Chapter_1.txt |
1.
Since \$1.60 per gallon is above the equilibrium price, the quantity demanded would be lower at 550 gallons and the quantity supplied would be higher at 640 gallons. (These results are due to the laws of demand and supply, respectively.) The outcome of lower Qd and higher Qs would be a surplus in the gasoline market of 640 – 550 = 90 gallons.
2.
To make it easier to analyze complex problems. Ceteris paribus allows you to look at the effect of one factor at a time on what it is you are trying to analyze. When you have analyzed all the factors individually, you add the results together to get the final answer.
3.
1. An improvement in technology that reduces the cost of production will cause an increase in supply. Alternatively, you can think of this as a reduction in price necessary for firms to supply any quantity. Either way, this can be shown as a rightward (or downward) shift in the supply curve.
2. An improvement in product quality is treated as an increase in tastes or preferences, meaning consumers demand more paint at any price level, so demand increases or shifts to the right. If this seems counterintuitive, note that demand in the future for the longer-lasting paint will fall, since consumers are essentially shifting demand from the future to the present.
3. An increase in need causes an increase in demand or a rightward shift in the demand curve.
4. Factory damage means that firms are unable to supply as much in the present. Technically, this is an increase in the cost of production. Either way you look at it, the supply curve shifts to the left.
4.
1. More fuel-efficient cars means there is less need for gasoline. This causes a leftward shift in the demand for gasoline and thus oil. Since the demand curve is shifting down the supply curve, the equilibrium price and quantity both fall.
2. Cold weather increases the need for heating oil. This causes a rightward shift in the demand for heating oil and thus oil. Since the demand curve is shifting up the supply curve, the equilibrium price and quantity both rise.
3. A discovery of new oil will make oil more abundant. This can be shown as a rightward shift in the supply curve, which will cause a decrease in the equilibrium price along with an increase in the equilibrium quantity. (The supply curve shifts down the demand curve so price and quantity follow the law of demand. If price goes down, then the quantity goes up.)
4. When an economy slows down, it produces less output and demands less input, including energy, which is used in the production of virtually everything. A decrease in demand for energy will be reflected as a decrease in the demand for oil, or a leftward shift in demand for oil. Since the demand curve is shifting down the supply curve, both the equilibrium price and quantity of oil will fall.
5. Disruption of oil pumping will reduce the supply of oil. This leftward shift in the supply curve will show a movement up the demand curve, resulting in an increase in the equilibrium price of oil and a decrease in the equilibrium quantity.
6. Increased insulation will decrease the demand for heating. This leftward shift in the demand for oil causes a movement down the supply curve, resulting in a decrease in the equilibrium price and quantity of oil.
7. Solar energy is a substitute for oil-based energy. So if solar energy becomes cheaper, the demand for oil will decrease as consumers switch from oil to solar. The decrease in demand for oil will be shown as a leftward shift in the demand curve. As the demand curve shifts down the supply curve, both equilibrium price and quantity for oil will fall.
8. A new, popular kind of plastic will increase the demand for oil. The increase in demand will be shown as a rightward shift in demand, raising the equilibrium price and quantity of oil.
5.
Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity.
Step 2. Did the economic event affect supply or demand? Jet fuel is a cost of producing air travel, so an increase in jet fuel price affects supply.
Step 3. An increase in the price of jet fuel caused an increase in the cost of air travel. We show this as an upward or leftward shift in supply.
Step 4. A leftward shift in supply causes a movement up the demand curve, increasing the equilibrium price of air travel and decreasing the equilibrium quantity.
6.
Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity.
Step 2. Did the economic event affect supply or demand? A tariff is treated like a cost of production, so this affects supply.
Step 3. A tariff reduction is equivalent to a decrease in the cost of production, which we can show as a rightward (or downward) shift in supply.
Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price and raising the equilibrium quantity.
7.
A price ceiling (which is below the equilibrium price) will cause the quantity demanded to rise and the quantity supplied to fall. This is why a price ceiling creates a shortage.
8.
A price ceiling is just a legal restriction. Equilibrium is an economic condition. People may or may not obey the price ceiling, so the actual price may be at or above the price ceiling, but the price ceiling does not change the equilibrium price.
9.
A price ceiling is a legal maximum price, but a price floor is a legal minimum price and, consequently, it would leave room for the price to rise to its equilibrium level. In other words, a price floor below equilibrium will not be binding and will have no effect.
10.
Assuming that people obey the price ceiling, the market price will be below equilibrium, which means that Qd will be more than Qs. Buyers can only buy what is offered for sale, so the number of transactions will fall to Qs. This is easy to see graphically. By analogous reasoning, with a price floor the market price will be above the equilibrium price, so Qd will be less than Qs. Since the limit on transactions here is demand, the number of transactions will fall to Qd. Note that because both price floors and price ceilings reduce the number of transactions, social surplus is less.
11.
Because the losses to consumers are greater than the benefits to producers, so the net effect is negative. Since the lost consumer surplus is greater than the additional producer surplus, social surplus falls. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.03%3A_Chapter_3.txt |
1.
Changes in the wage rate (the price of labor) cause a movement along the demand curve. A change in anything else that affects demand for labor (e.g., changes in output, changes in the production process that use more or less labor, government regulation) causes a shift in the demand curve.
2.
Changes in the wage rate (the price of labor) cause a movement along the supply curve. A change in anything else that affects supply of labor (e.g., changes in how desirable the job is perceived to be, government policy to promote training in the field) causes a shift in the supply curve.
3.
Since a living wage is a suggested minimum wage, it acts like a price floor (assuming, of course, that it is followed). If the living wage is binding, it will cause an excess supply of labor at that wage rate.
4.
Changes in the interest rate (i.e., the price of financial capital) cause a movement along the demand curve. A change in anything else (non-price variable) that affects demand for financial capital (e.g., changes in confidence about the future, changes in needs for borrowing) would shift the demand curve.
5.
Changes in the interest rate (i.e., the price of financial capital) cause a movement along the supply curve. A change in anything else that affects the supply of financial capital (a non-price variable) such as income or future needs would shift the supply curve.
6.
If market interest rates stay in their normal range, an interest rate limit of 35% would not be binding. If the equilibrium interest rate rose above 35%, the interest rate would be capped at that rate, and the quantity of loans would be lower than the equilibrium quantity, causing a shortage of loans.
7.
b and c will lead to a fall in interest rates. At a lower demand, lenders will not be able to charge as much, and with more available lenders, competition for borrowers will drive rates down.
8.
a and c will increase the quantity of loans. More people who want to borrow will result in more loans being given, as will more people who want to lend.
9.
A price floor prevents a price from falling below a certain level, but has no effect on prices above that level. It will have its biggest effect in creating excess supply (as measured by the entire area inside the dotted lines on the graph, from D to S) if it is substantially above the equilibrium price. This is illustrated in the following figure.
It will have a lesser effect if it is slightly above the equilibrium price. This is illustrated in the next figure.
It will have no effect if it is set either slightly or substantially below the equilibrium price, since an equilibrium price above a price floor will not be affected by that price floor. The following figure illustrates these situations.
10.
A price ceiling prevents a price from rising above a certain level, but has no effect on prices below that level. It will have its biggest effect in creating excess demand if it is substantially below the equilibrium price. The following figure illustrates these situations.
When the price ceiling is set substantially or slightly above the equilibrium price, it will have no effect on creating excess demand. The following figure illustrates these situations.
11.
Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price floor does not shift a demand curve or a supply curve. However, if the price floor is set above the equilibrium, it will cause the quantity supplied on the supply curve to be greater than the quantity demanded on the demand curve, leading to excess supply.
12.
Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price ceiling does not shift a demand curve or a supply curve. However, if the price ceiling is set below the equilibrium, it will cause the quantity demanded on the demand curve to be greater than the quantity supplied on the supply curve, leading to excess demand. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.04%3A_Chapter_4.txt |
1.
From point B to point C, price rises from \$70 to \$80, and Qd decreases from 2,800 to 2,600. So:
$% change in quantity = 2600 – 2800 2600 + 2800 ÷ 2 × 100 = –200 2700 × 100 = –7.41 % change in price = 80 – 70 80 + 70 ÷ 2 × 100 = 10 75 × 100 = 13.33 Elasticity of Demand = –7.41% 13.33% = 0.56 % change in quantity = 2600 – 2800 2600 + 2800 ÷ 2 × 100 = –200 2700 × 100 = –7.41 % change in price = 80 – 70 80 + 70 ÷ 2 × 100 = 10 75 × 100 = 13.33 Elasticity of Demand = –7.41% 13.33% = 0.56$
The demand curve is inelastic in this area; that is, its elasticity value is less than one.
Answer from Point D to point E:
$% change in quantity = 2200 – 2400 2200 + 2400 ÷ 2 × 100 = –200 2300 × 100 = –8.7 % change in price = 100 – 90 100 + 90 ÷ 2 × 100 = 10 95 × 100 = 10.53 Elasticity of Demand = –8.7% 10.53% = 0.83 % change in quantity = 2200 – 2400 2200 + 2400 ÷ 2 × 100 = –200 2300 × 100 = –8.7 % change in price = 100 – 90 100 + 90 ÷ 2 × 100 = 10 95 × 100 = 10.53 Elasticity of Demand = –8.7% 10.53% = 0.83$
The demand curve is inelastic in this area; that is, its elasticity value is less than one.
Answer from Point G to point H:
$% change in quantity=1600–1800 1700 × 100 =–2001700 × 100 =–11.76% change in price=130–120 125 × 100 =10125 × 100 =8.00Elasticity of Demand=–11.76% 8.00% =–1.47 % change in quantity=1600–1800 1700 × 100 =–2001700 × 100 =–11.76% change in price=130–120 125 × 100 =10125 × 100 =8.00Elasticity of Demand=–11.76% 8.00% =–1.47$
The demand curve is elastic in this interval.
2.
From point J to point K, price rises from \$8 to \$9, and quantity rises from 50 to 70. So:
$% change in quantity = 70 – 50 70 + 50 ÷ 2 × 100 = 20 60 × 100 = 33.33 % change in price = 9 – 8 9 + 8 ÷ 2 × 100 = 1 8.5 × 100 = 11.76 Elasticity of Supply = 33.33% 11.76% = 2.83 % change in quantity = 70 – 50 70 + 50 ÷ 2 × 100 = 20 60 × 100 = 33.33 % change in price = 9 – 8 9 + 8 ÷ 2 × 100 = 1 8.5 × 100 = 11.76 Elasticity of Supply = 33.33% 11.76% = 2.83$
The supply curve is elastic in this area; that is, its elasticity value is greater than one.
From point L to point M, the price rises from \$10 to \$11, while the Qs rises from 80 to 88:
$% change in quantity = 88 – 80 88 + 80 ÷ 2 × 100 = 8 84 × 100 = 9.52 %change in price = 11 – 10 11 + 10 ÷ 2 × 100 = 1 10.5 × 100 = 9.52 Elasticity of Demand = 9.52% 9.52% = 1.0 % change in quantity = 88 – 80 88 + 80 ÷ 2 × 100 = 8 84 × 100 = 9.52 %change in price = 11 – 10 11 + 10 ÷ 2 × 100 = 1 10.5 × 100 = 9.52 Elasticity of Demand = 9.52% 9.52% = 1.0$
The supply curve has unitary elasticity in this area.
From point N to point P, the price rises from \$12 to \$13, and Qs rises from 95 to 100:
$% change in quantity = 100 – 95 100 + 95 ÷ 2 × 100 = 5 97.5 × 100 = 5.13 % change in price = 13 – 12 13 + 12 ÷ 2 × 100 = 1 12.5 × 100 = 8.0 Elasticity of Supply = 5.13% 8.0% = 0.64 % change in quantity = 100 – 95 100 + 95 ÷ 2 × 100 = 5 97.5 × 100 = 5.13 % change in price = 13 – 12 13 + 12 ÷ 2 × 100 = 1 12.5 × 100 = 8.0 Elasticity of Supply = 5.13% 8.0% = 0.64$
The supply curve is inelastic in this region of the supply curve.
3.
The demand curve with constant unitary elasticity is concave because the absolute value of declines in price are not identical. The left side of the curve starts with high prices, and then price falls by smaller amounts as it goes down toward the right side. This results in a slope of demand that is steeper on the left but flatter on the right, creating a curved, concave shape.
4.
The constant unitary elasticity is a straight line because the curve slopes upward and both price and quantity are increasing proportionally.
5.
Carmakers can pass this cost along to consumers if the demand for these cars is inelastic. If the demand for these cars is elastic, then the manufacturer must pay for the equipment.
6.
If the elasticity is 1.4 at current prices, you would advise the company to lower its price on the product, since a decrease in price will be offset by the increase in the amount of the drug sold. If the elasticity were 0.6, then you would advise the company to increase its price. Increases in price will offset the decrease in number of units sold, but increase your total revenue. If elasticity is 1, the total revenue is already maximized, and you would advise that the company maintain its current price level.
7.
The percentage change in quantity supplied as a result of a given percentage change in the price of gasoline.
8.
$Percentage change in quantity demanded=[(change in quantity)/(original quantity)] × 100=[22 – 30]/[(22 + 30)/2] × 100=–8/26 × 100=–30.77Percentage change in income=[(change in income)/(original income)] × 100=[38,000 – 25,000]/[(38,000 + 25,000)/2] × 100=13/31.5 × 100=41.27Percentage change in quantity demanded=[(change in quantity)/(original quantity)] × 100=[22 – 30]/[(22 + 30)/2] × 100=–8/26 × 100=–30.77Percentage change in income=[(change in income)/(original income)] × 100=[38,000 – 25,000]/[(38,000 + 25,000)/2] × 100=13/31.5 × 100=41.27$
In this example, bread is an inferior good because its consumption falls as income rises.
9.
The formula for cross-price elasticity is % change in Qd for apples / % change in P of oranges. Multiplying both sides by % change in P of oranges yields:
% change in Qd for apples = cross-price elasticity X% change in P of oranges
= 0.4 × (–3%) = –1.2%, or a 1.2 % decrease in demand for apples. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.05%3A_Chapter_5.txt |
1.
GDP is C + I + G + (X – M). GDP = \$2,000 billion + \$50 billion + \$1,000 billion + (\$20 billion – \$40 billion) = \$3,030
2.
1. Hospital stays are part of GDP.
2. Changes in life expectancy are not market transactions and not part of GDP.
3. Child care that is paid for is part of GDP.
4. If Grandma gets paid and reports this as income, it is part of GDP, otherwise not.
5. A used car is not produced this year, so it is not part of GDP.
6. A new car is part of GDP.
7. Variety does not count in GDP, where the cheese could all be cheddar.
8. The iron is not counted because it is an intermediate good.
3.
From 1980 to 1990, real GDP grew by (8,225.0 – 5,926.5) / (5,926.5) = 39%. Over the same period, prices increased by (72.7 – 48.3) / (48.3/100) = 51%. So about 57% of the growth 51 / (51 + 39) was inflation, and the remainder: 39 / (51 + 39) = 43% was growth in real GDP.
4.
Two other major recessions are visible in the figure as slight dips: those of 1973–1975, and 1981–1982. Two other recessions appear in the figure as a flattening of the path of real GDP. These were in 1990–1991 and 2001.
5.
11 recessions in approximately 70 years averages about one recession every six years.
6.
The table lists the “Months of Contraction” for each recession. Averaging these figures for the post-WWII recessions gives an average duration of 11 months, or slightly less than a year.
7.
The table lists the “Months of Expansion.” Averaging these figures for the post-WWII expansions gives an average expansion of 60.5 months, or more than five years.
8.
Yes. The answer to both questions depends on whether GDP is growing faster or slower than population. If population grows faster than GDP, GDP increases, while GDP per capita decreases. If GDP falls, but population falls faster, then GDP decreases, while GDP per capita increases.
9.
Start with Central African Republic’s GDP measured in francs. Divide it by the exchange rate to convert to U.S. dollars, and then divide by population to obtain the per capita figure. That is, 1,107,689 million francs / 284.681 francs per dollar / 4.862 million people = \$800.28 GDP per capita.
10.
1. A dirtier environment would reduce the broad standard of living, but not be counted in GDP, so a rise in GDP would overstate the standard of living.
2. A lower crime rate would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the standard of living.
3. A greater variety of goods would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the rise in the standard of living.
4. A decline in infant mortality would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the rise in the standard of living. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.06%3A_Chapter_6.txt |
1.
The Industrial Revolution refers to the widespread use of power-driven machinery and the economic and social changes that resulted in the first half of the 1800s. Ingenious machines—the steam engine, the power loom, and the steam locomotive—performed tasks that would have taken vast numbers of workers to do. The Industrial Revolution began in Great Britain, and soon spread to the United States, Germany, and other countries.
2.
Property rights are the rights of individuals and firms to own property and use it as they see fit. Contractual rights are based on property rights and they allow individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance. Economic growth occurs when the standard of living increases in an economy, which occurs when output is increasing and incomes are rising. For this to happen, societies must create a legal environment that gives individuals the ability to use their property to their fullest and highest use, including the right to trade or sell that property. Without a legal system that enforces contracts, people would not be likely to enter into contracts for current or future services because of the risk of non-payment. This would make it difficult to transact business and would slow economic growth.
3.
Yes. Since productivity is output per unit of input, we can measure productivity using GDP (output) per worker (input).
4.
In 20 years the United States will have an income of 10,000 × (1 + 0.01)20 = \$12,201.90, and South Korea will have an income of 10,000 × (1 + 0.04)20 = \$21,911.23. South Korea has grown by a multiple of 2.1 and the United States by a multiple of 1.2.
5.
Capital deepening and technology are important. What seems to be more important is how they are combined.
6.
Government can contribute to economic growth by investing in human capital through the education system, building a strong physical infrastructure for transportation and commerce, increasing investment by lowering capital gains taxes, creating special economic zones that allow for reduced tariffs, and investing in research and development.
7.
Public education, low investment taxes, funding for infrastructure projects, special economic zones
8.
A good way to think about this is how a runner who has fallen behind in a race feels psychologically and physically as he catches up. Playing catch-up can be more taxing than maintaining one’s position at the head of the pack.
9.
1. No. Capital deepening refers to an increase in the amount of capital per person in an economy. A decrease in investment by firms will actually cause the opposite of capital deepening (since the population will grow over time).
2. There is no direct connection between an increase in international trade and capital deepening. One could imagine particular scenarios where trade could lead to capital deepening (for example, if international capital inflows—which are the counterpart to increasing the trade deficit—lead to an increase in physical capital investment), but in general, no.
3. Yes. Capital deepening refers to an increase in either physical capital or human capital per person. Continuing education or any time of lifelong learning adds to human capital and thus creates capital deepening.
10.
The advantages of backwardness include faster growth rates because of the process of convergence, as well as the ability to adopt new technologies that were developed first in the “leader” countries. While being “backward” is not inherently a good thing, Gerschenkron stressed that there are certain advantages which aid countries trying to “catch up.”
11.
Capital deepening, by definition, should lead to diminished returns because you're investing more and more but using the same methods of production, leading to the marginal productivity declining. This is shown on a production function as a movement along the curve. Improvements in technology should not lead to diminished returns because you are finding new and more efficient ways of using the same amount of capital. This can be illustrated as a shift upward of the production function curve.
12.
In high-income economies, diminishing returns to investments in physical and human capital may not apply because many high-income economies have developed economic and political institutions that provide a healthy economic climate for an ongoing stream of technological innovations. Continuous technological innovation can counterbalance diminishing returns to investments in human and physical capital. These two factors have the added effect of making additional technological advances even easier for these countries.
As a result, productivity growth from new advances in technology will not increase at a diminishing rate or otherwise slow down because the new methods of production will be adopted relatively quickly and easily, at very low marginal cost. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.07%3A_Chapter_7.txt |
1.
The population is divided into those “in the labor force” and those “not in the labor force.” Thus, the number of adults not in the labor force is 237.8 – 153.9 = 83.9 million. Since the labor force is divided into employed persons and unemployed persons, the number of unemployed persons is 153.9 – 139.1 = 14.8 million. Thus, the adult population has the following proportions:
• 139.1/237.8 = 58.5% employed persons
• 14.8/237.8 = 6.2% unemployed persons
• 83.9/237.8 = 35.3% persons out of the labor force
2.
The unemployment rate is defined as the number of unemployed persons as a percentage of the labor force or 14.8/153.9 = 9.6%. This is higher than the February 2015 unemployment rate, computed earlier, of 5.5%.
3.
Over the long term, the U.S. unemployment rate has remained basically the same level.
4.
1. Non-White people
2. The young
3. High school graduates
5.
Because of the influx of women into the labor market, the supply of labor shifts to the right. Since wages are sticky downward, the increased supply of labor causes an increase in people looking for jobs (Qs), but no change in the number of jobs available (Qe). As a result, unemployment increases by the amount of the increase in the labor supply. This can be seen in the following figure.
Over time, as labor demand grows, the unemployment will decline and eventually wages will begin to increase again. But this increase in labor demand goes beyond the scope of this problem.
6.
The increase in labor supply was a social demographic trend—it was not caused by the economy falling into a recession. Therefore, the influx of women into the work force increased the natural rate of unemployment.
7.
New entrants to the labor force, whether from college or otherwise, are counted as frictionally unemployed until they find a job.
22.3.09: Chapter 9
1.
To compute the amount spent on each fruit in each year, you multiply the quantity of each fruit by the price.
• 10 apples × 50 cents each = \$5.00 spent on apples in 2001.
• 12 bananas × 20 cents each = \$2.40 spent on bananas in 2001.
• 2 bunches of grapes at 65 cents each = \$1.30 spent on grapes in 2001.
• 1 pint of raspberries at \$2 each = \$2.00 spent on raspberries in 2001.
Adding up the amounts gives you the total cost of the fruit basket. The total cost of the fruit basket in 2001 was \$5.00 + \$2.40 + \$1.30 + \$2.00 = \$10.70. The total costs for all the years are shown in the following table.
2001 2002 2003 2004
\$10.70 \$13.80 \$15.35 \$16.31
2.
If 2003 is the base year, then the index number has a value of 100 in 2003. To transform the cost of a fruit basket each year, we divide each year’s value by \$15.35, the value of the base year, and then multiply the result by 100. The price index is shown in the following table.
2001 2002 2003 2004
69.71 89.90 100.00 106.3
Note that the base year has a value of 100; years before the base year have values less than 100; and years after have values more than 100.
3.
The inflation rate is calculated as the percentage change in the price index from year to year. For example, the inflation rate between 2001 and 2002 is (89.90 – 69.71) / 69.71 = 0.2137 = 28.96%. The inflation rates for all the years are shown in the last row of the following table, which includes the two previous answers.
Items Qty (2001) Price (2001) Amount Spent (2002) Price (2002) Amount Spent (2003) Price (2003) Amount Spent (2004) Price (2004) Amount Spent
Apples 10 \$0.50 \$5.00 \$0.75 \$7.50 \$0.85 \$8.50 \$0.88 \$8.80
Bananas 12 \$0.20 \$2.40 \$0.25 \$3.00 \$0.25 \$3.00 \$0.29 \$3.48
Grapes 2 \$0.65 \$1.30 \$0.70 \$1.40 \$0.90 \$1.80 \$0.95 \$1.90
Raspberries 1 \$2.00 \$2.00 \$1.90 \$1.90 \$2.05 \$2.05 \$2.13 \$2.13
Total \$10.70 \$13.80 \$15.35 \$16.31
Price Index 69.71 89.90 100.00 106.3
Inflation Rate 28.96% 11.23% 6.3%
4.
Begin by calculating the total cost of buying the basket in each time period, as shown in the following table.
Items Quantity (Time 1) Price (Time 1) Total Cost (Time 2) Price (Time 2) Total Cost
Gifts 12 \$50 \$600 \$60 \$720
Pizza 24 \$15 \$360 \$16 \$384
Blouses 6 \$60 \$360 \$50 \$300
Trips 2 \$400 \$800 \$420 \$840
Total Cost \$2,120 \$2,244
The rise in cost of living is calculated as the percentage increase:
(2244 – 2120) / 2120 = 0.0585 = 5.85%.
5.
Since the CPI measures the prices of the goods and services purchased by the typical urban consumer, it measures the prices of things that people buy with their paycheck. For that reason, the CPI would be the best price index to use for this purpose.
6.
The PPI is subject to those biases for essentially the same reasons as the CPI is. The GDP deflator picks up prices of what is actually purchased that year, so there are no biases. That is the advantage of using the GDP deflator over the CPI.
7.
The calculator requires you to input three numbers:
• The first year, in this case the year of your birth
• The amount of money you would want to translate in terms of its purchasing power
• The last year—now or the most recent year the calculator will accept
My birth year is 1955. The amount is \$1. The year 2012 is currently the latest year the calculator will accept. The simple purchasing power calculator shows that \$1 of purchases in 1955 would cost \$8.57 in 2012. The website also explains how the true answer is more complicated than that shown by the simple purchasing power calculator.
8.
The state government would benefit because it would repay the loan in less valuable dollars than it borrowed. Plus, tax revenues for the state government would increase because of the inflation.
9.
Higher inflation reduces real interest rates on fixed rate mortgages. Because ARMs can be adjusted, higher inflation leads to higher interest rates on ARMs.
10.
Because the mortgage has an adjustable rate, the rate should fall by 3%, the same as inflation, to keep the real interest rate the same. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.08%3A_Chapter_8.txt |
1.
The stock and bond values will not show up in the current account. However, the dividends from the stocks and the interest from the bonds show up as an import to income in the current account.
2.
It becomes more negative as imports, which are a negative to the current account, are growing faster than exports, which are a positive.
3.
1. Money flows out of the Mexican economy.
2. Money flows into the Mexican economy.
3. Money flows out of the Mexican economy.
4.
GDP is a dollar value of all production of goods and services. Exports are produced domestically but shipped abroad. The percent ratio of exports to GDP gives us an idea of how important exports are to the national economy out of all goods and services produced. For example, exports represent only 14% of U.S. GDP, but 50% of Germany’s GDP
5.
Divide \$542 billion by \$1,800 billion.
6.
Divide –\$400 billion by \$16,800 billion.
7.
The trade balance is the difference between exports and imports. The current account balance includes this number (whether it is a trade balance or a trade surplus), but also includes international flows of money from global investments.
8.
1. An export sale to Germany involves a financial flow from Germany to the U.S. economy.
2. The issue here is not U.S. investments in Brazil, but the return paid on those investments, which involves a financial flow from the Brazilian economy to the U.S. economy.
3. Foreign aid from the United States to Egypt is a financial flow from the United States to Egypt.
4. Importing oil from the Russian Federation means a flow of financial payments from the U.S. economy to the Russian Federation.
5. Japanese investors buying U.S. real estate is a financial flow from Japan to the U.S. economy.
9.
The top portion tracks the flow of exports and imports and the payments for those. The bottom portion is looking at international financial investments and the outflow and inflow of monies from those investments. These investments can include investments in stocks and bonds or real estate abroad, as well as international borrowing and lending.
10.
If more monies are flowing out of the country (for example, to pay for imports) it will make the current account more negative or less positive, and if more monies are flowing into the country, it will make the current account less negative or more positive.
11.
Write out the national savings and investment identity for the situation of the economy implied by this question:
$Supply of capital = Demand for capitalS + (M – X) + (T – G) = I Savings + (trade deficit) + (government budget surplus)=InvestmentSupply of capital = Demand for capitalS + (M – X) + (T – G) = I Savings + (trade deficit) + (government budget surplus)=Investment$
If domestic savings increases and nothing else changes, then the trade deficit will fall. In effect, the economy would be relying more on domestic capital and less on foreign capital. If the government starts borrowing instead of saving, then the trade deficit must rise. In effect, the government is no longer providing savings and so, if nothing else is to change, more investment funds must arrive from abroad. If the rate of domestic investment surges, then, ceteris paribus, the trade deficit must also rise, to provide the extra capital. The ceteris paribus—or “other things being equal”—assumption is important here. In all of these situations, there is no reason to expect in the real world that the original change will affect only, or primarily, the trade deficit. The identity only says that something will adjust—it does not specify what.
12.
The government is saving rather than borrowing. The supply of savings, whether private or public, is on the left side of the identity.
13.
A trade deficit is determined by a country’s level of private and public savings and the amount of domestic investment.
14.
The trade deficit must increase. To put it another way, this increase in investment must be financed by an inflow of financial capital from abroad.
15.
Incomes fall during a recession, and consumers buy fewer good, including imports.
16.
A booming economy will increase the demand for goods in general, so import sales will increase. If our trading partners’ economies are doing well, they will buy more of our products and so U.S. exports will increase.
17.
1. Increased federal spending on Medicare may not increase productivity, so a budget deficit is not justified.
2. Increased spending on education will increase productivity and foster greater economic growth, so a budget deficit is justified.
3. Increased spending on the space program may not increase productivity, so a budget deficit is not justified.
4. Increased spending on airports and air traffic control will increase productivity and foster greater economic growth, so a budget deficit is justified.
18.
Foreign investors worried about repayment so they began to pull money out of these countries. The money can be pulled out of stock and bond markets, real estate, and banks.
19.
A rapidly growing trade surplus could result from a number of factors, so you would not want to be too quick to assume a specific cause. However, if the choice is between whether the economy is in recession or growing rapidly, the answer would have to be recession. In a recession, demand for all goods, including imports, has declined; however, demand for exports from other countries has not necessarily altered much, so the result is a larger trade surplus.
20.
Germany has a higher level of trade than the United States. The United States has a large domestic economy so it has a large volume of internal trade.
21.
1. A large economy tends to have lower levels of international trade, because it can do more of its trade internally, but this has little impact on its trade imbalance.
2. An imbalance between domestic physical investment and domestic saving (including government and private saving) will always lead to a trade imbalance, but has little to do with the level of trade.
3. Many large trading partners nearby geographically increases the level of trade, but has little impact one way or the other on a trade imbalance.
4. The answer here is not obvious. An especially large budget deficit means a large demand for financial capital which, according to the national saving and investment identity, makes it somewhat more likely that there will be a need for an inflow of foreign capital, which means a trade deficit.
5. A strong tradition of discouraging trade certainly reduces the level of trade. However, it does not necessarily say much about the balance of trade, since this is determined by both imports and exports, and by national levels of physical investment and savings. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.10%3A_Chapter_10.txt |
1.
In order to supply goods, suppliers must employ workers, whose incomes increase as a result of their labor. They use this additional income to demand goods of an equivalent value to those they supply.
2.
When consumers demand more goods than are available on the market, prices are driven higher and the additional opportunities for profit induce more suppliers to enter the market, producing an equivalent amount to that which is demanded.
3.
Higher input prices make output less profitable, decreasing the desired supply. This is shown graphically as a leftward shift in the AS curve.
4.
Equilibrium occurs at the level of GDP where AD = AS. Insufficient aggregate demand could explain why the equilibrium occurs at a level of GDP less than potential. A decrease (or leftward shift) in aggregate supply could be another reason.
5.
Equilibrium real GDP will decrease and the price level will increase.
6.
Given the assumptions made here, the cuts in R&D funding should reduce productivity growth. The model would show this as a leftward shift in the SRAS curve, leading to a lower equilibrium GDP and a higher price level.
7.
An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending, shifting the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level.
8.
Since imports depend on GDP, if Mexico goes into recession, its GDP declines and so do its imports. This decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level.
9.
Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. This would shift AD to the right, so if the tax cuts occurred when the economy was in recession (and GDP was less than potential), the tax cuts would increase GDP and “lead the economy out of recession.”
10.
A negative report on home prices would make consumers feel like the value of their homes, which for most Americans is a major portion of their wealth, has declined. A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level. A positive report on the home price index or consumer confidence would do the opposite.
11.
A smaller labor force would be reflected in a leftward shift in AS, leading to a lower equilibrium level of GDP and higher price level.
12.
Higher EU growth would increase demand for U.S. exports, reducing our trade deficit. The increased demand for exports would show up as a rightward shift in AD, causing GDP to rise (and the price level to rise as well). Higher GDP would require more jobs to fulfill, so U.S. employment would also rise.
13.
Expansionary monetary policy shifts AD to the right. A continuing expansionary policy would cause larger and larger shifts (given the parameters of this problem). The result would be an increase in GDP and employment (a decrease in unemployment) and higher prices until potential output was reached. After that point, the expansionary policy would simply cause inflation.
14.
Since the SRAS curve is vertical in the neoclassical zone, unless the economy is bordering the intermediate zone, a decrease in AS will cause a decrease in the price level, but no effect on real economic activity (for example, real GDP or employment).
15.
Because the SRAS curve is horizontal in the Keynesian zone, a decrease in AD should depress real economic activity but have no effect on prices. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.11%3A_Chapter_11.txt |
1.
1. An increase in home values will increase consumption spending (due to increased wealth). AD will shift to the right and may cause inflation if it goes beyond potential GDP.
2. Rapid growth by a major trading partner will increase demand for exports. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
3. Increased profit opportunities will increase business investment. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
4. Higher interest rates reduce investment spending. AD will shift to the left and may cause recession if it falls below potential GDP.
5. Demand for cheaper imports increases, reducing demand for domestic products. AD will shift to the left and may be recessionary.
2.
1. A tax increase on consumer income will cause consumption to fall, pushing the AD curve left, and is a possible solution to inflation.
2. A surge in military spending is an increase in government spending. This will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and military spending will be inflationary.
3. A tax cut focused on business investment will shift AD to the right. If the original macroeconomic equilibrium is below potential GDP, then this policy can help move an economy out of a recession.
4. Government spending on healthcare will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to th right of potential GDP, then the AD curve will shift farther to the right and healthcare spending will be inflationary.
3.
An inflationary gap is the result of an increase in aggregate demand when the economy is at potential output. Since the AS curve is vertical at potential GDP, any increase in AD will lead to a higher price level (i.e. inflation) but no higher real GDP. This is easy to see if you draw AD1 to the right of AD0.
4.
A decrease in government spending will shift AD to the left.
5.
A decrease in energy prices, a positive supply shock, would cause the AS curve to shift out to the right, yielding more real GDP at a lower price level. This would shift the Phillips curve down toward the origin, meaning the economy would experience lower unemployment and a lower rate of inflation.
6.
Keynesian economics does not require microeconomic price controls of any sort. It is true that many Keynesian economic prescriptions were for the government to influence the total amount of aggregate demand in the economy, often through government spending and tax cuts.
7.
The three problems center on government’s ability to estimate potential GDP, decide whether to influence aggregate demand through tax changes or changes in government spending, and the lag time that occurs as Congress and the President attempt to pass legislation. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.12%3A_Chapter_12.txt |
1.
No, this statement is false. It would be more accurate to say that rational expectations seek to predict the future as accurately as possible, using all of past experience as a guide. Adaptive expectations are largely backward looking; that is, they adapt as experience accumulates, but without attempting to look forward.
2.
An unemployment rate of zero percent is presumably well below the rate that is consistent with potential GDP and with the natural rate of unemployment. As a result, this policy would be attempting to push AD out to the right.
In the short run, it is possible to have unemployment slightly below the natural rate for a time, at a price of higher inflation, as shown by the movement from E0 to E1 along the short-run AS curve. However, over time the extremely low unemployment rates will tend to cause wages to be bid up, and shift the short-run AS curve back to the left. The result would be a higher price level, but an economy still at potential GDP and the natural rate of unemployment, as determined by the long-run AS curve. If the government continues this policy, it will continually be pushing the price level higher and higher, but it will not be able to achieve its goal of zero percent unemployment, because that goal is inconsistent with market forces.
3.
The statement is accurate. Rational expectations can be thought of as a version of neoclassical economics because it argues that potential GDP and the rate of unemployment are shaped by market forces as wages and prices adjust. However, it is an “extreme” version because it argues that this adjustment takes place very quickly. Other theories, like adaptive expectations, suggest that adjustment to the neoclassical outcome takes a few years.
4.
The short-term Keynesian model is built on the importance of aggregate demand as a cause of business cycles and a degree of wage and price rigidity, and thus does a sound job of explaining many recessions and why cyclical unemployment rises and falls. The neoclassical model emphasizes aggregate supply by focusing on the underlying determinants of output and employment in markets, and thus tends to put more emphasis on economic growth and how labor markets work.
22.3.14: Chapter 14
1.
As long as you remain within the walls of the casino, chips fit the definition of money; that is, they serve as a medium of exchange, a unit of account, and a store of value. Chips do not work very well as money once you leave the casino, but many kinds of money do not work well in other areas. For example, it is hard to spend money from Turkey or Brazil at your local supermarket or at the movie theater.
2.
Many physical items that a person buys at one time but may sell at another time can serve as an answer to this question. Examples include a house, land, art, rare coins or stamps, and so on.
3.
The currency and checks in M1 are easiest to spend. It is harder to spend M2 directly, although if there is an automatic teller machine in the shopping mall, you can turn M2 from your savings account into an M1 of currency quite quickly. If your answer is about “credit cards,” then you are really talking about spending M1—although it is M1 from the account of the credit card company, which you will repay later when you credit card bill comes due.
4.
1. Neither in M1 or M2
2. That is part of M1, and because M2 includes M1 it is also part of M2
3. Currency out in the public hands is part of M1 and M2
4. Checking deposits are in M1 and M2
5. Money market accounts are in M2
5.
A bank’s assets include cash held in their vaults, but assets also include monies that the bank holds at the Federal Reserve Bank (called “reserves”), loans that are made to customers, and bonds.
6.
1. A borrower who has been late on a number of loan payments looks perhaps less likely to repay the loan, or to repay it on time, and so you would want to pay less for that loan.
2. If interest rates generally have risen, then this loan made at a time of relatively lower interest rates looks less attractive, and you would pay less for it.
3. If the borrower is a firm with a record of high profits, then it is likely to be able to repay the loan, and you would be willing to pay more for the loan.
4. If interest rates in the economy have fallen, then the loan is worth more. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.13%3A_Chapter_13.txt |
1.
Longer terms insulate the Board from political forces. Since the presidency can potentially change every four years, the Federal Reserve’s independence prevents drastic swings in monetary policy with every new administration and allows policy decisions to be made only on economic grounds.
2.
Banks make their money from issuing loans and charging interest. The more money that is stored in the bank’s vault, the less is available for lending and the less money the bank stands to make.
3.
The fear and uncertainty created by the suggestion that a bank might fail can lead depositors to withdraw their money. If many depositors do this at the same time, the bank may not be able to meet their demands and will, indeed, fail.
4.
The bank has to hold \$1,000 in reserves, so when it buys the \$500 in bonds, it will have to reduce its loans by \$500 to make up the difference. The money supply decreases by the same amount.
5.
An increase in reserve requirements would reduce the supply of money, since more money would be held in banks rather than circulating in the economy.
6.
Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises.
7.
An increase in the amount of available loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing (the interest rate) down.
8.
In times of economic uncertainty, banks may worry that borrowers will lose the ability to repay their loans. They may also fear that a panic is more likely and they will need the excess reserves to meet their obligations.
9.
If consumer optimism changes, spending can speed up or slow down. This could also happen in a case where consumers need to buy a large number of items quickly, such as in a situation of national emergency.
22.3.16: Chapter 16
1.
1. The British use the pound sterling, while Germans use the euro, so a British exporter will receive euros from export sales, which will need to be exchanged for pounds. A stronger euro will mean more pounds per euro, so the exporter will be better off. In addition, the lower price for German imports will stimulate demand for British exports. For both these reasons, a stronger euro benefits the British exporter.
2. The Dutch use euros while the Chileans use pesos, so the Dutch tourist needs to turn euros into Chilean pesos. An increase in the euro means that the tourist will get more pesos per euro. As a consequence, the Dutch tourist will have a less expensive vacation than he planned, so the tourist will be better off.
3. The Greek use euros while the Canadians use dollars. An increase in the euro means it will buy more Canadian dollars. As a result, the Greek bank will see a decrease in the cost of the Canadian bonds, so it may purchase more bonds. Either way, the Greek bank benefits.
4. Since both the French and Germans use the euro, an increase in the euro, in terms of other currencies, should have no impact on the French exporter.
2.
Expected depreciation in a currency will lead people to divest themselves of the currency. We should expect to see an increase in the supply of pounds and a decrease in demand for pounds. The result should be a decrease in the value of the pound vis à vis the dollar.
3.
Lower U.S. interest rates make U.S. assets less desirable compared to assets in the European Union. We should expect to see a decrease in demand for dollars and an increase in supply of dollars in foreign currency markets. As a result, we should expect to see the dollar depreciate compared to the euro.
4.
A decrease in Argentine inflation relative to other countries should cause an increase in demand for pesos, a decrease in supply of pesos, and an appreciation of the peso in foreign currency markets.
5.
The problem occurs when banks borrow foreign currency but lend in domestic currency. Since banks’ assets (loans they made) are in domestic currency, while their debts (money they borrowed) are in foreign currency, when the domestic currency declines, their debts grow larger. If the domestic currency falls substantially in value, as happened during the Asian financial crisis, then the banking system could fail. This problem is unlikely to occur for U.S. banks because, even when they borrow from abroad, they tend to borrow dollars. Remember, there are trillions of dollars in circulation in the global economy. Since both assets and debts are in dollars, a change in the value of the dollar does not cause banking system failure the way it can when banks borrow in foreign currency.
6.
While capital flight is possible in either case, if a country borrows to invest in real capital it is more likely to be able to generate the income to pay back its debts than a country that borrows to finance consumption. As a result, an investment-stimulated economy is less likely to provoke capital flight and economic recession.
7.
A contractionary monetary policy, by driving up domestic interest rates, would cause the currency to appreciate. The higher value of the currency in foreign exchange markets would reduce exports, since from the perspective of foreign buyers, they are now more expensive. The higher value of the currency would similarly stimulate imports, since they would now be cheaper from the perspective of domestic buyers. Lower exports and higher imports cause net exports (EX – IM) to fall, which causes aggregate demand to fall. The result would be a decrease in GDP working through the exchange rate mechanism reinforcing the effect contractionary monetary policy has on domestic investment expenditure. However, cheaper imports would stimulate aggregate supply, bringing GDP back to potential, though at a lower price level.
8.
For a currency to fall, a central bank need only supply more of its currency in foreign exchange markets. It can print as much domestic currency as it likes. For a currency to rise, a central bank needs to buy its currency in foreign exchange markets, paying with foreign currency. Since no central bank has an infinite amount of foreign currency reserves, it cannot buy its currency indefinitely.
9.
Variations in exchange rates, because they change import and export prices, disturb international trade flows. When trade is a large part of a nation’s economic activity, government will find it more advantageous to fix exchange rates to minimize disruptions of trade flows. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.15%3A_Chapter_15.txt |
1.
The government borrows funds by selling Treasury bonds, notes, and bills.
2.
The funds can be used to pay down the national debt or else be refunded to the taxpayers.
3.
Yes, a nation can run budget deficits and see its debt/GDP ratio fall. In fact, this is not uncommon. If the deficit is small in a given year, than the addition to debt in the numerator of the debt/GDP ratio will be relatively small, while the growth in GDP is larger, and so the debt/GDP ratio declines. This was the experience of the U.S. economy for the period from the end of World War II to about 1980. It is also theoretically possible, although not likely, for a nation to have a budget surplus and see its debt/GDP ratio rise. Imagine the case of a nation with a small surplus, but in a recession year when the economy shrinks. It is possible that the decline in the nation’s debt, in the numerator of the debt/GDP ratio, would be proportionally less than the fall in the size of GDP, so the debt/GDP ratio would rise.
4.
Progressive. People who give larger gifts subject to the higher tax rate would typically have larger incomes as well.
5.
Corporate income tax on his profits, individual income tax on his salary, and payroll tax taken out of the wages he pays himself.
6.
individual income taxes
7.
The tax is regressive because wealthy income earners are not taxed at all on income above \$113,000. As a percent of total income, the social security tax hits lower income earners harder than wealthier individuals.
8.
As debt increases, interest payments also rise, so that the deficit grows even if we keep other government spending constant.
9.
1. As a share of GDP, this is false. In nominal dollars, it is true.
2. False.
3. False.
4. False. Education spending is much higher at the state level.
5. False. As a share of GDP, it is up about 50.
6. As a share of GDP, this is false, and in real dollars, it is also false.
7. False.
8. False; it’s about 1%.
9. False. Although budget deficits were large in 2003 and 2004, and continued into the later 2000s, the federal government ran budget surpluses from 1998–2001.
10. False.
10.
To keep prices from rising too much or too rapidly.
11.
To increase employment.
12.
It falls below because less tax revenue than expected is collected.
13.
Automatic stabilizers take effect very quickly, whereas discretionary policy can take a long time to implement.
14.
In a recession, because of the decline in economic output, less income is earned, and so less in taxes is automatically collected. Many welfare and unemployment programs are designed so that those who fall into certain categories, like “unemployed” or “low income,” are eligible for benefits. During a recession, more people fall into these categories and become eligible for benefits automatically. The combination of reduced taxes and higher spending is just what is needed for an economy in recession producing below potential GDP. With an economic boom, average income levels rise in the economy, so more in taxes is automatically collected. Fewer people meet the criteria for receiving government assistance to the unemployed or the needy, so government spending on unemployment assistance and welfare falls automatically. This combination of higher taxes and lower spending is just what is needed if an economy is producing above its potential GDP.
15.
Prices would be pushed up as a result of too much spending.
16.
Employment would suffer as a result of too little spending.
17.
Monetary policy probably has shorter time lags than fiscal policy. Imagine that the data becomes fairly clear that an economy is in or near a recession. Expansionary monetary policy can be carried out through open market operations, which can be done fairly quickly, since the Federal Reserve’s Open Market Committee meets six times a year. Also, monetary policy takes effect through interest rates, which can change fairly quickly. However, fiscal policy is carried out through acts of Congress that need to be signed into law by the president. Negotiating such laws often takes months, and even after the laws are negotiated, it takes more months for spending programs or tax cuts to have an effect on the macroeconomy.
18.
The government would have to make up the revenue either by raising taxes in a different area or cutting spending.
19.
Programs where the amount of spending is not fixed, but rather determined by macroeconomic conditions, such as food stamps, would lose a great deal of flexibility if spending increases had to be met by corresponding tax increases or spending cuts. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.17%3A_Chapter_17.txt |
1.
We use the national savings and investment identity to solve this question. In this case, the government has a budget surplus, so the government surplus appears as part of the supply of financial capital. Then:
$Quantity supplied of financial capital = Quantity demanded of financial capital S + (T – G) = I + (X – M) 600 + 200 = I + 100 I = 700 Quantity supplied of financial capital = Quantity demanded of financial capital S + (T – G) = I + (X – M) 600 + 200 = I + 100 I = 700$
2.
1. Since the government has a budget surplus, the government budget term appears with the supply of capital. The following shows the national savings and investment identity for this economy. $Quantity supplied of financial capital = Quantity demanded of financial capitalS + (T – G) = I + (X – M)Quantity supplied of financial capital = Quantity demanded of financial capitalS + (T – G) = I + (X – M)$
2. Plugging the given values into the identity shown in part (a), we find that (X – M) = 0.
3. Since the government has a budget deficit, the government budget term appears with the demand for capital. You do not know in advance whether the economy has a trade deficit or a trade surplus. But when you see that the quantity demanded of financial capital exceeds the quantity supplied, you know that there must be an additional quantity of financial capital supplied by foreign investors, which means a trade deficit of 2000. This example shows that in this case there is a higher budget deficit, and a higher trade deficit. $Quantity supplied of financial capital = Quantity demanded of financial capitalS + (M – X) = I + (G – T)4000 + 2000 = 5000 + 1000Quantity supplied of financial capital = Quantity demanded of financial capitalS + (M – X) = I + (G – T)4000 + 2000 = 5000 + 1000$
3.
In this case, the national saving and investment identity is written in this way:
$Quantity supplied of financial capital = Quantity demanded of financial capital (T – G) + (M – X) + S = I Quantity supplied of financial capital = Quantity demanded of financial capital (T – G) + (M – X) + S = I$
The increase in the government budget surplus and the increase in the trade deficit both increased the supply of financial capital. If investment in physical capital remained unchanged, then private savings must go down, and if savings remained unchanged, then investment must go up. In fact, both effects happened; that is, in the late 1990s, in the U.S. economy, savings declined and investment rose.
4.
Ricardian equivalence means that private saving changes to offset exactly any changes in the government budget. So, if the deficit increases by 20, private saving increases by 20 as well, and the trade deficit and the budget deficit will not change from their original levels. The original national saving and investment identity is written below. Notice that if any change in the (G – T) term is offset by a change in the S term, then the other terms do not change. So if (G – T) rises by 20, then S must also increase by 20.
$Quantity supplied of financial capital = Quantity demanded of financial capital S + (M – X) = I + (G – T) 130 + 20 = 100 + 50 Quantity supplied of financial capital = Quantity demanded of financial capital S + (M – X) = I + (G – T) 130 + 20 = 100 + 50$
5.
In the last few decades, spending per student has climbed substantially. However, test scores have fallen over this time. This experience has led a number of experts to argue that the problem is not resources—or is not just resources by itself—but is also a problem of how schools are organized and managed and what incentives they have for success. There are a number of proposals to alter the incentives that schools face, but relatively little hard evidence on what proposals work well. Without trying to evaluate whether these proposals are good or bad ideas, you can just list some of them: testing students regularly; rewarding teachers or schools that perform well on such tests; requiring additional teacher training; allowing students to choose between public schools; allowing teachers and parents to start new schools; giving student “vouchers” that they can use to pay tuition at either public or private schools.
6.
The government can direct government spending to R&D. It can also create tax incentives for business to invest in R&D. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.18%3A_Chapter_18.txt |
1.
The answers are shown in the following two tables.
Region GDP (in millions)
East Asia \$10,450,032
Latin America \$5,339,390
South Asia \$2,288,812
Europe and Central Asia \$1,862,384
Middle East and North Africa \$1,541,900
Sub-Saharan Africa \$1,287,650
Region GDP Per Capita (in millions)
East Asia \$5,246
Latin America \$1,388
South Asia \$1,415
Europe and Central Asia \$9,190
Middle East and North Africa \$4,535
Sub-Saharan Africa \$6,847
East Asia appears to be the largest economy on GDP basis, but on a per capita basis it drops to third, after Europe and Central Asia and Sub-Saharan Africa.
2.
A region can have some of high-income countries and some of the low-income countries. Aggregating per capita real GDP will vary widely across countries within a region, so aggregating data for a region has little meaning. For example, if you were to compare per capital real GDP for the United States, Canada, Haiti, and Honduras, it looks much different than if you looked at the same data for North America as a whole. Thus, regional comparisons are broad-based and may not adequately capture an individual country’s economic attributes.
3.
The following table provides a summary of possible answers.
High-Income
Countries
Middle-Income
Countries
Low-Income
Countries
• Foster a more educated workforce
• Create, invest in, and apply new
technologies
• Adopt fiscal policies focused on
investment, including investment in
human capital, in technology,
and in physical plant and equipment
• Create stable and market-oriented
economic climate
• Use monetary policy to keep inflation
low and stable
• Minimize the risk of exchange rate
fluctuations, while also encouraging
domestic and international competition
• Invest in technology, human
capital, and physical capital
• Provide incentives of a market-
oriented economic context
• Work to reduce government
economic controls on market
activities
• Deregulate the banking and
financial sector
• Reduce protectionist policies
• Eradicate poverty and extreme
hunger
• Achieve universal primary
education
• Promote gender equality
• Reduce child mortality rates
• Improve maternal health
• Combat HIV/AIDS, malaria,
and other diseases
• Ensure environmental
sustainability
• Develop global partnerships
for development
4.
Low-income countries must adopt government policies that are market-oriented and that educate the workforce and population. After this is done, low-income countries should focus on eradicating other social ills that inhibit their growth. The economically challenged are stuck in poverty traps. They need to focus more on health and education and create a stable macroeconomic and political environment. This will attract foreign aid and foreign investment. Middle-income countries strive for increases in physical capital and innovation, while higher-income countries must work to maintain their economies through innovation and technology.
5.
If there is a recession and unemployment increases, we can call on an expansionary fiscal policy (lower taxes or increased government spending) or an expansionary monetary policy (increase the money supply and lower interest rates). Both policies stimulate output and decrease unemployment.
6.
Aside from a high natural rate of unemployment due to government regulations, subsistence households may be counted as not working.
7.
Indexing wage contracts means wages rise when prices rise. This means what you can buy with your wages, your standard of living, remains the same. When wages are not indexed, or rise with inflation, your standard of living falls.
8.
An increase in government spending shifts the AD curve to the right, raising both income and price levels.
9.
A decrease in the money supply will shift the AD curve leftward and reduce income and price levels. Banks will have less money to lend. Interest rates will increase, affecting consumption and investment, which are both key determinants of aggregate demand.
10.
Given the high level of activity in international financial markets, it is typically believed that financial flows across borders are the real reason for trade imbalances. For example, the United States had an enormous trade deficit in the late 1990s and early 2000s because it was attracting vast inflows of foreign capital. Smaller countries that have attracted such inflows of international capital worry that if the inflows suddenly turn to outflows, the resulting decline in their currency could collapse their banking system and bring on a deep recession.
11.
The demand for the country’s currency would decrease, lowering the exchange rate. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.19%3A_Chapter_19.txt |
1.
False. Anything that leads to different levels of productivity between two economies can be a source of comparative advantage. For example, the education of workers, the knowledge base of engineers and scientists in a country, the part of a split-up value chain where they have their specialized learning, economies of scale, and other factors can all determine comparative advantage.
2.
Brazil has the absolute advantage in producing beef and the United States has the absolute advantage in autos. The opportunity cost of producing one pound of beef is 1/10 of an auto; in the United States it is 3/4 of an auto.
3.
In answering questions like these, it is often helpful to begin by organizing the information in a table, such as in the following table. Notice that, in this case, the productivity of the countries is expressed in terms of how many workers it takes to produce a unit of a product.
Country One Sweater One Bottle of wine
France 1 worker 1 worker
Tunisia 2 workers 3 workers
In this example, France has an absolute advantage in the production of both sweaters and wine. You can tell because it takes France less labor to produce a unit of the good.
4.
1. In Germany, it takes fewer workers to make either a television or a video camera. Germany has an absolute advantage in the production of both goods.
2. Producing an additional television in Germany requires three workers. Shifting those three German workers will reduce video camera production by 3/4 of a camera. Producing an additional television set in Poland requires six workers, and shifting those workers from the other good reduces output of video cameras by 6/12 of a camera, or 1/2. Thus, the opportunity cost of producing televisions is lower in Poland, so Poland has the comparative advantage in the production of televisions. Note: Do not let the fractions like 3/4 of a camera or 1/2 of a video camera bother you. If either country was to expand television production by a significant amount—that is, lots more than one unit—then we will be talking about whole cameras and not fractional ones. You can also spot this conclusion by noticing that Poland’s absolute disadvantage is relatively lower in televisions, because Poland needs twice as many workers to produce a television but three times as many to produce a video camera, so the product with the relatively lower absolute disadvantage is Poland’s comparative advantage.
3. Producing a video camera in Germany requires four workers, and shifting those four workers away from television production has an opportunity cost of 4/3 television sets. Producing a video camera in Poland requires 12 workers, and shifting those 12 workers away from television production has an opportunity cost of two television sets. Thus, the opportunity cost of producing video cameras is lower in Germany, and video cameras will be Germany’s comparative advantage.
4. In this example, absolute advantage differs from comparative advantage. Germany has the absolute advantage in the production of both goods, but Poland has a comparative advantage in the production of televisions.
5. Germany should specialize, at least to some extent, in the production of video cameras, export video cameras, and import televisions. Conversely, Poland should specialize, at least to some extent, in the production of televisions, export televisions, and import video cameras.
5.
There are a number of possible advantages of intra-industry trade. Both nations can take advantage of extreme specialization and learning in certain kinds of cars with certain traits, like gas-efficient cars, luxury cars, sport-utility vehicles, higher- and lower-quality cars, and so on. Moreover, nations can take advantage of economies of scale, so that large companies will compete against each other across international borders, providing the benefits of competition and variety to customers. This same argument applies to trade between U.S. states, where people often buy products made by people of other states, even though a similar product is made within the boundaries of their own state. All states—and all countries—can benefit from this kind of competition and trade.
6.
1. Start by plotting the points on a sketch diagram and then drawing a line through them. The following figure illustrates the average costs of production of semiconductors.
The curve illustrates economies of scale by showing that as the scale increases—that is, as production at this particular factory goes up—the average cost of production declines. The economies of scale exist up to an output of 40,000 semiconductors; at higher outputs, the average cost of production does not seem to decline any further.
2. At any quantity demanded above 40,000, this economy can take full advantage of economies of scale; that is, it can produce at the lowest cost per unit. Indeed, if the quantity demanded was quite high, like 500,000, then there could be a number of different factories all taking full advantage of economies of scale and competing with each other. If the quantity demanded falls below 40,000, then the economy by itself, without foreign trade, cannot take full advantage of economies of scale.
3. The simplest answer to this question is that the small country could have a large enough factory to take full advantage of economies of scale, but then export most of the output. For semiconductors, countries like Taiwan and Korea have recently fit this description. Moreover, this country could also import semiconductors from other countries which also have large factories, thus getting the benefits of competition and variety. A slightly more complex answer is that the country can get these benefits of economies of scale without producing semiconductors, but simply by buying semiconductors made at low cost around the world. An economy, especially a smaller country, may well end up specializing and producing a few items on a large scale, but then trading those items for other items produced on a large scale, and thus gaining the benefits of economies of scale by trade, as well as by direct production.
7.
A nation might restrict trade on imported products to protect an industry that is important for national security. For example, nation X and nation Y may be geopolitical rivals, each with ambitions of increased political and economic strength. Even if nation Y has comparative advantage in the production of missile defense systems, it is unlikely that nation Y would seek to export those goods to nation X. It is also the case that, for some nations, the production of a particular good is a key component of national identity. In Japan, the production of rice is culturally very important. It may be difficult for Japan to import rice from a nation like Vietnam, even if Vietnam has a comparative advantage in rice production. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.20%3A_Chapter_20.txt |
1.
This is the opposite case of the Work It Out feature. A reduced tariff is like a decrease in the cost of production, which is shown by a downward (or rightward) shift in the supply curve.
2.
A subsidy is like a reduction in cost. This shifts the supply curve down (or to the right), driving the price of sugar down. If the subsidy is large enough, the price of sugar can fall below the cost of production faced by foreign producers, which means they will lose money on any sugar they produce and sell.
3.
Trade barriers raise the price of goods in protected industries. If those products are inputs in other industries, it raises their production costs and then prices, so sales fall in those other industries. Lower sales lead to lower employment. Additionally, if the protected industries are consumer goods, their customers pay higher prices, which reduce demand for other consumer products and thus employment in those industries.
4.
Trade based on comparative advantage raises the average wage rate economy-wide, though it can reduce the incomes of import-substituting industries. By moving away from a country’s comparative advantage, trade barriers do the opposite: they give workers in protected industries an advantage, while reducing the average wage economy-wide.
5.
By raising incomes, trade tends to raise working conditions also, even though those conditions may not (yet) be equivalent to those in high-income countries.
6.
They typically pay more than the next-best alternative. If a Nike firm did not pay workers at least as much as they would earn, for example, in a subsistence rural lifestyle, they many never come to work for Nike.
7.
Since trade barriers raise prices, real incomes fall. The average worker would also earn less.
8.
Workers working in other sectors and the protected sector see a decrease in their real wage.
9.
If imports can be sold at extremely low prices, domestic firms would have to match those prices to be competitive. By definition, matching prices would imply selling under cost and, therefore, losing money. Firms cannot sustain losses forever. When they leave the industry, importers can “take over,” raising prices to monopoly levels to cover their short-term losses and earn long-term profits.
10.
Because low-income countries need to provide necessities—food, clothing, and shelter—to their people. In other words, they consider environmental quality a luxury.
11.
Low-income countries can compete for jobs by reducing their environmental standards to attract business to their countries. This could lead to a competitive reduction in regulations, which would lead to greater environmental damage. While pollution management is a cost for businesses, it is tiny relative to other costs, like labor and adequate infrastructure. It is also costly for firms to locate far away from their customers, which many low-income countries are.
12.
The decision should not be arbitrary or unnecessarily discriminatory. It should treat foreign companies the same way as domestic companies. It should be based on science.
13.
Restricting imports today does not solve the problem. If anything, it makes it worse since it implies using up domestic sources of the products faster than if they are imported. Also, the national security argument can be used to support protection of nearly any product, not just things critical to our national security.
14.
The effect of increasing standards may increase costs to the small exporting country. The supply curve of toys will shift to the left. Exports will decrease and toy prices will rise. Tariffs also raise prices. So the effect on the price of toys is the same. A tariff is a “second best” policy and also affects other sectors. However, a common standard across countries is a “first best” policy that attacks the problem at its root.
15.
A free trade association offers free trade between its members, but each country can determine its own trade policy outside the association. A common market requires a common external trade policy in addition to free trade within the group. An economic union is a common market with coordinated fiscal and monetary policy.
16.
International agreements can serve as a political counterweight to domestic special interests, thereby preventing stronger protectionist measures.
17.
Reductions in tariffs, quotas, and other trade barriers, improved transportation, and communication media have made people more aware of what is available in the rest of the world.
18.
Competition from firms with better or cheaper products can reduce a business’s profits, and may drive it out of business. Workers would similarly lose income or even their jobs.
19.
Consumers get better or less expensive products. Businesses with the better or cheaper products increase their profits. Employees of those businesses earn more income. On balance, the gains outweigh the losses to a nation. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/22%3A_Appendix/22.03%3A_Answer_Key/22.3.21%3A_Chapter_21.txt |
Chapter 1: Introduction to key ideas
In this chapter we will explore:
1.1
What it's all about
1.2
Understanding through the use of models
1.3
Opportunity cost and the market
1.4
A model of exchange and specialization
1.5
Production possibilities for the economy
1.6
Aggregate output, growth and cycles
1.1 What's it all about?
The big issues
Economics is the study of human behaviour. Since it uses scientific methods it is called a social science. We study human behaviour to better understand and improve our world. During his acceptance speech, a recent Nobel Laureate in Economics suggested:
Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we cannot face the challenges of stagnation, job loss and widening inequality.
Christopher Sims, Nobel Laureate in Economics 2011
This is an elegant definition of economics and serves as a timely caution about the perils of ideology. Economics evolves continuously as current observations and experience provide new evidence about economic behaviour and relationships. Inference and policy recommendations based on earlier theories, observations and institutional structures require constant analysis and updating if they are to furnish valuable responses to changing conditions and problems.
Much of today's developed world still faces severe challenges as a result of the financial crisis that began in 2008. Unemployment rates among young people are at historically high levels in several economies, many government balance sheets are in disarray, and inequality is on the rise. In addition to the challenges posed by this severe economic cycle, the world simultaneously faces structural upheaval: Overpopulation, climate change, political instability and globalization challenge us to understand and modify our behaviour.
These challenges do not imply that our world is deteriorating. Literacy rates have been rising dramatically in the developing world for decades; child mortality has plummeted; family size is a fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; life expectancy is increasing universally and deaths through wars are in a state of long-term decline.
These developments, good and bad, have a universal character and affect billions of individuals. They involve an understanding of economies as large organisms with interactive components.
Aggregate output in a national economy
A national economy is a complete multi-sector system, made up of household, business, financial, government and international sectors. Each of these sectors is an aggregate or sum of a many smaller economic units with very similar characteristics. The government sector, for example aggregates the taxing and spending activities of local, provincial and national governments. Similarly, the household sector is an aggregate of the income, spending and saving of all households but not the specifics of each individual household. Economic activity within any one of these sectors reflects, in part, the conditions and choices made in that sector. But it is also affects and is affected by conditions and actions in the other sectors. These interactions and feedbacks within the system mean that the workings of the macro-economy are more complex than the operation of the sum of its parts.
Macroeconomics: the study of the economy as a system in which interactions and feedbacks among sectors determine national output, employment and prices.
For example, consider a simple economy with just household, business and financial sectors. The household sector earns income by providing labour to the other sectors. Households make choices about spending or saving this income. Businesses make decisions about the sizes of their establishments, their labour forces, and their outputs of goods and services. The financial sector provides banking services: bank deposits, loans, and the payments system used by all three sectors.
Suppose households decide to spend more on goods and services and save less. That decision by itself does not change household sector income, but it does increase business sector sales and revenues. It also reduces the flow of household savings into bank deposits in the financial sector. As a result the business sector has an incentive to increase employment and output and perhaps to borrow from the financial sector to finance that expansion. Increased employment in the business sector increases incomes in the household sector and further increases household expenditure and savings. These inter-sector linkages and feedbacks produce a response in aggregate economy greater than the initial change.
Expanding this simple example to include more sectors increases its complexity but does not change the basics. A change in behaviour within a sector,or disturbance from outside that sector, changes aggregate levels of output, employment and prices. A complete multisector macroeconomic theory and model is required to understand the effects, on the aggregate economy, of changes in either internal or external economic conditions. It is also essential for the design of policies to manage the macroeconomic conditions.
Mitigating the effects of a large random shock from outside the economy, like the COVID-19 pandemic, disrupts all sectors of the economy. Flows of income, expenditure, revenue,and output among sectors are reduced sharply both by the pandemic and by government and financial sectors policy responses.
Application Box 1.1 COVID-19 and the Economy
The COVID-19 pandemic attacked Canada in early 2020. It revealed the complexities and interdependencies that drive the macro economy. Control and elimination of the disease depends on stopping person to person transmission. This is why the government mandated personal and social distancing for individuals plus self-isolation and quarantine in some cases. In addition businesses, mainly in the service sector, that relied on face to face interactions with customers or live audiences were forced to close.
As a result, businesses lost sales revenues and cut output. They reduced employment to cut labour costs, but overhead costs remained. Households lost employment and employment incomes. They reduced their discretionary spending, but their overhead costs continued. As a result the economy faced a unique, simultaneous collapse in overall private supply and demand and the risk of a deep recession. The government and financial sectors intervened with fiscal and monetary policy support. Government introduced a wide range of new income supports for the household sector, and loan and subsidy programs to support businesses, funded by large increases in the government's budget deficit. The central bank lowered interest rates and increased the monetary base to support the government's borrowing requirements, and the credit demands on private banks and other financial institutions. The banking system lost the normal growth in customer deposits, but worked to accommodate the needs of their business and household clients.
This unprecedented support from government fiscal policy and central bank monetary policy will offset part of the loss in national output and income. But it will not reverse it. Recovery will begin with the reopening of business and the growth of employment at some time in the uncertain future. The size of the estimated effect of COVID-19 on the Canadian economy is stark. In its Monetary Policy Report, April 2020, The Bank of Canada estimates that real GDP in Canada will be 1% to 7.5% lower in 2020Q1 and lower by 15-30% in 2020Q2 than in 2019Q4. The Monetary Policy Report is available on the Bank of Canada's website at www.bankofcanada.ca.
Individual behaviours
Economic actions, at the level of the person or organization, form the subject matter of microeconomics. Formally, microeconomics is the study of individual behaviour in the context of scarcity. Not all individual behaviours are motivated by self-interest; many are motivated by a concern for the well being of society-at-large. Philanthropic societies are goal-oriented and seek to attain their objectives in an efficient manner.
Microeconomics: the study of individual behaviour in the context of scarcity.
Individual economic decisions need not be world-changing events, or motivated by a search for profit. Microeconomics is also about how we choose to spend our time and money. There are quite a few options to choose from: Sleep, work, study, food, shelter, transportation, entertainment, recreation and so forth. Because both time and income are limited we cannot do all things all the time. Many choices are routine or are driven by necessity. You have to eat and you need a place to live. If you have a job you have committed some of your time to work, or if you are a student some of your time is committed to lectures and study. There is more flexibility in other choices. Critically, microeconomics seeks to understand and explain how we make choices and how those choices affect our behaviour in the workplace, the marketplace, and society more generally.
A critical element in making choices is that there exists a scarcity of time, or income or productive resources. Decisions are invariably subject to limits or constraints, and it is these constraints that make decisions both challenging and scientific.
Microeconomics also concerns business choices. How does a business use its funds and management skill to produce goods and services? The individual business operator or firm has to decide what to produce, how to produce it, how to sell it and in many cases, how to price it. To make and sell pizza, for example, the pizza parlour needs, in addition to a source of pizza ingredients, a store location (land), a pizza oven (capital), a cook and a sales person (labour). Payments for the use of these inputs generate income to those supplying them. If revenue from the sale of pizzas is greater than the costs of production, the business earns a profit for the owner. A business fails if it cannot cover its costs.
In these micro-level behaviours the decision makers have a common goal: To do as well as they can, given the constraints imposed by the operating environment. The individual wants to mix work and leisure in a way that makes her as happy or contented as possible. The entrepreneur aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such maximizing behaviour is a central theme in this book and in economics at large.
Markets and government
Markets play a key role in coordinating the choices of individuals with the decisions of business. In modern market economies goods and services are supplied by both business and government. Hence we call them mixed economies. Some products or services are available through the marketplace to those who wish to buy them and have the necessary income—as in cases like coffee and wireless services. Other services are provided to all people through government programs like law enforcement and health care.
Mixed economy: goods and services are supplied both by private suppliers and government.
Markets offer the choice of a wide range of goods and services at various prices. Individuals can use their incomes to decide the pattern of expenditures and the bundle of goods and services they prefer. Businesses sell goods and services in the expectation that the market price will cover costs and yield a profit.
The market also allows for specialization and separation between production and use. Rather than each individual growing her own food, for example, she can sell her time or labour to employers in return for income. That income can then support her desired purchases. If businesses can produce food more cheaply than individuals the individual obviously gains from using the market – by both having the food to consume, and additional income with which to buy other goods and services. Economics seeks to explain how markets and specialization might yield such gains for individuals and society.
We will represent individuals and firms by envisaging that they have explicit objectives – to maximize their happiness or profit. However, this does not imply that individuals and firms are concerned only with such objectives. On the contrary, much of microeconomics and macroeconomics focuses upon the role of government: How it manages the economy through fiscal and monetary policy, how it redistributes through the tax-transfer system, how it supplies information to buyers and sets safety standards for products.
Since governments perform all of these society-enhancing functions, in large measure governments reflect the social ethos of voters. So, while these voters may be maximizing at the individual level in their everyday lives, and our models of human behaviour in microeconomics certainly emphasize this optimization, economics does not see individuals and corporations as being devoid of civic virtue or compassion, nor does it assume that only market-based activity is important. Governments play a central role in modern economies, to the point where they account for more than one third of all economic activity in the modern mixed economy.
Governments supply goods and services in many spheres, for example, health and education. The provision of public education is motivated both by a concern for equality and a realization that an educated labour force increases the productivity of an economy. Likewise, the provision of law and order, through our legal system broadly defined, represents more than a commitment to a just society at the individual level; without a legal system that enforces contracts and respects property rights, the private sector of the economy would diminish dramatically as a result of corruption, uncertainty and insecurity. It is the lack of such a secure environment in many of the world's economies that inhibits their growth and prosperity.
Let us consider now the methods of economics, methods that are common to science-based disciplines.
1.2 Understanding through the use of models
Most students have seen an image of Ptolemy's concept of our Universe. Planet Earth forms the centre, with the other planets and our sun revolving around it. The ancients' anthropocentric view of the universe necessarily placed their planet at the centre. Despite being false, this view of our world worked reasonably well – in the sense that the ancients could predict celestial motions, lunar patterns and the seasons quite accurately.
More than one Greek astronomer believed that it was more natural for smaller objects such as the earth to revolve around larger objects such as the sun, and they knew that the sun had to be larger as a result of having studied eclipses of the moon and sun. Nonetheless, the Ptolemaic description of the universe persisted until Copernicus wrote his treatise "On the Revolutions of the Celestial Spheres" in the early sixteenth century. And it was another hundred years before the Church accepted that our corner of the universe is heliocentric. During this time evidence accumulated as a result of the work of Brahe, Kepler and Galileo. The time had come for the Ptolemaic model of the universe to be supplanted with a better model.
All disciplines progress and develop and explain themselves using models of reality. A model is a formalization of theory that facilitates scientific inquiry. Any history or philosophy of science book will describe the essential features of a model. First, it is a stripped down, or reduced, version of the phenomenon that is under study. It incorporates the key elements while disregarding what are considered to be secondary elements. Second, it should accord with reality. Third, it should be able to make meaningful predictions. Ptolemy's model of the known universe met these criteria: It was not excessively complicated (for example distant stars were considered as secondary elements in the universe and were excluded); it corresponded to the known reality of the day, and made pretty good predictions. Evidently not all models are correct and this was the case here.
Model: a formalization of theory that facilitates scientific inquiry.
In short, models are frameworks we use to organize how we think about a problem. Economists sometimes interchange the terms theories and models, though they are conceptually distinct. A theory is a logical view of how things work, and is frequently formulated on the basis of observation. A model is a formalization of the essential elements of a theory, and has the characteristics we described above. As an example of an economic model, suppose we theorize that a household's expenditure depends on its key characteristics: A corresponding model might specify that wealth, income, and household size determine its expenditures, while it might ignore other, less important, traits such as the household's neighbourhood or its religious beliefs. The model reduces and simplifies the theory to manageable dimensions. From such a reduced picture of reality we develop an analysis of how an economy and its components work.
Theory: a logical view of how things work, and is frequently formulated on the basis of observation.
An economist uses a model as a tourist uses a map. Any city map misses out some detail—traffic lights and speed bumps, for example. But with careful study you can get a good idea of the best route to take. Economists are not alone in this approach; astronomers, meteorologists, physicists, and genetic scientists operate similarly. Meteorologists disregard weather conditions in South Africa when predicting tomorrow's conditions in Winnipeg. Genetic scientists concentrate on the interactions of limited subsets of genes that they believe are the most important for their purpose. Even with huge computers, all of these scientists build models that concentrate on the essentials.
1.3 Opportunity cost and the market
Individuals face choices at every turn: In deciding to go to the hockey game tonight, you may have to forgo a concert; or you will have to forgo some leisure time this week in order to earn additional income for the hockey game ticket. Indeed, there is no such thing as a free lunch, a free hockey game or a free concert. In economics we say that these limits or constraints reflect opportunity cost. The opportunity cost of a choice is what must be sacrificed when a choice is made. That cost may be financial; it may be measured in time, or simply the alternative foregone.
Opportunity cost: what must be sacrificed when a choice is made.
Opportunity costs play a determining role in markets. It is precisely because individuals and organizations have different opportunity costs that they enter into exchange agreements. If you are a skilled plumber and an unskilled gardener, while your neighbour is a skilled gardener and an unskilled plumber, then you and your neighbour not only have different capabilities, you also have different opportunity costs, and you could gain by trading your skills. Here's why. Fixing a leaking pipe has a low opportunity cost for you in terms of time: You can do it quickly. But pruning your apple trees will be costly because you must first learn how to avoid killing them and this may require many hours. Your neighbour has exactly the same problem, with the tasks in reverse positions. In a sensible world you would fix your own pipes and your neighbour's pipes, and she would ensure the health of the apple trees in both backyards.
If you reflect upon this 'sensible' solution—one that involves each of you achieving your objectives while minimizing the time input—you will quickly realize that it resembles the solution provided by the marketplace. You may not have a gardener as a neighbour, so you buy the services of a gardener in the marketplace. Likewise, your immediate neighbour may not need a leaking pipe repaired, but many others in your neighbourhood do, so you sell your service to them. You each specialize in the performance of specific tasks as a result of having different opportunity costs or different efficiencies. Let us now develop a model of exchange to illustrate the advantages of specialization and trade, and hence the markets that facilitate these activities. This model is developed with the help of some two-dimensional graphics.
1.4 A model of exchange and specialization
Production and specialization
We have two producers and two goods: Amanda and Zoe produce vegetables (V) and or fish (F). Their production capabilities are defined in Table 1.1 and in Figure 1.1, where the quantity of V appears on the vertical axis and the quantity of F on the horizontal axis. Zoe and Amanda each have 36-hour weeks and they devote that time to producing the two goods. But their efficiencies differ: Amanda requires two hours to produce a unit of V and three hours for a unit of F. As a consequence, if she devotes all of her time to V she can produce 18 units, or if she devotes all of her time to F she can produce 12 units. Or, she could share her time between the two. This environment can also be illustrated and analyzed graphically, as in Figure 1.1.
Table 1.1 Production possibilities in a two-person economy
Hours/ Hours/ Fish Vegetable
fish vegetable specialization specialization
Amanda 3 2 12 18
Zoe 2 4 18 9
Each producer has a time allocation of 36 hours. By allocating total time to one activity, Amanda can produce 12F or 18V, Zoe can produce 18F or 9V. By splitting their time each person can also produce a combination of the two.
Two-dimensional graphics are a means of portraying the operation of a model, as defined above. We will use these graphical representations throughout the text. In this case, Amanda's production capability is represented by the line that meets the vertical axis at 18 and the horizontal axis at 12. The vertical point indicates that she can produce 18 units of V if she produces zero units of F – keep in mind that where V has a value of 18, Amanda has no time left for fish production. Likewise, if she devotes all of her time to fish she can produce 12 units, since each unit requires 3 of her 36 hours. The point F=12 is thus another possibility for her. In addition to these two possibilities, which we can term 'specialization', she could allocate her time to producing some of each good. For example, by dividing her 36 hours equally she could produce 6 units of F and 9 units of V. A little computation will quickly convince us that different allocations of her time will lead to combinations of the two goods that lie along a straight line joining the specialization points.
Figure 1.1 Absolute advantage – production
Amanda's PPF indicates that she can produce either 18V (and zero F), or 12F (and zero V), or some combination. Zoe's PPF indicates she can produce either 9V (and zero F), or 18F (and zero V), or some combination. Amanda is more efficient in producing V and Zoe is more efficient at producing F.
We will call this straight line Amanda's production possibility frontier (PPF): It is the combination of goods she can produce while using all of her resources – time. She could not produce combinations of goods represented by points beyond this line (to the top right). She could indeed produce combinations below it (lower left) – for example, a combination of 4 units of V and 4 units of F; but such points would not require all of her time. The (4,4) combination would require just 20 hours. In sum, points beyond this line are not feasible, and points within it do not require all of her time resources.
Production possibility frontier (PPF): the combination of goods that can be produced using all of the resources available.
Having developed Amanda's PPF, it is straightforward to develop a corresponding set of possibilities for Zoe. If she requires 4 hours to produce a unit of V and 2 hours to produce a unit of F, then her 36 hours will enable her to specialize in 9 units of V or 18 units of F; or she could produce a combination represented by the straight line that joins these two specialty extremes.
Consider now the opportunity costs for each person. Suppose Amanda is currently producing 18 V and zero F, and considers producing some F and less V. For each unit of F she wishes to produce, it is evident from her PPF that she must sacrifice 1.5 units of V. This is because F requires 50% more hours than V. Her trade-off is 1.5:1.0. The additional time requirement is also expressed in the intercept values: She could give up 18 units of V and produce 12 units of F instead; this again is a ratio of 1.5:1.0. This ratio defines her opportunity cost: The cost of an additional unit of F is that 1.5 units of V must be 'sacrificed'.
Applying the same reasoning to Zoe's PPF, her opportunity cost is 0.5:1; she must sacrifice one half of a unit of V to free up enough time to produce one unit of F.
So we have established two things about Amanda and Zoe's production possibilities. First, if Amanda specializes in V she can produce more than Zoe, just as Zoe can produce more than Amanda if Zoe specializes in F. Second, their opportunity costs are different: Amanda must sacrifice more V than Zoe in producing one more unit of F. The different opportunity costs translate into potential gains for each individual.
The gains from exchange
We shall illustrate the gains that arise from specialization and exchange graphically. Note first that if these individuals are self-sufficient, in the sense that they consume their own production, each individual's consumption combination will lie on their own PPF. For example, Amanda could allocate half of her time to each good, and produce (and consume) 6F and 9V. Such a point necessarily lies on her PPF. Likewise for Zoe. So, in the absence of exchange, each individual's PPF is also her consumption possibility frontier (CPF). In Figure 1.1 the PPF for each individual is thus also her CPF.
Consumption possibility frontier (CPF): the combination of goods that can be consumed as a result of a given production choice.
Figure 1.2 Absolute advantage – consumption
With specialization and trade at a rate of 1:1 they consume along the line joining the specialization points. If Amanda trades 8V to Zoe in return for 8F, Amanda moves to the point A(8,10) and Zoe to Z(10,8). Each can consume more after specialization than before specialization.
Upon realizing that they are not equally efficient in producing the two goods, they decide to specialize completely in producing just the single good where they are most efficient. Amanda specializes in V and Zoe in F. Next they must agree to a rate at which to exchange V for F. Since Amanda's opportunity cost is 1.5:1 and Zoe's is 0.5:1, suppose they agree to exchange V for F at an intermediate rate of 1:1. There are many trading, or exchange, rates possible; our purpose is to illustrate that gains are possible for both individuals at some exchange rate. The choice of this rate also makes the graphic as simple as possible. At this exchange rate, 18V must exchange for 18F. In Figure 1.2, this means that each individual is now able to consume along the line joining the coordinates (0,18) and (18,0).1 This is because Amanda produces 18V and she can trade at a rate of 1:1, while Zoe produces 18F and trades at the same rate of 1:1.
The fundamental result illustrated in Figure 1.2 is that, as a result of specialization and trade, each individual can consume combinations of goods that lie on a line beyond her initial consumption possibilities. Their consumption well-being has thus improved. For example, suppose Amanda trades away 8V to Zoe and obtains 8F in return. The points 'A' and 'Z' with coordinates (8,10) and (10,8) respectively define their final consumption. Pre-specialization, if Amanda wished to consume 8F she would have been constrained to consume 6V rather than the 10V now possible. Zoe benefits correspondingly.2
The foregoing example illustrates that trade is not a zero-sum game; it has a positive net value because both parties to the trade can gain. A zero-sum gain is where the gains to one party exactly offset the losses to another. This is an extraordinarily important principle in trade negotiations, whether international or domestic.
A zero-sum game is an interaction where the gain to one party equals the loss to another party.
Market design
In the preceding example we have shown that specialization provides scope for gains that can accrue to those participating in the exchange. But this tells us little about how a market for these products comes into being: how does the exchange take place, and how is information transmitted? The answer is that while some markets have evolved historically to their current state, many markets are designed by an institution or a firm. Fruit and vegetable markets have been with us for thousands of years - since we ceased being purely a hunter-gatherer society. They exist in every community in the world economy. In contrast, the Dutch tulip auction was designed in the early 1600s and exists in basically the same form to this day: the auctioneer begins with a high price, lowers it at known time intervals (measured in seconds or minutes) until some buyer signals that she is willing to purchase the lot on offer. Supermarkets in contrast offer goods at a fixed price. Government contracts are normally signed after a tendering process, in which interested suppliers submit bids. Amazon Inc. is currently experimenting with cashierless 'bricks and mortar' stores that monitor all transactions electronically. Craig's List and E-Bay have their own sets of rules.
In each of these cases markets are designed, frequently with a specific objective on the part of the supplier or the mediating institution: Amazon wants to increase its share of all goods trades; governments wish to limit costs. Markets do not all grow spontaneously and the structure of a market will influence how the gains from trade are distributed.
1.5 Economy-wide production possibilities
The PPFs in Figures 1.1 and 1.2 define the amounts of the goods that each individual can produce while using all of their fixed productive capacity—time in this instance. The national, or economy-wide, PPF for this two-person economy reflects these individual possibilities combined. Such a frontier can be constructed using the individual frontiers as the component blocks.
First let us define this economy-wide frontier precisely. The economy-wide PPF is the set of goods and services combinations that can be produced in the economy when all available productive resources are in use. Figure 1.3 contains both of the individual frontiers plus the aggregate of these, represented by the kinked line ace. The point on the V axis, a=27, represents the total amount of V that could be produced if both individuals devoted all of their time to it. The point e=30 on the horizontal axis is the corresponding total for fish.
Figure 1.3 Economy-wide PPF
From a, to produce Fish it is more efficient to use Zoe because her opportunity cost is less (segment ac). When Zoe is completely specialized, Amanda produces (ce). With complete specialization this economy can produce 27V or 30F.
Economy-wide PPF: the set of goods and services combinations that can be produced in the economy when all available productive resources are in use.
To understand the point c, imagine initially that all resources are devoted to V. From such a point, a, consider a reduction in V and an increase in F. The most efficient way of increasing F production at the point a is to use the individual whose opportunity cost is lower. Zoe can produce one unit of F by sacrificing just 0.5 units of V, whereas Amanda must sacrifice 1.5 units of V to produce 1 unit of F. Hence, at this stage Amanda should stick to V and Zoe should devote some time to fish. In fact as long as we want to produce more fish Zoe should be the one to do it, until she has exhausted her time resource. This occurs after she has produced 18F and has ceased producing V. At this point the economy will be producing 18V and 18F – the point c.
From this combination, if the economy wishes to produce more fish Amanda must become involved. Since her opportunity cost is 1.5 units of V for each unit of F, the next segment of the economy-wide PPF must see a reduction of 1.5 units of V for each additional unit of F. This is reflected in the segment ce. When both producers allocate all of their time to F the economy can produce 30 units. Hence the economy's PPF is the two-segment line ace. Since this has an outward kink, we call it concave (rather than convex).
As a final step consider what this PPF would resemble if the economy were composed of many persons with differing efficiencies. A little imagination suggests (correctly) that it will have a segment for each individual and continue to have its outward concave form. Hence, a four-person economy in which each person had a different opportunity cost could be represented by the segmented line abcde, in Figure 1.4. Furthermore, we could represent the PPF of an economy with a very large number of such individuals by a somewhat smooth PPF that accompanies the 4-person PPF. The logic for its shape continues to be the same: As we produce less V and more F we progressively bring into play resources, or individuals, whose opportunity cost, in terms of reduced V is higher.
Figure 1.4 A multi-person PPF
The PPF for the whole economy, abcde, is obtained by allocating productive resources most efficiently. With many individuals we can think of the PPF as the concave envelope of the individual capabilities.
The outputs V and F in our economic model require just one input – time, but if other productive resources were required the result would be still a concave PPF. Furthermore, we generally interpret the PPF to define the output possibilities when the economy is running at its normal capacity. In this example, we consider a work week of 36 hours to be the 'norm'. Yet it is still possible that the economy's producers might work some additional time in exceptional circumstances, and this would increase total production possibilities. This event would be represented by an outward movement of the PPF.
1.6 Aggregate output, growth and business cycles
The PPF can be used to illustrate several aspects of macroeconomics: In particular, the level of an economy's output, the growth of national and per capita output over time, and short-run business-cycle fluctuations in national output and employment.
Aggregate output
An economy's capacity to produce goods and services depends on its endowment of resources and the productivity of those resources. The two-person, two-product examples in the previous section reflect this.
The productivity of labour, defined as output per worker or per hour, depends on:
• The skill, knowledge and experience of the labour force;
• The capital stock: Buildings, machinery, equipment, and software the labour force has to work with; and
• The current state of technology.
The productivity of labour is the output of goods and services per worker.
An economy's capital stock is the buildings, machinery, equipment and software used in producing goods and services.
The economy's output, which we define by Y, can be defined as the output per worker times the number of workers; hence, we can write:
When the employment of labour corresponds to 'full employment' in the sense that everyone willing to work at current wage rates and normal hours of work is working, the economy's actual output is also its capacity output Yc. We also term this capacity output as full employment output:
Full employment output .
Suppose the economy is operating with full employment of resources producing outputs of two types: Goods and services. In Figure 1.5, shows the different combinations of goods and services the economy can produce in a particular year using all its labour, capital and the best technology available at the time.
Figure 1.5 Growth and the PPF
Economic growth is illustrated by an outward shift in the PPF from PPF0 to PPF1. PPF1 shows the economy can produce more in both sectors than with PPF0.
An aggregate economy produces a large variety of outputs in two broad categories. Goods are the products of the agriculture, forestry, mining, manufacturing and construction industries. Services are provided by the wholesale and retail trade, transportation, hospitality, finance, health care, education, legal and other service sectors. As in the two-product examples used earlier, the shape of the PPF illustrates the opportunity cost of increasing the output of either product type. We are not concerned with who supplies the products for the moment: It may be the private sector or the government.
Point X0 on PPF0 shows one possible structure of capacity output. This combination may reflect the pattern of demand and hence expenditures in this economy. Output structures and therefore the shapes of PPFs differ among economies with different income levels. High-income economies spend more on services than goods and produce higher ratios of services to goods. Middle income countries produce lower ratios of services to goods, and low income countries much lower ratios of services to goods. For example, in 2017, the structure of national output in Canada was 70 percent services and 30 percent goods, while in Mexico the structure was 48 percent services and 52 percent goods.
Different countries also have different PPFs and different output structures, depending on their resource endowments, labour forces, capital stocks, technology and expenditure patterns.
Economic growth
Three things contribute to growth in the economy. The labour supply grows as the population expands; the stock of capital grows as spending by business (and government) on buildings, machinery, information technology and so forth increases; and labour-force productivity grows as a result of experience, the development of scientific knowledge combined with product and process innovations, and advances in the technology of production. Combined, these developments expand capacity output over time. In Figure 1.5 economic growth shifts the PPF out from to .
This basic description covers the key sources of growth in total output. Economies differ in their rates of overall economic growth as a result of different rates of growth in labour force, in capital stock, and improvements in technology. But improvements in standards of living require more than growth in total output. Increases in output per worker and per person are necessary. Sustained increases in living standards require sustained growth in labour productivity, which in turn is based on advances in the technology along with the amount of capital each worker has to work with. Furthermore, if the growth in output is to benefit society at large, workers across the board need to see an increase in their earnings. As we shall explore in Chapter 13, several developed countries have seen the fruits of growth concentrated in the hands of the highest income earners.
Recessions and booms
A prime objective of economic policy is to ensure that the economy operates on or near the PPF – it should use its resources to capacity and have minimal unemployment. However, economic conditions are seldom tranquil for long periods of time. Unpredictable changes in business expectations of future profits, in consumer confidence, in financial markets, in commodity and energy prices, in trade agreements and disputes, in economic conditions in major trading partners, in government policy and many other events disrupt patterns of expenditure and output. Some of these changes disturb the level of total expenditure and thus the demand for total output. Others disturb the conditions of production and thus the economy's production capacity. Whatever the exact cause, the economy may be pushed off its current PPF. If expenditures on goods and services decline, the economy may experience a recession. Output would fall short of capacity output and unemployment would rise. Alternatively, times of rapidly growing expenditure and output may result in an economic boom: Output and employment expand beyond capacity levels.
An economic recession occurs when output falls below the economy's capacity output.
A boom is a period of high growth that raises output above normal capacity output.
Recent history provides examples. Following the financial crisis of 2008-09 that hit the US and many other developed economies, many economies were pushed into recessions. Expenditure on new residential construction collapsed for lack of income and secure financing, as did business investment, consumption spending and exports. Lower expenditures reduced producers' revenues, forcing cuts in output and employment and reducing household incomes. Lower incomes led to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent, employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to 8.3 percent by 2010. The world's economies have been slow to recover, and even by 2019 the output in several developed economies was no higher than it was in 2008. Canada's recession was not nearly as severe as the recessions in economies such as Spain, Italy and Greece; but output between 2009 and 2019 has been below the potential of the Canadian economy. In the third quarter of 2019 the national output was about 0.7 percent below potential output and the unemployment rate was 5.5 percent.
Figure 1.6 Booms and recessions
Economic recessions leave the economy below its normal capacity; the economy might be driven to a point such as Z. Economic expansions, or booms, may drive capacity above its normal level, to a point such as W.
An economy in a recession is operating inside its PPF. The fall in output from X to Z in Figure 1.6 illustrates the effect of a recession. Expenditures on goods and services have declined. Output is less than capacity output, unemployment is up and some plant capacity is idle. Labour income and business profits are lower. More people would like to work and business would like to produce and sell more output, but it takes time for interdependent product, labour and financial markets in the economy to adjust and increase employment and output. Monetary and fiscal policy may be productive in specific circumstances, to stimulate demand, increase output and employment and move the economy back to capacity output and full employment. The development and implementation of such policies form the core of macroeconomics.
Alternatively, an unexpected increase in demand for exports would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process spread the effects of higher output sales to other sectors of the economy. The economy would move outside its PPF, for example to W in Figure 1.6, by using its resources more intensively than normal. Unemployment would fall and overtime work would increase. Extra production shifts would run plant and equipment for longer hours and work days than were planned when it was designed and installed. Output at this level may not be sustainable, because shortages of labour and materials along with excessive rates of equipment wear and tear would push costs and prices up. Again, we will examine how the economy reacts to such a state in our macroeconomic analysis.
Output and employment in the Canadian economy over the past twenty years fluctuated about growth trend in the way Figure 1.6 illustrates. For several years prior to 2008 the Canadian economy operated slightly above its capacity; but once the recession arrived monetary and fiscal policy were used to fight it – to bring the economy back from a point such as Z towards a point such as X on the PPF.
Macroeconomic models and policy
The PPF diagrams illustrate the main dimensions of macroeconomics: Capacity output, growth in capacity output and business cycle fluctuations in actual output relative to capacity. But these diagrams do not offer explanations and analysis of macroeconomic activity. We need a macroeconomic model to understand and evaluate the causes and consequences of business cycle fluctuations. As we shall see, these models are based on explanations of expenditure decisions by households and business, financial market conditions, production costs and producer pricing decisions at different levels of output. Models also capture the objectives of fiscal and monetary policies and provide a framework for policy evaluation. A full macroeconomic model integrates different sector behaviours and the feedbacks across sectors that can moderate or amplify the effects of changes in one sector on national output and employment.
Conclusion
We have covered a lot of ground in this introductory chapter. It is intended to open up the vista of economics to the new student in the discipline. Economics is powerful and challenging, and the ideas we have developed here will serve as conceptual foundations for our exploration of the subject.
Key Terms
Macroeconomics studies the economy as system in which linkages and feedbacks among sectors determine national output, employment and prices.
Microeconomics is the study of individual behaviour in the context of scarcity.
Mixed economy: goods and services are supplied both by private suppliers and government.
Model is a formalization of theory that facilitates scientific inquiry.
Theory is a logical view of how things work, and is frequently formulated on the basis of observation.
Opportunity cost of a choice is what must be sacrificed when a choice is made.
Production possibility frontier (PPF) defines the combination of goods that can be produced using all of the resources available.
Consumption possibility frontier (CPF): the combination of goods that can be consumed as a result of a given production choice.
A zero-sum game is an interaction where the gain to one party equals the loss to another party.
Economy-wide PPF is the set of goods combinations that can be produced in the economy when all available productive resources are in use.
Productivity of labour is the output of goods and services per worker.
Capital stock: the buildings, machinery, equipment and software used in producing goods and services.
Full employment output . Recession: when output falls below the economy's capacity output. Boom: a period of high growth that raises output above normal capacity output.
Exercises for Chapter 1
EXERCISE 1.1
An economy has 100 identical workers. Each one can produce four cakes or three shirts, regardless of the number of other individuals producing each good.
1. How many cakes can be produced in this economy when all the workers are cooking?
2. How many shirts can be produced in this economy when all the workers are sewing?
3. On a diagram with cakes on the vertical axis, and shirts on the horizontal axis, join these points with a straight line to form the PPF.
4. Label the inefficient and unattainable regions on the diagram.
EXERCISE 1.2
In the table below are listed a series of points that define an economy's production possibility frontier for goods Y and X.
Y 1000 900 800 700 600 500 400 300 200 100 0
X 0 1600 2500 3300 4000 4600 5100 5500 5750 5900 6000
1. Plot these pairs of points to scale, on graph paper, or with the help of a spreadsheet.
2. Given the shape of this PPF is the economy made up of individuals who are similar or different in their production capabilities?
3. What is the opportunity cost of producing 100 more Y at the combination (X=5500,Y=300).
4. Suppose next there is technological change so that at every output level of good Y the economy can produce 20 percent more X. Enter a new row in the table containing the new values, and plot the new PPF.
EXERCISE 1.3
Using the PPF that you have graphed using the data in Exercise 1.2, determine if the following combinations are attainable or not: (X=3000,Y=720), (X=4800,Y=480).
EXERCISE 1.4
You and your partner are highly efficient people. You can earn \$20 per hour in the workplace; your partner can earn \$30 per hour.
1. What is the opportunity cost of one hour of leisure for you?
2. What is the opportunity cost of one hour of leisure for your partner?
3. Now consider what a PPF would look like: You can produce/consume two things, leisure and income. Since income buys things you can think of the PPF as having these two 'products' – leisure and consumption goods/services. So, with leisure on the horizontal axis and income in dollars is on the vertical axis, plot your PPF. You can assume that you have 12 hours per day to allocate to either leisure or income. [Hint: the leisure axis will have an intercept of 12 hours. The income intercept will have a dollar value corresponding to where all hours are devoted to work.]
4. Draw the PPF for your partner.
EXERCISE 1.5
Louis and Carrie Anne are students who have set up a summer business in their neighbourhood. They cut lawns and clean cars. Louis is particularly efficient at cutting the grass – he requires one hour to cut a typical lawn, while Carrie Anne needs one and one half hours. In contrast, Carrie Anne can wash a car in a half hour, while Louis requires three quarters of an hour.
1. If they decide to specialize in the tasks, who should cut the grass and who should wash cars?
2. If they each work a twelve hour day, how many lawns can they cut and how many cars can they wash if they each specialize in performing the task where they are most efficient?
3. Illustrate the PPF for each individual where lawns are on the horizontal axis and car washes on the vertical axis, if each individual has twelve hours in a day.
EXERCISE 1.6
Continuing with the same data set, suppose Carrie Anne's productivity improves so that she can now cut grass as efficiently as Louis; that is, she can cut grass in one hour, and can still wash a car in one half of an hour.
1. In a new diagram draw the PPF for each individual.
2. In this case does specialization matter if they are to be as productive as possible as a team?
3. Draw the PPF for the whole economy, labelling the intercepts and the 'kink' point coordinates.
EXERCISE 1.7
Going back to the simple PPF plotted for Exercise 1.1 where each of 100 workers can produce either four cakes or three shirts, suppose a recession reduces demand for the outputs to 220 cakes and 129 shirts.
1. Plot this combination of outputs in the diagram that also shows the PPF.
2. How many workers are needed to produce this output of cakes and shirts?
3. What percentage of the 100 worker labour force is unemployed?
01: Introduction to key ideas
The big issues
Economics is the study of human behaviour. Since it uses scientific methods it is called a social science. We study human behaviour to better understand and improve our world. During his acceptance speech, a recent Nobel Laureate in Economics suggested:
Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we cannot face the challenges of stagnation, job loss and widening inequality.
Christopher Sims, Nobel Laureate in Economics 2011
This is an elegant definition of economics and serves as a timely caution about the perils of ideology. Economics evolves continuously as current observations and experience provide new evidence about economic behaviour and relationships. Inference and policy recommendations based on earlier theories, observations and institutional structures require constant analysis and updating if they are to furnish valuable responses to changing conditions and problems.
Much of today's developed world still faces severe challenges as a result of the financial crisis that began in 2008. Unemployment rates among young people are at historically high levels in several economies, many government balance sheets are in disarray, and inequality is on the rise. In addition to the challenges posed by this severe economic cycle, the world simultaneously faces structural upheaval: Overpopulation, climate change, political instability and globalization challenge us to understand and modify our behaviour.
These challenges do not imply that our world is deteriorating. Literacy rates have been rising dramatically in the developing world for decades; child mortality has plummeted; family size is a fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; life expectancy is increasing universally and deaths through wars are in a state of long-term decline.
These developments, good and bad, have a universal character and affect billions of individuals. They involve an understanding of economies as large organisms with interactive components.
Aggregate output in a national economy
A national economy is a complete multi-sector system, made up of household, business, financial, government and international sectors. Each of these sectors is an aggregate or sum of a many smaller economic units with very similar characteristics. The government sector, for example aggregates the taxing and spending activities of local, provincial and national governments. Similarly, the household sector is an aggregate of the income, spending and saving of all households but not the specifics of each individual household. Economic activity within any one of these sectors reflects, in part, the conditions and choices made in that sector. But it is also affects and is affected by conditions and actions in the other sectors. These interactions and feedbacks within the system mean that the workings of the macro-economy are more complex than the operation of the sum of its parts.
Macroeconomics: the study of the economy as a system in which interactions and feedbacks among sectors determine national output, employment and prices.
For example, consider a simple economy with just household, business and financial sectors. The household sector earns income by providing labour to the other sectors. Households make choices about spending or saving this income. Businesses make decisions about the sizes of their establishments, their labour forces, and their outputs of goods and services. The financial sector provides banking services: bank deposits, loans, and the payments system used by all three sectors.
Suppose households decide to spend more on goods and services and save less. That decision by itself does not change household sector income, but it does increase business sector sales and revenues. It also reduces the flow of household savings into bank deposits in the financial sector. As a result the business sector has an incentive to increase employment and output and perhaps to borrow from the financial sector to finance that expansion. Increased employment in the business sector increases incomes in the household sector and further increases household expenditure and savings. These inter-sector linkages and feedbacks produce a response in aggregate economy greater than the initial change.
Expanding this simple example to include more sectors increases its complexity but does not change the basics. A change in behaviour within a sector,or disturbance from outside that sector, changes aggregate levels of output, employment and prices. A complete multisector macroeconomic theory and model is required to understand the effects, on the aggregate economy, of changes in either internal or external economic conditions. It is also essential for the design of policies to manage the macroeconomic conditions.
Mitigating the effects of a large random shock from outside the economy, like the COVID-19 pandemic, disrupts all sectors of the economy. Flows of income, expenditure, revenue,and output among sectors are reduced sharply both by the pandemic and by government and financial sectors policy responses.
Application Box 1.1 COVID-19 and the Economy
The COVID-19 pandemic attacked Canada in early 2020. It revealed the complexities and interdependencies that drive the macro economy. Control and elimination of the disease depends on stopping person to person transmission. This is why the government mandated personal and social distancing for individuals plus self-isolation and quarantine in some cases. In addition businesses, mainly in the service sector, that relied on face to face interactions with customers or live audiences were forced to close.
As a result, businesses lost sales revenues and cut output. They reduced employment to cut labour costs, but overhead costs remained. Households lost employment and employment incomes. They reduced their discretionary spending, but their overhead costs continued. As a result the economy faced a unique, simultaneous collapse in overall private supply and demand and the risk of a deep recession. The government and financial sectors intervened with fiscal and monetary policy support. Government introduced a wide range of new income supports for the household sector, and loan and subsidy programs to support businesses, funded by large increases in the government's budget deficit. The central bank lowered interest rates and increased the monetary base to support the government's borrowing requirements, and the credit demands on private banks and other financial institutions. The banking system lost the normal growth in customer deposits, but worked to accommodate the needs of their business and household clients.
This unprecedented support from government fiscal policy and central bank monetary policy will offset part of the loss in national output and income. But it will not reverse it. Recovery will begin with the reopening of business and the growth of employment at some time in the uncertain future. The size of the estimated effect of COVID-19 on the Canadian economy is stark. In its Monetary Policy Report, April 2020, The Bank of Canada estimates that real GDP in Canada will be 1% to 7.5% lower in 2020Q1 and lower by 15-30% in 2020Q2 than in 2019Q4. The Monetary Policy Report is available on the Bank of Canada's website at www.bankofcanada.ca.
Individual behaviours
Economic actions, at the level of the person or organization, form the subject matter of microeconomics. Formally, microeconomics is the study of individual behaviour in the context of scarcity. Not all individual behaviours are motivated by self-interest; many are motivated by a concern for the well being of society-at-large. Philanthropic societies are goal-oriented and seek to attain their objectives in an efficient manner.
Microeconomics: the study of individual behaviour in the context of scarcity.
Individual economic decisions need not be world-changing events, or motivated by a search for profit. Microeconomics is also about how we choose to spend our time and money. There are quite a few options to choose from: Sleep, work, study, food, shelter, transportation, entertainment, recreation and so forth. Because both time and income are limited we cannot do all things all the time. Many choices are routine or are driven by necessity. You have to eat and you need a place to live. If you have a job you have committed some of your time to work, or if you are a student some of your time is committed to lectures and study. There is more flexibility in other choices. Critically, microeconomics seeks to understand and explain how we make choices and how those choices affect our behaviour in the workplace, the marketplace, and society more generally.
A critical element in making choices is that there exists a scarcity of time, or income or productive resources. Decisions are invariably subject to limits or constraints, and it is these constraints that make decisions both challenging and scientific.
Microeconomics also concerns business choices. How does a business use its funds and management skill to produce goods and services? The individual business operator or firm has to decide what to produce, how to produce it, how to sell it and in many cases, how to price it. To make and sell pizza, for example, the pizza parlour needs, in addition to a source of pizza ingredients, a store location (land), a pizza oven (capital), a cook and a sales person (labour). Payments for the use of these inputs generate income to those supplying them. If revenue from the sale of pizzas is greater than the costs of production, the business earns a profit for the owner. A business fails if it cannot cover its costs.
In these micro-level behaviours the decision makers have a common goal: To do as well as they can, given the constraints imposed by the operating environment. The individual wants to mix work and leisure in a way that makes her as happy or contented as possible. The entrepreneur aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such maximizing behaviour is a central theme in this book and in economics at large.
Markets and government
Markets play a key role in coordinating the choices of individuals with the decisions of business. In modern market economies goods and services are supplied by both business and government. Hence we call them mixed economies. Some products or services are available through the marketplace to those who wish to buy them and have the necessary income—as in cases like coffee and wireless services. Other services are provided to all people through government programs like law enforcement and health care.
Mixed economy: goods and services are supplied both by private suppliers and government.
Markets offer the choice of a wide range of goods and services at various prices. Individuals can use their incomes to decide the pattern of expenditures and the bundle of goods and services they prefer. Businesses sell goods and services in the expectation that the market price will cover costs and yield a profit.
The market also allows for specialization and separation between production and use. Rather than each individual growing her own food, for example, she can sell her time or labour to employers in return for income. That income can then support her desired purchases. If businesses can produce food more cheaply than individuals the individual obviously gains from using the market – by both having the food to consume, and additional income with which to buy other goods and services. Economics seeks to explain how markets and specialization might yield such gains for individuals and society.
We will represent individuals and firms by envisaging that they have explicit objectives – to maximize their happiness or profit. However, this does not imply that individuals and firms are concerned only with such objectives. On the contrary, much of microeconomics and macroeconomics focuses upon the role of government: How it manages the economy through fiscal and monetary policy, how it redistributes through the tax-transfer system, how it supplies information to buyers and sets safety standards for products.
Since governments perform all of these society-enhancing functions, in large measure governments reflect the social ethos of voters. So, while these voters may be maximizing at the individual level in their everyday lives, and our models of human behaviour in microeconomics certainly emphasize this optimization, economics does not see individuals and corporations as being devoid of civic virtue or compassion, nor does it assume that only market-based activity is important. Governments play a central role in modern economies, to the point where they account for more than one third of all economic activity in the modern mixed economy.
Governments supply goods and services in many spheres, for example, health and education. The provision of public education is motivated both by a concern for equality and a realization that an educated labour force increases the productivity of an economy. Likewise, the provision of law and order, through our legal system broadly defined, represents more than a commitment to a just society at the individual level; without a legal system that enforces contracts and respects property rights, the private sector of the economy would diminish dramatically as a result of corruption, uncertainty and insecurity. It is the lack of such a secure environment in many of the world's economies that inhibits their growth and prosperity.
Let us consider now the methods of economics, methods that are common to science-based disciplines. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/01%3A_Introduction_to_key_ideas/1.01%3A_What%27s_it_all_about.txt |
The big issues
Economics is the study of human behaviour. Since it uses scientific methods it is called a social science. We study human behaviour to better understand and improve our world. During his acceptance speech, a recent Nobel Laureate in Economics suggested:
Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we cannot face the challenges of stagnation, job loss and widening inequality.
Christopher Sims, Nobel Laureate in Economics 2011
This is an elegant definition of economics and serves as a timely caution about the perils of ideology. Economics evolves continuously as current observations and experience provide new evidence about economic behaviour and relationships. Inference and policy recommendations based on earlier theories, observations and institutional structures require constant analysis and updating if they are to furnish valuable responses to changing conditions and problems.
Much of today's developed world still faces severe challenges as a result of the financial crisis that began in 2008. Unemployment rates among young people are at historically high levels in several economies, many government balance sheets are in disarray, and inequality is on the rise. In addition to the challenges posed by this severe economic cycle, the world simultaneously faces structural upheaval: Overpopulation, climate change, political instability and globalization challenge us to understand and modify our behaviour.
These challenges do not imply that our world is deteriorating. Literacy rates have been rising dramatically in the developing world for decades; child mortality has plummeted; family size is a fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; life expectancy is increasing universally and deaths through wars are in a state of long-term decline.
These developments, good and bad, have a universal character and affect billions of individuals. They involve an understanding of economies as large organisms with interactive components.
Aggregate output in a national economy
A national economy is a complete multi-sector system, made up of household, business, financial, government and international sectors. Each of these sectors is an aggregate or sum of a many smaller economic units with very similar characteristics. The government sector, for example aggregates the taxing and spending activities of local, provincial and national governments. Similarly, the household sector is an aggregate of the income, spending and saving of all households but not the specifics of each individual household. Economic activity within any one of these sectors reflects, in part, the conditions and choices made in that sector. But it is also affects and is affected by conditions and actions in the other sectors. These interactions and feedbacks within the system mean that the workings of the macro-economy are more complex than the operation of the sum of its parts.
Macroeconomics: the study of the economy as a system in which interactions and feedbacks among sectors determine national output, employment and prices.
For example, consider a simple economy with just household, business and financial sectors. The household sector earns income by providing labour to the other sectors. Households make choices about spending or saving this income. Businesses make decisions about the sizes of their establishments, their labour forces, and their outputs of goods and services. The financial sector provides banking services: bank deposits, loans, and the payments system used by all three sectors.
Suppose households decide to spend more on goods and services and save less. That decision by itself does not change household sector income, but it does increase business sector sales and revenues. It also reduces the flow of household savings into bank deposits in the financial sector. As a result the business sector has an incentive to increase employment and output and perhaps to borrow from the financial sector to finance that expansion. Increased employment in the business sector increases incomes in the household sector and further increases household expenditure and savings. These inter-sector linkages and feedbacks produce a response in aggregate economy greater than the initial change.
Expanding this simple example to include more sectors increases its complexity but does not change the basics. A change in behaviour within a sector,or disturbance from outside that sector, changes aggregate levels of output, employment and prices. A complete multisector macroeconomic theory and model is required to understand the effects, on the aggregate economy, of changes in either internal or external economic conditions. It is also essential for the design of policies to manage the macroeconomic conditions.
Mitigating the effects of a large random shock from outside the economy, like the COVID-19 pandemic, disrupts all sectors of the economy. Flows of income, expenditure, revenue,and output among sectors are reduced sharply both by the pandemic and by government and financial sectors policy responses.
Application Box 1.1 COVID-19 and the Economy
The COVID-19 pandemic attacked Canada in early 2020. It revealed the complexities and interdependencies that drive the macro economy. Control and elimination of the disease depends on stopping person to person transmission. This is why the government mandated personal and social distancing for individuals plus self-isolation and quarantine in some cases. In addition businesses, mainly in the service sector, that relied on face to face interactions with customers or live audiences were forced to close.
As a result, businesses lost sales revenues and cut output. They reduced employment to cut labour costs, but overhead costs remained. Households lost employment and employment incomes. They reduced their discretionary spending, but their overhead costs continued. As a result the economy faced a unique, simultaneous collapse in overall private supply and demand and the risk of a deep recession. The government and financial sectors intervened with fiscal and monetary policy support. Government introduced a wide range of new income supports for the household sector, and loan and subsidy programs to support businesses, funded by large increases in the government's budget deficit. The central bank lowered interest rates and increased the monetary base to support the government's borrowing requirements, and the credit demands on private banks and other financial institutions. The banking system lost the normal growth in customer deposits, but worked to accommodate the needs of their business and household clients.
This unprecedented support from government fiscal policy and central bank monetary policy will offset part of the loss in national output and income. But it will not reverse it. Recovery will begin with the reopening of business and the growth of employment at some time in the uncertain future. The size of the estimated effect of COVID-19 on the Canadian economy is stark. In its Monetary Policy Report, April 2020, The Bank of Canada estimates that real GDP in Canada will be 1% to 7.5% lower in 2020Q1 and lower by 15-30% in 2020Q2 than in 2019Q4. The Monetary Policy Report is available on the Bank of Canada's website at www.bankofcanada.ca.
Individual behaviours
Economic actions, at the level of the person or organization, form the subject matter of microeconomics. Formally, microeconomics is the study of individual behaviour in the context of scarcity. Not all individual behaviours are motivated by self-interest; many are motivated by a concern for the well being of society-at-large. Philanthropic societies are goal-oriented and seek to attain their objectives in an efficient manner.
Microeconomics: the study of individual behaviour in the context of scarcity.
Individual economic decisions need not be world-changing events, or motivated by a search for profit. Microeconomics is also about how we choose to spend our time and money. There are quite a few options to choose from: Sleep, work, study, food, shelter, transportation, entertainment, recreation and so forth. Because both time and income are limited we cannot do all things all the time. Many choices are routine or are driven by necessity. You have to eat and you need a place to live. If you have a job you have committed some of your time to work, or if you are a student some of your time is committed to lectures and study. There is more flexibility in other choices. Critically, microeconomics seeks to understand and explain how we make choices and how those choices affect our behaviour in the workplace, the marketplace, and society more generally.
A critical element in making choices is that there exists a scarcity of time, or income or productive resources. Decisions are invariably subject to limits or constraints, and it is these constraints that make decisions both challenging and scientific.
Microeconomics also concerns business choices. How does a business use its funds and management skill to produce goods and services? The individual business operator or firm has to decide what to produce, how to produce it, how to sell it and in many cases, how to price it. To make and sell pizza, for example, the pizza parlour needs, in addition to a source of pizza ingredients, a store location (land), a pizza oven (capital), a cook and a sales person (labour). Payments for the use of these inputs generate income to those supplying them. If revenue from the sale of pizzas is greater than the costs of production, the business earns a profit for the owner. A business fails if it cannot cover its costs.
In these micro-level behaviours the decision makers have a common goal: To do as well as they can, given the constraints imposed by the operating environment. The individual wants to mix work and leisure in a way that makes her as happy or contented as possible. The entrepreneur aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such maximizing behaviour is a central theme in this book and in economics at large.
Markets and government
Markets play a key role in coordinating the choices of individuals with the decisions of business. In modern market economies goods and services are supplied by both business and government. Hence we call them mixed economies. Some products or services are available through the marketplace to those who wish to buy them and have the necessary income—as in cases like coffee and wireless services. Other services are provided to all people through government programs like law enforcement and health care.
Mixed economy: goods and services are supplied both by private suppliers and government.
Markets offer the choice of a wide range of goods and services at various prices. Individuals can use their incomes to decide the pattern of expenditures and the bundle of goods and services they prefer. Businesses sell goods and services in the expectation that the market price will cover costs and yield a profit.
The market also allows for specialization and separation between production and use. Rather than each individual growing her own food, for example, she can sell her time or labour to employers in return for income. That income can then support her desired purchases. If businesses can produce food more cheaply than individuals the individual obviously gains from using the market – by both having the food to consume, and additional income with which to buy other goods and services. Economics seeks to explain how markets and specialization might yield such gains for individuals and society.
We will represent individuals and firms by envisaging that they have explicit objectives – to maximize their happiness or profit. However, this does not imply that individuals and firms are concerned only with such objectives. On the contrary, much of microeconomics and macroeconomics focuses upon the role of government: How it manages the economy through fiscal and monetary policy, how it redistributes through the tax-transfer system, how it supplies information to buyers and sets safety standards for products.
Since governments perform all of these society-enhancing functions, in large measure governments reflect the social ethos of voters. So, while these voters may be maximizing at the individual level in their everyday lives, and our models of human behaviour in microeconomics certainly emphasize this optimization, economics does not see individuals and corporations as being devoid of civic virtue or compassion, nor does it assume that only market-based activity is important. Governments play a central role in modern economies, to the point where they account for more than one third of all economic activity in the modern mixed economy.
Governments supply goods and services in many spheres, for example, health and education. The provision of public education is motivated both by a concern for equality and a realization that an educated labour force increases the productivity of an economy. Likewise, the provision of law and order, through our legal system broadly defined, represents more than a commitment to a just society at the individual level; without a legal system that enforces contracts and respects property rights, the private sector of the economy would diminish dramatically as a result of corruption, uncertainty and insecurity. It is the lack of such a secure environment in many of the world's economies that inhibits their growth and prosperity.
Let us consider now the methods of economics, methods that are common to science-based disciplines. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/01%3A_Introduction_to_key_ideas/1.01%3A_What's_it_all_about.txt |
Most students have seen an image of Ptolemy's concept of our Universe. Planet Earth forms the centre, with the other planets and our sun revolving around it. The ancients' anthropocentric view of the universe necessarily placed their planet at the centre. Despite being false, this view of our world worked reasonably well – in the sense that the ancients could predict celestial motions, lunar patterns and the seasons quite accurately.
More than one Greek astronomer believed that it was more natural for smaller objects such as the earth to revolve around larger objects such as the sun, and they knew that the sun had to be larger as a result of having studied eclipses of the moon and sun. Nonetheless, the Ptolemaic description of the universe persisted until Copernicus wrote his treatise "On the Revolutions of the Celestial Spheres" in the early sixteenth century. And it was another hundred years before the Church accepted that our corner of the universe is heliocentric. During this time evidence accumulated as a result of the work of Brahe, Kepler and Galileo. The time had come for the Ptolemaic model of the universe to be supplanted with a better model.
All disciplines progress and develop and explain themselves using models of reality. A model is a formalization of theory that facilitates scientific inquiry. Any history or philosophy of science book will describe the essential features of a model. First, it is a stripped down, or reduced, version of the phenomenon that is under study. It incorporates the key elements while disregarding what are considered to be secondary elements. Second, it should accord with reality. Third, it should be able to make meaningful predictions. Ptolemy's model of the known universe met these criteria: It was not excessively complicated (for example distant stars were considered as secondary elements in the universe and were excluded); it corresponded to the known reality of the day, and made pretty good predictions. Evidently not all models are correct and this was the case here.
Model: a formalization of theory that facilitates scientific inquiry.
In short, models are frameworks we use to organize how we think about a problem. Economists sometimes interchange the terms theories and models, though they are conceptually distinct. A theory is a logical view of how things work, and is frequently formulated on the basis of observation. A model is a formalization of the essential elements of a theory, and has the characteristics we described above. As an example of an economic model, suppose we theorize that a household's expenditure depends on its key characteristics: A corresponding model might specify that wealth, income, and household size determine its expenditures, while it might ignore other, less important, traits such as the household's neighbourhood or its religious beliefs. The model reduces and simplifies the theory to manageable dimensions. From such a reduced picture of reality we develop an analysis of how an economy and its components work.
Theory: a logical view of how things work, and is frequently formulated on the basis of observation.
An economist uses a model as a tourist uses a map. Any city map misses out some detail—traffic lights and speed bumps, for example. But with careful study you can get a good idea of the best route to take. Economists are not alone in this approach; astronomers, meteorologists, physicists, and genetic scientists operate similarly. Meteorologists disregard weather conditions in South Africa when predicting tomorrow's conditions in Winnipeg. Genetic scientists concentrate on the interactions of limited subsets of genes that they believe are the most important for their purpose. Even with huge computers, all of these scientists build models that concentrate on the essentials.
1.03: Opportunity cost and the market
Individuals face choices at every turn: In deciding to go to the hockey game tonight, you may have to forgo a concert; or you will have to forgo some leisure time this week in order to earn additional income for the hockey game ticket. Indeed, there is no such thing as a free lunch, a free hockey game or a free concert. In economics we say that these limits or constraints reflect opportunity cost. The opportunity cost of a choice is what must be sacrificed when a choice is made. That cost may be financial; it may be measured in time, or simply the alternative foregone.
Opportunity cost: what must be sacrificed when a choice is made.
Opportunity costs play a determining role in markets. It is precisely because individuals and organizations have different opportunity costs that they enter into exchange agreements. If you are a skilled plumber and an unskilled gardener, while your neighbour is a skilled gardener and an unskilled plumber, then you and your neighbour not only have different capabilities, you also have different opportunity costs, and you could gain by trading your skills. Here's why. Fixing a leaking pipe has a low opportunity cost for you in terms of time: You can do it quickly. But pruning your apple trees will be costly because you must first learn how to avoid killing them and this may require many hours. Your neighbour has exactly the same problem, with the tasks in reverse positions. In a sensible world you would fix your own pipes and your neighbour's pipes, and she would ensure the health of the apple trees in both backyards.
If you reflect upon this 'sensible' solution—one that involves each of you achieving your objectives while minimizing the time input—you will quickly realize that it resembles the solution provided by the marketplace. You may not have a gardener as a neighbour, so you buy the services of a gardener in the marketplace. Likewise, your immediate neighbour may not need a leaking pipe repaired, but many others in your neighbourhood do, so you sell your service to them. You each specialize in the performance of specific tasks as a result of having different opportunity costs or different efficiencies. Let us now develop a model of exchange to illustrate the advantages of specialization and trade, and hence the markets that facilitate these activities. This model is developed with the help of some two-dimensional graphics. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/01%3A_Introduction_to_key_ideas/1.02%3A_Understanding_through_the_use_of_models.txt |
Production and specialization
We have two producers and two goods: Amanda and Zoe produce vegetables (V) and or fish (F). Their production capabilities are defined in Table 1.1 and in Figure 1.1, where the quantity of V appears on the vertical axis and the quantity of F on the horizontal axis. Zoe and Amanda each have 36-hour weeks and they devote that time to producing the two goods. But their efficiencies differ: Amanda requires two hours to produce a unit of V and three hours for a unit of F. As a consequence, if she devotes all of her time to V she can produce 18 units, or if she devotes all of her time to F she can produce 12 units. Or, she could share her time between the two. This environment can also be illustrated and analyzed graphically, as in Figure 1.1.
Table 1.1 Production possibilities in a two-person economy
Hours/ Hours/ Fish Vegetable
fish vegetable specialization specialization
Amanda 3 2 12 18
Zoe 2 4 18 9
Each producer has a time allocation of 36 hours. By allocating total time to one activity, Amanda can produce 12F or 18V, Zoe can produce 18F or 9V. By splitting their time each person can also produce a combination of the two.
Two-dimensional graphics are a means of portraying the operation of a model, as defined above. We will use these graphical representations throughout the text. In this case, Amanda's production capability is represented by the line that meets the vertical axis at 18 and the horizontal axis at 12. The vertical point indicates that she can produce 18 units of V if she produces zero units of F – keep in mind that where V has a value of 18, Amanda has no time left for fish production. Likewise, if she devotes all of her time to fish she can produce 12 units, since each unit requires 3 of her 36 hours. The point F=12 is thus another possibility for her. In addition to these two possibilities, which we can term 'specialization', she could allocate her time to producing some of each good. For example, by dividing her 36 hours equally she could produce 6 units of F and 9 units of V. A little computation will quickly convince us that different allocations of her time will lead to combinations of the two goods that lie along a straight line joining the specialization points.
Figure 1.1 Absolute advantage – production
Amanda's PPF indicates that she can produce either 18V (and zero F), or 12F (and zero V), or some combination. Zoe's PPF indicates she can produce either 9V (and zero F), or 18F (and zero V), or some combination. Amanda is more efficient in producing V and Zoe is more efficient at producing F.
We will call this straight line Amanda's production possibility frontier (PPF): It is the combination of goods she can produce while using all of her resources – time. She could not produce combinations of goods represented by points beyond this line (to the top right). She could indeed produce combinations below it (lower left) – for example, a combination of 4 units of V and 4 units of F; but such points would not require all of her time. The (4,4) combination would require just 20 hours. In sum, points beyond this line are not feasible, and points within it do not require all of her time resources.
Production possibility frontier (PPF): the combination of goods that can be produced using all of the resources available.
Having developed Amanda's PPF, it is straightforward to develop a corresponding set of possibilities for Zoe. If she requires 4 hours to produce a unit of V and 2 hours to produce a unit of F, then her 36 hours will enable her to specialize in 9 units of V or 18 units of F; or she could produce a combination represented by the straight line that joins these two specialty extremes.
Consider now the opportunity costs for each person. Suppose Amanda is currently producing 18 V and zero F, and considers producing some F and less V. For each unit of F she wishes to produce, it is evident from her PPF that she must sacrifice 1.5 units of V. This is because F requires 50% more hours than V. Her trade-off is 1.5:1.0. The additional time requirement is also expressed in the intercept values: She could give up 18 units of V and produce 12 units of F instead; this again is a ratio of 1.5:1.0. This ratio defines her opportunity cost: The cost of an additional unit of F is that 1.5 units of V must be 'sacrificed'.
Applying the same reasoning to Zoe's PPF, her opportunity cost is 0.5:1; she must sacrifice one half of a unit of V to free up enough time to produce one unit of F.
So we have established two things about Amanda and Zoe's production possibilities. First, if Amanda specializes in V she can produce more than Zoe, just as Zoe can produce more than Amanda if Zoe specializes in F. Second, their opportunity costs are different: Amanda must sacrifice more V than Zoe in producing one more unit of F. The different opportunity costs translate into potential gains for each individual.
The gains from exchange
We shall illustrate the gains that arise from specialization and exchange graphically. Note first that if these individuals are self-sufficient, in the sense that they consume their own production, each individual's consumption combination will lie on their own PPF. For example, Amanda could allocate half of her time to each good, and produce (and consume) 6F and 9V. Such a point necessarily lies on her PPF. Likewise for Zoe. So, in the absence of exchange, each individual's PPF is also her consumption possibility frontier (CPF). In Figure 1.1 the PPF for each individual is thus also her CPF.
Consumption possibility frontier (CPF): the combination of goods that can be consumed as a result of a given production choice.
Figure 1.2 Absolute advantage – consumption
With specialization and trade at a rate of 1:1 they consume along the line joining the specialization points. If Amanda trades 8V to Zoe in return for 8F, Amanda moves to the point A(8,10) and Zoe to Z(10,8). Each can consume more after specialization than before specialization.
Upon realizing that they are not equally efficient in producing the two goods, they decide to specialize completely in producing just the single good where they are most efficient. Amanda specializes in V and Zoe in F. Next they must agree to a rate at which to exchange V for F. Since Amanda's opportunity cost is 1.5:1 and Zoe's is 0.5:1, suppose they agree to exchange V for F at an intermediate rate of 1:1. There are many trading, or exchange, rates possible; our purpose is to illustrate that gains are possible for both individuals at some exchange rate. The choice of this rate also makes the graphic as simple as possible. At this exchange rate, 18V must exchange for 18F. In Figure 1.2, this means that each individual is now able to consume along the line joining the coordinates (0,18) and (18,0).1 This is because Amanda produces 18V and she can trade at a rate of 1:1, while Zoe produces 18F and trades at the same rate of 1:1.
The fundamental result illustrated in Figure 1.2 is that, as a result of specialization and trade, each individual can consume combinations of goods that lie on a line beyond her initial consumption possibilities. Their consumption well-being has thus improved. For example, suppose Amanda trades away 8V to Zoe and obtains 8F in return. The points 'A' and 'Z' with coordinates (8,10) and (10,8) respectively define their final consumption. Pre-specialization, if Amanda wished to consume 8F she would have been constrained to consume 6V rather than the 10V now possible. Zoe benefits correspondingly.2
The foregoing example illustrates that trade is not a zero-sum game; it has a positive net value because both parties to the trade can gain. A zero-sum gain is where the gains to one party exactly offset the losses to another. This is an extraordinarily important principle in trade negotiations, whether international or domestic.
A zero-sum game is an interaction where the gain to one party equals the loss to another party.
Market design
In the preceding example we have shown that specialization provides scope for gains that can accrue to those participating in the exchange. But this tells us little about how a market for these products comes into being: how does the exchange take place, and how is information transmitted? The answer is that while some markets have evolved historically to their current state, many markets are designed by an institution or a firm. Fruit and vegetable markets have been with us for thousands of years - since we ceased being purely a hunter-gatherer society. They exist in every community in the world economy. In contrast, the Dutch tulip auction was designed in the early 1600s and exists in basically the same form to this day: the auctioneer begins with a high price, lowers it at known time intervals (measured in seconds or minutes) until some buyer signals that she is willing to purchase the lot on offer. Supermarkets in contrast offer goods at a fixed price. Government contracts are normally signed after a tendering process, in which interested suppliers submit bids. Amazon Inc. is currently experimenting with cashierless 'bricks and mortar' stores that monitor all transactions electronically. Craig's List and E-Bay have their own sets of rules.
In each of these cases markets are designed, frequently with a specific objective on the part of the supplier or the mediating institution: Amazon wants to increase its share of all goods trades; governments wish to limit costs. Markets do not all grow spontaneously and the structure of a market will influence how the gains from trade are distributed. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/01%3A_Introduction_to_key_ideas/1.04%3A_A_model_of_exchange_and_specialization.txt |
The PPFs in Figures 1.1 and 1.2 define the amounts of the goods that each individual can produce while using all of their fixed productive capacity—time in this instance. The national, or economy-wide, PPF for this two-person economy reflects these individual possibilities combined. Such a frontier can be constructed using the individual frontiers as the component blocks.
First let us define this economy-wide frontier precisely. The economy-wide PPF is the set of goods and services combinations that can be produced in the economy when all available productive resources are in use. Figure 1.3 contains both of the individual frontiers plus the aggregate of these, represented by the kinked line ace. The point on the V axis, a=27, represents the total amount of V that could be produced if both individuals devoted all of their time to it. The point e=30 on the horizontal axis is the corresponding total for fish.
Figure 1.3 Economy-wide PPF
From a, to produce Fish it is more efficient to use Zoe because her opportunity cost is less (segment ac). When Zoe is completely specialized, Amanda produces (ce). With complete specialization this economy can produce 27V or 30F.
Economy-wide PPF: the set of goods and services combinations that can be produced in the economy when all available productive resources are in use.
To understand the point c, imagine initially that all resources are devoted to V. From such a point, a, consider a reduction in V and an increase in F. The most efficient way of increasing F production at the point a is to use the individual whose opportunity cost is lower. Zoe can produce one unit of F by sacrificing just 0.5 units of V, whereas Amanda must sacrifice 1.5 units of V to produce 1 unit of F. Hence, at this stage Amanda should stick to V and Zoe should devote some time to fish. In fact as long as we want to produce more fish Zoe should be the one to do it, until she has exhausted her time resource. This occurs after she has produced 18F and has ceased producing V. At this point the economy will be producing 18V and 18F – the point c.
From this combination, if the economy wishes to produce more fish Amanda must become involved. Since her opportunity cost is 1.5 units of V for each unit of F, the next segment of the economy-wide PPF must see a reduction of 1.5 units of V for each additional unit of F. This is reflected in the segment ce. When both producers allocate all of their time to F the economy can produce 30 units. Hence the economy's PPF is the two-segment line ace. Since this has an outward kink, we call it concave (rather than convex).
As a final step consider what this PPF would resemble if the economy were composed of many persons with differing efficiencies. A little imagination suggests (correctly) that it will have a segment for each individual and continue to have its outward concave form. Hence, a four-person economy in which each person had a different opportunity cost could be represented by the segmented line abcde, in Figure 1.4. Furthermore, we could represent the PPF of an economy with a very large number of such individuals by a somewhat smooth PPF that accompanies the 4-person PPF. The logic for its shape continues to be the same: As we produce less V and more F we progressively bring into play resources, or individuals, whose opportunity cost, in terms of reduced V is higher.
Figure 1.4 A multi-person PPF
The PPF for the whole economy, abcde, is obtained by allocating productive resources most efficiently. With many individuals we can think of the PPF as the concave envelope of the individual capabilities.
The outputs V and F in our economic model require just one input – time, but if other productive resources were required the result would be still a concave PPF. Furthermore, we generally interpret the PPF to define the output possibilities when the economy is running at its normal capacity. In this example, we consider a work week of 36 hours to be the 'norm'. Yet it is still possible that the economy's producers might work some additional time in exceptional circumstances, and this would increase total production possibilities. This event would be represented by an outward movement of the PPF. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/01%3A_Introduction_to_key_ideas/1.05%3A_Economy-wide_production_possibilities.txt |
The PPF can be used to illustrate several aspects of macroeconomics: In particular, the level of an economy's output, the growth of national and per capita output over time, and short-run business-cycle fluctuations in national output and employment.
Aggregate output
An economy's capacity to produce goods and services depends on its endowment of resources and the productivity of those resources. The two-person, two-product examples in the previous section reflect this.
The productivity of labour, defined as output per worker or per hour, depends on:
• The skill, knowledge and experience of the labour force;
• The capital stock: Buildings, machinery, equipment, and software the labour force has to work with; and
• The current state of technology.
The productivity of labour is the output of goods and services per worker.
An economy's capital stock is the buildings, machinery, equipment and software used in producing goods and services.
The economy's output, which we define by Y, can be defined as the output per worker times the number of workers; hence, we can write:
When the employment of labour corresponds to 'full employment' in the sense that everyone willing to work at current wage rates and normal hours of work is working, the economy's actual output is also its capacity output Yc. We also term this capacity output as full employment output:
Full employment output .
Suppose the economy is operating with full employment of resources producing outputs of two types: Goods and services. In Figure 1.5, shows the different combinations of goods and services the economy can produce in a particular year using all its labour, capital and the best technology available at the time.
Figure 1.5 Growth and the PPF
Economic growth is illustrated by an outward shift in the PPF from PPF0 to PPF1. PPF1 shows the economy can produce more in both sectors than with PPF0.
An aggregate economy produces a large variety of outputs in two broad categories. Goods are the products of the agriculture, forestry, mining, manufacturing and construction industries. Services are provided by the wholesale and retail trade, transportation, hospitality, finance, health care, education, legal and other service sectors. As in the two-product examples used earlier, the shape of the PPF illustrates the opportunity cost of increasing the output of either product type. We are not concerned with who supplies the products for the moment: It may be the private sector or the government.
Point X0 on PPF0 shows one possible structure of capacity output. This combination may reflect the pattern of demand and hence expenditures in this economy. Output structures and therefore the shapes of PPFs differ among economies with different income levels. High-income economies spend more on services than goods and produce higher ratios of services to goods. Middle income countries produce lower ratios of services to goods, and low income countries much lower ratios of services to goods. For example, in 2017, the structure of national output in Canada was 70 percent services and 30 percent goods, while in Mexico the structure was 48 percent services and 52 percent goods.
Different countries also have different PPFs and different output structures, depending on their resource endowments, labour forces, capital stocks, technology and expenditure patterns.
Economic growth
Three things contribute to growth in the economy. The labour supply grows as the population expands; the stock of capital grows as spending by business (and government) on buildings, machinery, information technology and so forth increases; and labour-force productivity grows as a result of experience, the development of scientific knowledge combined with product and process innovations, and advances in the technology of production. Combined, these developments expand capacity output over time. In Figure 1.5 economic growth shifts the PPF out from to .
This basic description covers the key sources of growth in total output. Economies differ in their rates of overall economic growth as a result of different rates of growth in labour force, in capital stock, and improvements in technology. But improvements in standards of living require more than growth in total output. Increases in output per worker and per person are necessary. Sustained increases in living standards require sustained growth in labour productivity, which in turn is based on advances in the technology along with the amount of capital each worker has to work with. Furthermore, if the growth in output is to benefit society at large, workers across the board need to see an increase in their earnings. As we shall explore in Chapter 13, several developed countries have seen the fruits of growth concentrated in the hands of the highest income earners.
Recessions and booms
A prime objective of economic policy is to ensure that the economy operates on or near the PPF – it should use its resources to capacity and have minimal unemployment. However, economic conditions are seldom tranquil for long periods of time. Unpredictable changes in business expectations of future profits, in consumer confidence, in financial markets, in commodity and energy prices, in trade agreements and disputes, in economic conditions in major trading partners, in government policy and many other events disrupt patterns of expenditure and output. Some of these changes disturb the level of total expenditure and thus the demand for total output. Others disturb the conditions of production and thus the economy's production capacity. Whatever the exact cause, the economy may be pushed off its current PPF. If expenditures on goods and services decline, the economy may experience a recession. Output would fall short of capacity output and unemployment would rise. Alternatively, times of rapidly growing expenditure and output may result in an economic boom: Output and employment expand beyond capacity levels.
An economic recession occurs when output falls below the economy's capacity output.
A boom is a period of high growth that raises output above normal capacity output.
Recent history provides examples. Following the financial crisis of 2008-09 that hit the US and many other developed economies, many economies were pushed into recessions. Expenditure on new residential construction collapsed for lack of income and secure financing, as did business investment, consumption spending and exports. Lower expenditures reduced producers' revenues, forcing cuts in output and employment and reducing household incomes. Lower incomes led to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent, employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to 8.3 percent by 2010. The world's economies have been slow to recover, and even by 2019 the output in several developed economies was no higher than it was in 2008. Canada's recession was not nearly as severe as the recessions in economies such as Spain, Italy and Greece; but output between 2009 and 2019 has been below the potential of the Canadian economy. In the third quarter of 2019 the national output was about 0.7 percent below potential output and the unemployment rate was 5.5 percent.
Figure 1.6 Booms and recessions
Economic recessions leave the economy below its normal capacity; the economy might be driven to a point such as Z. Economic expansions, or booms, may drive capacity above its normal level, to a point such as W.
An economy in a recession is operating inside its PPF. The fall in output from X to Z in Figure 1.6 illustrates the effect of a recession. Expenditures on goods and services have declined. Output is less than capacity output, unemployment is up and some plant capacity is idle. Labour income and business profits are lower. More people would like to work and business would like to produce and sell more output, but it takes time for interdependent product, labour and financial markets in the economy to adjust and increase employment and output. Monetary and fiscal policy may be productive in specific circumstances, to stimulate demand, increase output and employment and move the economy back to capacity output and full employment. The development and implementation of such policies form the core of macroeconomics.
Alternatively, an unexpected increase in demand for exports would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process spread the effects of higher output sales to other sectors of the economy. The economy would move outside its PPF, for example to W in Figure 1.6, by using its resources more intensively than normal. Unemployment would fall and overtime work would increase. Extra production shifts would run plant and equipment for longer hours and work days than were planned when it was designed and installed. Output at this level may not be sustainable, because shortages of labour and materials along with excessive rates of equipment wear and tear would push costs and prices up. Again, we will examine how the economy reacts to such a state in our macroeconomic analysis.
Output and employment in the Canadian economy over the past twenty years fluctuated about growth trend in the way Figure 1.6 illustrates. For several years prior to 2008 the Canadian economy operated slightly above its capacity; but once the recession arrived monetary and fiscal policy were used to fight it – to bring the economy back from a point such as Z towards a point such as X on the PPF.
Macroeconomic models and policy
The PPF diagrams illustrate the main dimensions of macroeconomics: Capacity output, growth in capacity output and business cycle fluctuations in actual output relative to capacity. But these diagrams do not offer explanations and analysis of macroeconomic activity. We need a macroeconomic model to understand and evaluate the causes and consequences of business cycle fluctuations. As we shall see, these models are based on explanations of expenditure decisions by households and business, financial market conditions, production costs and producer pricing decisions at different levels of output. Models also capture the objectives of fiscal and monetary policies and provide a framework for policy evaluation. A full macroeconomic model integrates different sector behaviours and the feedbacks across sectors that can moderate or amplify the effects of changes in one sector on national output and employment. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/01%3A_Introduction_to_key_ideas/1.06%3A_New_Page.txt |
We have covered a lot of ground in this introductory chapter. It is intended to open up the vista of economics to the new student in the discipline. Economics is powerful and challenging, and the ideas we have developed here will serve as conceptual foundations for our exploration of the subject.
1.08: Key Terms
Macroeconomics studies the economy as system in which linkages and feedbacks among sectors determine national output, employment and prices.
Microeconomics is the study of individual behaviour in the context of scarcity.
Mixed economy: goods and services are supplied both by private suppliers and government.
Model is a formalization of theory that facilitates scientific inquiry.
Theory is a logical view of how things work, and is frequently formulated on the basis of observation.
Opportunity cost of a choice is what must be sacrificed when a choice is made.
Production possibility frontier (PPF) defines the combination of goods that can be produced using all of the resources available.
Consumption possibility frontier (CPF): the combination of goods that can be consumed as a result of a given production choice.
A zero-sum game is an interaction where the gain to one party equals the loss to another party.
Economy-wide PPF is the set of goods combinations that can be produced in the economy when all available productive resources are in use.
Productivity of labour is the output of goods and services per worker.
Capital stock: the buildings, machinery, equipment and software used in producing goods and services.
Full employment output . Recession: when output falls below the economy's capacity output. Boom: a period of high growth that raises output above normal capacity output.
1.09: Exercises for Chapter 1
EXERCISE 1.1
An economy has 100 identical workers. Each one can produce four cakes or three shirts, regardless of the number of other individuals producing each good.
1. How many cakes can be produced in this economy when all the workers are cooking?
2. How many shirts can be produced in this economy when all the workers are sewing?
3. On a diagram with cakes on the vertical axis, and shirts on the horizontal axis, join these points with a straight line to form the PPF.
4. Label the inefficient and unattainable regions on the diagram.
EXERCISE 1.2
In the table below are listed a series of points that define an economy's production possibility frontier for goods Y and X.
Y 1000 900 800 700 600 500 400 300 200 100 0
X 0 1600 2500 3300 4000 4600 5100 5500 5750 5900 6000
1. Plot these pairs of points to scale, on graph paper, or with the help of a spreadsheet.
2. Given the shape of this PPF is the economy made up of individuals who are similar or different in their production capabilities?
3. What is the opportunity cost of producing 100 more Y at the combination (X=5500,Y=300).
4. Suppose next there is technological change so that at every output level of good Y the economy can produce 20 percent more X. Enter a new row in the table containing the new values, and plot the new PPF.
EXERCISE 1.3
Using the PPF that you have graphed using the data in Exercise 1.2, determine if the following combinations are attainable or not: (X=3000,Y=720), (X=4800,Y=480).
EXERCISE 1.4
You and your partner are highly efficient people. You can earn \$20 per hour in the workplace; your partner can earn \$30 per hour.
1. What is the opportunity cost of one hour of leisure for you?
2. What is the opportunity cost of one hour of leisure for your partner?
3. Now consider what a PPF would look like: You can produce/consume two things, leisure and income. Since income buys things you can think of the PPF as having these two 'products' – leisure and consumption goods/services. So, with leisure on the horizontal axis and income in dollars is on the vertical axis, plot your PPF. You can assume that you have 12 hours per day to allocate to either leisure or income. [Hint: the leisure axis will have an intercept of 12 hours. The income intercept will have a dollar value corresponding to where all hours are devoted to work.]
4. Draw the PPF for your partner.
EXERCISE 1.5
Louis and Carrie Anne are students who have set up a summer business in their neighbourhood. They cut lawns and clean cars. Louis is particularly efficient at cutting the grass – he requires one hour to cut a typical lawn, while Carrie Anne needs one and one half hours. In contrast, Carrie Anne can wash a car in a half hour, while Louis requires three quarters of an hour.
1. If they decide to specialize in the tasks, who should cut the grass and who should wash cars?
2. If they each work a twelve hour day, how many lawns can they cut and how many cars can they wash if they each specialize in performing the task where they are most efficient?
3. Illustrate the PPF for each individual where lawns are on the horizontal axis and car washes on the vertical axis, if each individual has twelve hours in a day.
EXERCISE 1.6
Continuing with the same data set, suppose Carrie Anne's productivity improves so that she can now cut grass as efficiently as Louis; that is, she can cut grass in one hour, and can still wash a car in one half of an hour.
1. In a new diagram draw the PPF for each individual.
2. In this case does specialization matter if they are to be as productive as possible as a team?
3. Draw the PPF for the whole economy, labelling the intercepts and the 'kink' point coordinates.
EXERCISE 1.7
Going back to the simple PPF plotted for Exercise 1.1 where each of 100 workers can produce either four cakes or three shirts, suppose a recession reduces demand for the outputs to 220 cakes and 129 shirts.
1. Plot this combination of outputs in the diagram that also shows the PPF.
2. How many workers are needed to produce this output of cakes and shirts?
3. What percentage of the 100 worker labour force is unemployed? | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/01%3A_Introduction_to_key_ideas/1.07%3A_Conclusion.txt |
Chapter 2: Theories, data and beliefs
In this chapter we will explore:
2.1
Data analysis
2.2
Data, theory and economic models
2.3
Ethics, efficiency and beliefs
Economists, like other scientists and social scientists, observe and analyze behaviour and events. Economists are concerned primarily with the economic causes and consequences of what they observe. They want to understand an extensive range of human experience, including: money, government finances, industrial production, household consumption, inequality in income distribution, war, monopoly power, health, professional and amateur sports, pollution, marriage, the arts, and much more.
Economists approach these issues using theories and models. To present, explain, illustrate and evaluate their theories and models they have developed a set of techniques or tools. These involve verbal descriptions and explanations, diagrams, algebraic equations, data tables and charts and statistical tests of economic relationships.
This chapter covers some of these basic techniques of analysis.
2.1 Data analysis
The analysis of behaviour necessarily involves data. Data may serve to validate or contradict a theory. Data analysis, even without being motivated by economic theory, frequently displays patterns of behaviour that merit examination. The terms variables and data are related. Variables are measures that can take on different magnitudes. The interest rate on a student loan, for example, is a variable with a certain value at a point in time but perhaps a different value at an earlier or later date. Economic theories and models explain the causal relationships between variables. In contrast, Data are the recorded values of variables. Sets of data provide specific values for the variables we want to study and analyze. Knowing that gross domestic product (a variable) declined in 2009 is just a partial description of events. If the data indicate that it decreased by exactly 3%, we know a great deal more – the decline was large.
Variables: measures that can take on different values.
Data: recorded values of variables.
Sets of data help us to test our models or theories, but first we need to pay attention to the economic logic involved in observations and modelling. For example, if sunspots or baggy pants were found to be correlated with economic expansion, would we consider these events a coincidence or a key to understanding economic growth? The observation is based on facts or data, but it need not have any economic content. The economist's task is to distinguish between coincidence and economic causation. Merely because variables are associated or correlated does not mean that one causes the other.
While the more frequent wearing of loose clothing in the past may have been associated with economic growth because they both occurred at the same time (correlation), one could not argue on a logical basis that this behaviour causes good economic times. Therefore, the past association of these variables should be considered as no more than a coincidence. Once specified on the basis of economic logic, a model must be tested to determine its usefulness in explaining observed economic events.
Table 2.1 House prices and price indexes
Year House Percentage Percentage Real Index for 5-year
prices in change in change in percentage price of mortgage
dollars consumer change housing rate
() prices in
2001 350,000 100 7.75
2002 360,000 102.9 6.85
2003 395,000 35,000/360,000=9.7% 3% 6.7% 112.9 6.6
2004 434,000 124.0 5.8
2005 477,000 136.3 6.1
2006 580,000 165.7 6.3
2007 630,000 180.0 6.65
2008 710,000 202.9 7.3
2009 605,000 -105,000/710,000=-14.8% 1.6% -16.4% 172.9 5.8
2010 740,000 211.4 5.4
2011 800,000 228.6 5.2
Note: Data on changes in consumer prices come from Statistics Canada, CANSIM series V41692930; data on house prices are for N. Vancouver from Royal Le Page; data on mortgage rates from http://www.ratehub.ca. Index for house prices obtained by scaling each entry in column 2 by 100/350,000. The real percentage change in the price of housing is: The percentage change in the price of housing minus the percentage change in consumer prices.
Data types
Data come in several forms. One form is time-series, which reflects a set of measurements made in sequence at different points in time. The first column in Table 2.1 reports the values for house prices in North Vancouver for the first quarter of each year, between 2001 and 2011. Evidently this is a time series. Annual data report one observation per year. We could, alternatively, have presented the data in monthly, weekly, or even daily form. The frequency we use depends on the purpose: If we are interested in the longer-term trend in house prices, then the annual form suffices. In contrast, financial economists, who study the behaviour of stock prices, might not be content with daily or even hourly prices; they may need prices minute-by-minute. Such data are called high-frequency data, whereas annual data are low-frequency data.
Table 2.2 Unemployment rates, Canada and Provinces, monthly 2012, seasonally adjusted
Jan Feb Mar Apr May Jun
CANADA 7.6 7.4 7.2 7.3 7.3 7.2
NFLD 13.5 12.9 13.0 12.3 12.0 13.0
PEI 12.2 10.5 11.3 11.0 11.3 11.3
NS 8.4 8.2 8.3 9.0 9.2 9.6
NB 9.5 10.1 12.2 9.8 9.4 9.5
QUE 8.4 8.4 7.9 8.0 7.8 7.7
ONT 8.1 7.6 7.4 7.8 7.8 7.8
MAN 5.4 5.6 5.3 5.3 5.1 5.2
SASK 5.0 5.0 4.8 4.9 4.5 4.9
ALTA 4.9 5.0 5.3 4.9 4.5 4.6
BC 6.9 6.9 7.0 6.2 7.4 6.6
Source: Statistics Canada CANSIM Table 282-0087.
Time-series: a set of measurements made sequentially at different points in time.
High (low) frequency data: series with short (long) intervals between observations.
In contrast to time-series data, cross-section data record the values of different variables at a point in time. Table 2.2 contains a cross-section of unemployment rates for Canada and Canadian provinces economies. For January 2012 we have a snapshot of the provincial economies at that point in time, likewise for the months until June. This table therefore contains repeated cross-sections.
When the unit of observation is the same over time such repeated cross sections are called longitudinal data. For example, a health survey that followed and interviewed the same individuals over time would yield longitudinal data. If the individuals differ each time the survey is conducted, the data are repeated cross sections. Longitudinal data therefore follow the same units of observation through time.
Cross-section data: values for different variables recorded at a point in time.
Repeated cross-section data: cross-section data recorded at regular or irregular intervals.
Longitudinal data: follow the same units of observation through time.
Graphing the data
Data can be presented in graphical as well as tabular form. Figure 2.1 plots the house price data from the second column of Table 2.1. Each asterisk in the figure represents a price value and a corresponding time period. The horizontal axis reflects time, the vertical axis price in dollars. The graphical presentation of data simply provides a visual rather than numeric perspective. It is immediately evident that house prices increased consistently during this 11-year period, with a single downward 'correction' in 2009. We have plotted the data a second time in Figure 2.2 to illustrate the need to read graphs carefully. The greater apparent slope in Figure 2.1 might easily be interpreted to mean that prices increased more steeply than suggested in Figure 2.2. But a careful reading of the axes reveals that this is not so; using different scales when plotting data or constructing diagrams can mislead the unaware viewer.
Figure 2.1 House prices in dollars 1999-2012
Figure 2.2 House prices in dollars 1999-2012
Percentage changes
The use of percentages makes the analysis of data particularly simple. Suppose we wanted to compare the prices of New York luxury condominiums with the prices of homes in rural Mississippi. In the latter case, a change in average prices of \$10,000 might be considered enormous, whereas a change of one million dollars in New York might be pretty normal – because the average price in New York is so much higher than in Mississippi. To make comparisons between the two markets, we can use the concept of a percentage change. This is defined as the change in the value of the variable, relative to its initial value, multiplied by 100.
Percentage change.
The third column of Table 2.1 contains the values of the percentage change in house prices for two pairs of years. Between 2002 and 2003 the price change was \$35,000. Relative to the price in the first of these two years this change was the fraction 35,000/395,000=0.097. If we multiply this fraction by 100 we obtain a percentage price change of 9.7%. Evidently we could calculate the percentage price changes for all pairs of years. A second price change is calculated for the 2008-2009 pair of years. Here price declined and the result is thus a negative percentage change.
Consumer prices
Most variables in economics are averages of the components that go into them. When variables are denominated in dollar terms it is important to be able to interpret them correctly. While the house price series above indicates a strong pattern of price increases, it is vital to know if the price of housing increased more or less rapidly that other prices in the economy. If all prices in the economy were increasing in line with house prices there would be no special information in the house price series. However, if house prices increased more rapidly than prices in general, then the data indicate that something special took place in the housing market during the decade in question. To determine an answer to this we need to know the degree to which the general price level changed each year.
Statistics Canada regularly surveys the price of virtually every product produced in the economy. One such survey records the prices of goods and services purchased by consumers. Statistics Canada then computes an average price level for all of these goods combined for each time period the survey is carried out (monthly). Once Statistics Canada has computed the average consumer price, it can compute the change in the price level from one period to the next. In Table 2.1 two such values are entered in the following data column: Consumer prices increased by 3% between 2002 and 2003, and by 1.6% between 2008 and 2009. These percentage changes in the general price level represent inflation if prices increase, and deflation if prices decline.
In this market it is clear that housing price changes were substantially larger than the changes in consumer prices for these two pairs of years. The next column provides information on the difference between the house price changes and changes in the general consumer price level, in percentage terms. This is (approximately) the change in the relative price of housing, or what economists call the real price of housing. It is obtained by subtracting the rate of change in the general price index from the rate of change in the variable of interest.
Consumer price index: the average price level for consumer goods and services.
Inflation (deflation) rate: the annual percentage increase (decrease) in the level of consumer prices.
Real price: the actual price adjusted by the general (consumer) price level in the economy.
Index numbers
Statistics Canada and other statistical agencies frequently present data in index number form. An index number provides an easy way to read the data. For example, suppose we wanted to compute the percentage change in the price of housing between 2001 and 2007. We could do this by entering the two data points in a spreadsheet or calculator and do the computation. But suppose the prices were entered in another form. In particular, by dividing each price value by the first year value and multiplying the result by 100 we obtain a series of prices that are all relative to the initial year – which we call the base year. The resulting series in column 6 of Table 2.1 is an index of house price values. Each entry is the corresponding value in column 2, divided by the first entry in column 2. For example, the value 124.0 in row 4 is obtained as . The key characteristics of indexes are that they are not dependent upon the units of measurement of the data in question, and they are interpretable easily with reference to a given base value. To illustrate, suppose we wish to know how prices behaved between 2001 and 2007. The index number column immediately tells us that prices increased by 80%, because relative to 2001, the 2007 value is 80% higher.
Index number: value for a variable, or an average of a set of variables, expressed relative to a given base value.
Furthermore, index numbers enable us to make comparisons with the price patterns for other goods much more easily. If we had constructed a price index for automobiles, which also had a base value of 100 in 2001, we could make immediate comparisons without having to compare one set of numbers defined in thousands of dollars with another defined in hundreds of thousands of dollars. In short, index numbers simplify the interpretation of data.
2.2 Data, theory and economic models
Let us now investigate the interplay between economic theories on the one hand and data on the other. We will develop two examples. The first will be based upon the data on house prices, the second upon a new data set.
House prices – theory
Remember from Chapter 1 that a theory is a logical argument regarding economic relationships. A theory of house prices would propose that the price of housing depends upon a number of elements in the economy. In particular, if borrowing costs are low then buyers are able to afford the interest costs on larger borrowings. This in turn might mean they are willing to pay higher prices. Conversely, if borrowing rates are higher. Consequently, the borrowing rate, or mortgage rate, is a variable for an economic model of house prices. A second variable might be available space for development: If space in a given metropolitan area is tight then the land value will reflect this, and consequently the higher land price should be reflected in higher house prices. A third variable would be the business climate: If there is a high volume of high-value business transacted in a given area then buildings will be more in demand, and that in turn should be reflected in higher prices. For example, both business and residential properties are more highly priced in San Francisco and New York than in Moncton, New Brunswick. A fourth variable might be environmental attractiveness: Vancouver may be more enticing than other towns in Canada. A fifth variable might be the climate.
House prices – evidence
These and other variables could form the basis of a theory of house prices. A model of house prices, as explained in Chapter 1, focuses upon what we would consider to be the most important subset of these variables. In the limit, we could have an extremely simple model that specified a dependence between the price of housing and the mortgage rate alone. To test such a simple model we need data on house prices and mortgage rates. The final column of Table 2.1 contains data on the 5-year fixed-rate mortgage for the period in question. Since our simple model proposes that prices depend (primarily) upon mortgage rates, in Figure 2.3 we plot the house price series on the vertical axis, and the mortgage rate on the horizontal axis, for each year from 2001 to 2011. As before, each point (shown as a '+') represents a pair of price and mortgage rate values.
Figure 2.3 Price of housing
The resulting plot (called a scatter diagram) suggests that there is a negative relationship between these two variables. That is, higher prices are correlated with lower mortgage rates. Such a correlation is consistent with our theory of house prices, and so we might conclude that changes in mortgage rates cause changes in house prices. Or at least the data suggest that we should not reject the idea that such causation is in the data.
House prices – inference
To summarize the relationship between these variables, the pattern suggests that a straight line through the scatter plot would provide a reasonably good description of the relationship between these variables. Obviously it is important to define the most appropriate line – one that 'fits' the data well.1 The line we have drawn through the data points is informative, because it relates the two variables in a quantitative manner. It is called a regression line. It predicts that, on average, if the mortgage rate increases, the price of housing will respond in the downward direction. This particular line states that a one point change in the mortgage rate will move prices in the opposing direction by \$105,000. This is easily verified by considering the dollar value corresponding to say a mortgage value of 6.5, and then the value corresponding to a mortgage value of 7.5. Projecting vertically to the regression line from each of these points on the horizontal axis, and from there across to the vertical axis will produce a change in price of \$105,000.
Note that the line is not at all a 'perfect' fit. For example, the mortgage rate declined between 2008 and 2009, but the price declined also – contrary to our theory. The model is not a perfect predictor; it states that on average a change in the magnitude of the x-axis variable leads to a change of a specific amount in the magnitude of the y-axis variable.
In this instance the slope of the line is given by -105,000/1, which is the vertical distance divided by the corresponding horizontal distance. Since the line is straight, this slope is unchanging.
Regression line: representation of the average relationship between two variables in a scatter diagram.
Road fatalities – theory, evidence and inference
Table 2.3 contains data on annual road fatalities per 100,000 drivers for various age groups. In the background, we have a theory, proposing that driver fatalities depend upon the age of the driver, the quality of roads and signage, speed limits, the age of the automobile stock and perhaps some other variables. Our model focuses upon a subset of these variables, and in order to present the example in graphical terms we specify fatalities as being dependent upon a single variable – age of driver.
Table 2.3 Non-linearity: Driver fatality rates Canada, 2009
Age of driver Fatality rate
per 100,000 drivers
20-24 9.8
25-34 4.4
35-44 2.7
45-54 2.4
55-64 1.9
65+ 2.9
Source: Transport Canada, Canadian motor vehicle traffic collision statistics, 2009.
The scatter diagram is presented in Figure 2.4. Two aspects of this plot stand out. First, there is an exceedingly steep decline in the fatality rate when we go from the youngest age group to the next two age groups. The decline in fatalities between the youngest and second youngest groups is 5.4 points, and between the second and third age groups is 1.7 points. The decline between the third and fourth groups is minimal - just 0.3 points. Hence, behaviour is not the same throughout the age distribution. Second, we notice that fatalities increase for the oldest age group, perhaps indicating that the oldest drivers are not as good as middle-aged drivers.
These two features suggest that the relationship between fatalities and age differs across the age spectrum. Accordingly, a straight line would not be an accurate way of representing the behaviours in these data. A straight line through the plot implies that a given change in age should have a similar impact on fatalities, no matter the age group. Accordingly we have an example of a non-linear relationship. Such a non-linear relationship might be represented by the curve going through the plot. Clearly the slope of this line varies as we move from one age category to another.
Figure 2.4 Non-linearity: Driver fatality rates Canada, 2009
Fatality rates vary non-linearly with age: At first they decline, then increase again, relative to the youngest age group.
2.3 Ethics, efficiency and beliefs
Positive economics studies objective or scientific explanations of how the economy functions. Its aim is to understand and generate predictions about how the economy may respond to changes and policy initiatives. In this effort economists strive to act as detached scientists, regardless of political sympathies or ethical code. Personal judgments and preferences are (ideally) kept apart. In this particular sense, economics is similar to the natural sciences such as physics or biology. To date in this chapter we have been exploring economics primarily from a positive standpoint.
In contrast, normative economics offers recommendations based partly on value judgments. While economists of different political persuasions can agree that raising the income tax rate would lead to some reduction in the number of hours worked, they may yet differ in their views on the advisability of such a rise. One economist may believe that the additional revenue that may come in to government coffers is not worth the disincentives to work; another may think that, if such monies can be redistributed to benefit the needy, or provide valuable infrastructure, the negative impact on the workers paying the income tax is worth it.
Positive economics studies objective or scientific explanations of how the economy functions.
Normative economics offers recommendations that incorporate value judgments.
Scientific research can frequently resolve differences that arise in positive economics—not so in normative economics. For example, if we claim that "the elderly have high medical bills, and the government should cover all of the bills", we are making both a positive and a normative statement. The first part is positive, and its truth is easily established. The latter part is normative, and individuals of different beliefs may reasonably differ. Some people may believe that the money would be better spent on the environment and have the aged cover at least part of their own medical costs. Positive economics does not attempt to show that one of these views is correct and the other false. The views are based on value judgments, and are motivated by a concern for equity. Equity is a vital guiding principle in the formation of policy and is frequently, though not always, seen as being in competition with the drive for economic growth. Equity is driven primarily by normative considerations. Few economists would disagree with the assertion that a government should implement policies that improve the lot of the poor—but to what degree?
Economic equity is concerned with the distribution of well-being among members of the economy.
Application Box 2.1 Wealth Tax
US Senator Elizabeth Warren, in seeking her (Democratic) Party's nomination as candidate for the Presidency in 2020, proposed that individuals with high wealth should pay a wealth tax. Her proposal was to levy a tax of 2% on individual wealth holdings above \$50 million and a 6% tax on wealth above one billion dollars. This is clearly a normative approach to the issue of wealth concentration; it represented her ethical solution to what she perceived as socially unjust inequality.
In contrast, others in her party (Professor Larry Summers of Harvard for example) argued that the impact of such a tax would be to incentivize wealthy individuals to reclassify their wealth, or to give it to family members, or to offshore it, in order to avoid such a tax. If individuals behaved in this way the tax take would be far less than envisaged by Senator Warren. Such an analysis by Professor Summers is positive in nature; it attempts to define what might happen in response to the normative policy of Senator Warren. If he took the further step of saying that wealth should not be taxed, then he would be venturing into normative territory. Henry Aaron of the Brookings Institution argued that a more progressive inheritance tax than currently exists would be easier to implement, and would be more effective in both generating tax revenue and equalizing wealth holdings. Since he also advocated implementing such a proposal, as an alternative to Senator Warren's proposals, he was being both normative and positive.
Most economists hold normative views, sometimes very strongly. They frequently see themselves, not just as cold hearted scientists, but as champions for their (normative) cause in addition. Conservative economists see a smaller role for government than left-leaning economists.
Many economists see a conflict between equity and the efficiency considerations that we developed in Chapter 1. For example, high taxes may provide disincentives to work in the marketplace and therefore reduce the efficiency of the economy: Plumbers and gardeners may decide to do their own gardening and their own plumbing because, by staying out of the marketplace where monetary transactions are taxed, they can avoid the taxes. And avoiding the taxes may turn out to be as valuable as the efficiency gains they forgo.
In other areas the equity-efficiency trade-off is not so obvious: If taxes (that may have disincentive effects) are used to educate individuals who otherwise would not develop the skills that follow education, then economic growth may be higher as a result of the intervention.
Revisiting the definition of economics – core beliefs
This is an appropriate point at which to return to the definition of economics in Chapter 1 that we borrowed from Nobel Laureate Christopher Sims: Economics is a set of ideas and methods for the betterment of society.
If economics is concerned about the betterment of society, clearly there are ethical as well as efficiency considerations at play. And given the philosophical differences among scientists (including economists), can we define an approach to economics that is shared by the economics profession at large? Most economists would answer that the profession shares a set of beliefs, and that differences refer to the extent to which one consideration may collide with another.
• First of all we believe that markets are critical because they facilitate exchange and therefore encourage efficiency. Specialization and trade creates benefits for the trading parties. For example, Canada has not the appropriate climate for growing coffee beans, and Colombia has not the terrain for wheat. If Canada had to be self-sufficient, we might have to grow coffee beans in green-houses—a costly proposition. But with trade we can specialize, and then exchange some of our wheat for Colombian coffee. Similar benefits arise for the Colombians.
A frequent complaint against trade is that its modern-day form (globalization) does not benefit the poor. For example, workers in the Philippines may earn only a few dollars per day manufacturing clothing for Western markets. From this perspective, most of the gains from trade go to the Western consumers and capitalists, come at the expense of jobs to western workers, and provide Asian workers with meagre rewards.
• A corollary of the centrality of markets is that incentives matter. If the price of business class seats on your favourite airline is reduced, you may consider upgrading. Economists believe that the price mechanism influences behaviour, and therefore favour the use of price incentives in the marketplace and public policy more generally. Environmental economists, for example, advocate the use of pollution permits that can be traded at a price between users, or carbon taxes on the emission of greenhouse gases. We will develop such ideas in Principles of Microeconomics Chapter 5 more fully.
• In saying that economists believe in incentives, we are not proposing that human beings are purely mercenary. People have many motivations: Self-interest, a sense of public duty, kindness, etc. Acting out of a sense of self-interest does not imply that people are morally empty or have no altruistic sense.
• Economists believe universally in the importance of the rule of law, no matter where they sit on the political spectrum. Legal institutions that govern contracts are critical to the functioning of an economy. If goods and services are to be supplied in a market economy, the suppliers must be guaranteed that they will be remunerated. And this requires a developed legal structure with penalties imposed on individuals or groups who violate contracts. Markets alone will not function efficiently.
Modern development economics sees the implementation of the rule of law as perhaps the central challenge facing poorer economies. There is a strong correlation between economic growth and national wealth on the one hand, and an effective judicial and policing system on the other. The consequence on the world stage is that numerous 'economic' development projects now focus upon training jurists, police officers and bureaucrats in the rule of law!
• Finally, economists believe in the centrality of government. Governments can solve a number of problems that arise in market economies that cannot be addressed by the private market place. For example, governments can best address the potential abuses of monopoly power. Monopoly power, as we shall see in Microeconomics Chapter 10, not only has equity impacts it may also reduce economic efficiency. Governments are also best positioned to deal with environmental or other types of externalities – the impact of economic activity on sectors of the economy that are not directly involved in the activity under consideration.
In summary, governments have a variety of roles to play in the economy. These roles involve making the economy more equitable and more efficient by using their many powers.
Key Terms
Variables: measures that can take on different sizes.
Data: recorded values of variables.
Time series data: a set of measurements made sequentially at different points in time.
High (low) frequency data series have short (long) intervals between observations.
Cross-section data: values for different variables recorded at a point in time.
Repeated cross-section data: cross-section data recorded at regular or irregular intervals.
Longitudinal data follow the same units of observation through time.
Percentage change.
Consumer price index: the average price level for consumer goods and services.
Inflation (deflation) rate: the annual percentage increase (decrease) in the level of consumer prices.
Real price: the actual price adjusted by the general (consumer) price level in the economy.
Index number: value for a variable, or an average of a set of variables, expressed relative to a given base value.
Regression line: representation of the average relationship between two variables in a scatter diagram.
Positive economics studies objective or scientific explanations of how the economy functions.
Normative economics offers recommendations that incorporate value judgments.
Economic equity is concerned with the distribution of well-being among members of the economy.
Exercises for Chapter 2
EXERCISE 2.1
An examination of a country's recent international trade flows yields the data in the table below.
Year National Income (\$b) Imports (\$b)
2011 1,500 550
2012 1,575 573
2013 1,701 610
2014 1,531 560
2015 1,638 591
1. Based on an examination of these data do you think the national income and imports are not related, positively related, or negatively related?
2. Plot each pair of observations in a two-dimensional line diagram to illustrate your view of the import/income relationship. Measure income on the horizontal axis and imports on the vertical axis. This can be done using graph paper or a spreadsheet-cum-graphics software.
EXERCISE 2.2
The average price of a medium coffee at Wakeup Coffee Shop in each of the past ten years is given in the table below.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
\$1.05 \$1.10 \$1.14 \$1.20 \$1.25 \$1.25 \$1.33 \$1.35 \$1.45 \$1.49
1. Construct an annual 'coffee price index' for this time period using 2005 as the base year. [Hint: follow the procedure detailed in the chapter – divide each yearly price by the base year price.]
2. Based on your price index, what was the percentage change in the price of a medium coffee from 2005 to 2012?
3. Based on your index, what was the average annual percentage change in the price of coffee from 2005 to 2010?
4. Assuming the inflation rate in this economy was 2% every year, what was the real change in the price of coffee between 2007 and 2008; and between 2009 and 2010?
EXERCISE 2.3
The following table shows hypothetical consumption spending by households and income of households in billions of dollars.
Year Income Consumption
2006 476 434
2007 482 447
2008 495 454
2009 505 471
2010 525 489
2011 539 509
2012 550 530
2013 567 548
1. Plot the scatter diagram with consumption on the vertical axis and income on the horizontal axis.
2. Fit a line through these points.
3. Does the line indicate that these two variables are related to each other?
4. How would you describe the causal relationship between income and consumption?
EXERCISE 2.4
Using the data from Exercise 2.3, compute the percentage change in consumption and the percentage change in income for each pair of adjoining years between 2006 and 2013.
EXERCISE 2.5
You are told that the relationship between two variables, X and Y, has the form Y=10+2X. By trying different values for X you can obtain the corresponding predicted value for Y (e.g., if X=3, then ). For values of X between 0 and 12, compute the matching value of Y and plot the scatter diagram.
EXERCISE 2.6
For the data below, plot a scatter diagram with variable Y on the vertical axis and variable X on the horizontal axis.
Y 40 33 29 56 81 19 20
X 5 7 9 3 1 11 10
1. Is the relationship between the variables positive or negative?
2. Do you think that a linear or non-linear line better describes the relationship?
02: Theories data and beliefs
The analysis of behaviour necessarily involves data. Data may serve to validate or contradict a theory. Data analysis, even without being motivated by economic theory, frequently displays patterns of behaviour that merit examination. The terms variables and data are related. Variables are measures that can take on different magnitudes. The interest rate on a student loan, for example, is a variable with a certain value at a point in time but perhaps a different value at an earlier or later date. Economic theories and models explain the causal relationships between variables. In contrast, Data are the recorded values of variables. Sets of data provide specific values for the variables we want to study and analyze. Knowing that gross domestic product (a variable) declined in 2009 is just a partial description of events. If the data indicate that it decreased by exactly 3%, we know a great deal more – the decline was large.
Variables: measures that can take on different values.
Data: recorded values of variables.
Sets of data help us to test our models or theories, but first we need to pay attention to the economic logic involved in observations and modelling. For example, if sunspots or baggy pants were found to be correlated with economic expansion, would we consider these events a coincidence or a key to understanding economic growth? The observation is based on facts or data, but it need not have any economic content. The economist's task is to distinguish between coincidence and economic causation. Merely because variables are associated or correlated does not mean that one causes the other.
While the more frequent wearing of loose clothing in the past may have been associated with economic growth because they both occurred at the same time (correlation), one could not argue on a logical basis that this behaviour causes good economic times. Therefore, the past association of these variables should be considered as no more than a coincidence. Once specified on the basis of economic logic, a model must be tested to determine its usefulness in explaining observed economic events.
Table 2.1 House prices and price indexes
Year House Percentage Percentage Real Index for 5-year
prices in change in change in percentage price of mortgage
dollars consumer change housing rate
() prices in
2001 350,000 100 7.75
2002 360,000 102.9 6.85
2003 395,000 35,000/360,000=9.7% 3% 6.7% 112.9 6.6
2004 434,000 124.0 5.8
2005 477,000 136.3 6.1
2006 580,000 165.7 6.3
2007 630,000 180.0 6.65
2008 710,000 202.9 7.3
2009 605,000 -105,000/710,000=-14.8% 1.6% -16.4% 172.9 5.8
2010 740,000 211.4 5.4
2011 800,000 228.6 5.2
Note: Data on changes in consumer prices come from Statistics Canada, CANSIM series V41692930; data on house prices are for N. Vancouver from Royal Le Page; data on mortgage rates from http://www.ratehub.ca. Index for house prices obtained by scaling each entry in column 2 by 100/350,000. The real percentage change in the price of housing is: The percentage change in the price of housing minus the percentage change in consumer prices.
Data types
Data come in several forms. One form is time-series, which reflects a set of measurements made in sequence at different points in time. The first column in Table 2.1 reports the values for house prices in North Vancouver for the first quarter of each year, between 2001 and 2011. Evidently this is a time series. Annual data report one observation per year. We could, alternatively, have presented the data in monthly, weekly, or even daily form. The frequency we use depends on the purpose: If we are interested in the longer-term trend in house prices, then the annual form suffices. In contrast, financial economists, who study the behaviour of stock prices, might not be content with daily or even hourly prices; they may need prices minute-by-minute. Such data are called high-frequency data, whereas annual data are low-frequency data.
Table 2.2 Unemployment rates, Canada and Provinces, monthly 2012, seasonally adjusted
Jan Feb Mar Apr May Jun
CANADA 7.6 7.4 7.2 7.3 7.3 7.2
NFLD 13.5 12.9 13.0 12.3 12.0 13.0
PEI 12.2 10.5 11.3 11.0 11.3 11.3
NS 8.4 8.2 8.3 9.0 9.2 9.6
NB 9.5 10.1 12.2 9.8 9.4 9.5
QUE 8.4 8.4 7.9 8.0 7.8 7.7
ONT 8.1 7.6 7.4 7.8 7.8 7.8
MAN 5.4 5.6 5.3 5.3 5.1 5.2
SASK 5.0 5.0 4.8 4.9 4.5 4.9
ALTA 4.9 5.0 5.3 4.9 4.5 4.6
BC 6.9 6.9 7.0 6.2 7.4 6.6
Source: Statistics Canada CANSIM Table 282-0087.
Time-series: a set of measurements made sequentially at different points in time.
High (low) frequency data: series with short (long) intervals between observations.
In contrast to time-series data, cross-section data record the values of different variables at a point in time. Table 2.2 contains a cross-section of unemployment rates for Canada and Canadian provinces economies. For January 2012 we have a snapshot of the provincial economies at that point in time, likewise for the months until June. This table therefore contains repeated cross-sections.
When the unit of observation is the same over time such repeated cross sections are called longitudinal data. For example, a health survey that followed and interviewed the same individuals over time would yield longitudinal data. If the individuals differ each time the survey is conducted, the data are repeated cross sections. Longitudinal data therefore follow the same units of observation through time.
Cross-section data: values for different variables recorded at a point in time.
Repeated cross-section data: cross-section data recorded at regular or irregular intervals.
Longitudinal data: follow the same units of observation through time.
Graphing the data
Data can be presented in graphical as well as tabular form. Figure 2.1 plots the house price data from the second column of Table 2.1. Each asterisk in the figure represents a price value and a corresponding time period. The horizontal axis reflects time, the vertical axis price in dollars. The graphical presentation of data simply provides a visual rather than numeric perspective. It is immediately evident that house prices increased consistently during this 11-year period, with a single downward 'correction' in 2009. We have plotted the data a second time in Figure 2.2 to illustrate the need to read graphs carefully. The greater apparent slope in Figure 2.1 might easily be interpreted to mean that prices increased more steeply than suggested in Figure 2.2. But a careful reading of the axes reveals that this is not so; using different scales when plotting data or constructing diagrams can mislead the unaware viewer.
Figure 2.1 House prices in dollars 1999-2012
Figure 2.2 House prices in dollars 1999-2012
Percentage changes
The use of percentages makes the analysis of data particularly simple. Suppose we wanted to compare the prices of New York luxury condominiums with the prices of homes in rural Mississippi. In the latter case, a change in average prices of \$10,000 might be considered enormous, whereas a change of one million dollars in New York might be pretty normal – because the average price in New York is so much higher than in Mississippi. To make comparisons between the two markets, we can use the concept of a percentage change. This is defined as the change in the value of the variable, relative to its initial value, multiplied by 100.
Percentage change.
The third column of Table 2.1 contains the values of the percentage change in house prices for two pairs of years. Between 2002 and 2003 the price change was \$35,000. Relative to the price in the first of these two years this change was the fraction 35,000/395,000=0.097. If we multiply this fraction by 100 we obtain a percentage price change of 9.7%. Evidently we could calculate the percentage price changes for all pairs of years. A second price change is calculated for the 2008-2009 pair of years. Here price declined and the result is thus a negative percentage change.
Consumer prices
Most variables in economics are averages of the components that go into them. When variables are denominated in dollar terms it is important to be able to interpret them correctly. While the house price series above indicates a strong pattern of price increases, it is vital to know if the price of housing increased more or less rapidly that other prices in the economy. If all prices in the economy were increasing in line with house prices there would be no special information in the house price series. However, if house prices increased more rapidly than prices in general, then the data indicate that something special took place in the housing market during the decade in question. To determine an answer to this we need to know the degree to which the general price level changed each year.
Statistics Canada regularly surveys the price of virtually every product produced in the economy. One such survey records the prices of goods and services purchased by consumers. Statistics Canada then computes an average price level for all of these goods combined for each time period the survey is carried out (monthly). Once Statistics Canada has computed the average consumer price, it can compute the change in the price level from one period to the next. In Table 2.1 two such values are entered in the following data column: Consumer prices increased by 3% between 2002 and 2003, and by 1.6% between 2008 and 2009. These percentage changes in the general price level represent inflation if prices increase, and deflation if prices decline.
In this market it is clear that housing price changes were substantially larger than the changes in consumer prices for these two pairs of years. The next column provides information on the difference between the house price changes and changes in the general consumer price level, in percentage terms. This is (approximately) the change in the relative price of housing, or what economists call the real price of housing. It is obtained by subtracting the rate of change in the general price index from the rate of change in the variable of interest.
Consumer price index: the average price level for consumer goods and services.
Inflation (deflation) rate: the annual percentage increase (decrease) in the level of consumer prices.
Real price: the actual price adjusted by the general (consumer) price level in the economy.
Index numbers
Statistics Canada and other statistical agencies frequently present data in index number form. An index number provides an easy way to read the data. For example, suppose we wanted to compute the percentage change in the price of housing between 2001 and 2007. We could do this by entering the two data points in a spreadsheet or calculator and do the computation. But suppose the prices were entered in another form. In particular, by dividing each price value by the first year value and multiplying the result by 100 we obtain a series of prices that are all relative to the initial year – which we call the base year. The resulting series in column 6 of Table 2.1 is an index of house price values. Each entry is the corresponding value in column 2, divided by the first entry in column 2. For example, the value 124.0 in row 4 is obtained as . The key characteristics of indexes are that they are not dependent upon the units of measurement of the data in question, and they are interpretable easily with reference to a given base value. To illustrate, suppose we wish to know how prices behaved between 2001 and 2007. The index number column immediately tells us that prices increased by 80%, because relative to 2001, the 2007 value is 80% higher.
Index number: value for a variable, or an average of a set of variables, expressed relative to a given base value.
Furthermore, index numbers enable us to make comparisons with the price patterns for other goods much more easily. If we had constructed a price index for automobiles, which also had a base value of 100 in 2001, we could make immediate comparisons without having to compare one set of numbers defined in thousands of dollars with another defined in hundreds of thousands of dollars. In short, index numbers simplify the interpretation of data. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/02%3A_Theories_data_and_beliefs/2.01%3A_Data_analysis.txt |
Let us now investigate the interplay between economic theories on the one hand and data on the other. We will develop two examples. The first will be based upon the data on house prices, the second upon a new data set.
House prices – theory
Remember from Chapter 1 that a theory is a logical argument regarding economic relationships. A theory of house prices would propose that the price of housing depends upon a number of elements in the economy. In particular, if borrowing costs are low then buyers are able to afford the interest costs on larger borrowings. This in turn might mean they are willing to pay higher prices. Conversely, if borrowing rates are higher. Consequently, the borrowing rate, or mortgage rate, is a variable for an economic model of house prices. A second variable might be available space for development: If space in a given metropolitan area is tight then the land value will reflect this, and consequently the higher land price should be reflected in higher house prices. A third variable would be the business climate: If there is a high volume of high-value business transacted in a given area then buildings will be more in demand, and that in turn should be reflected in higher prices. For example, both business and residential properties are more highly priced in San Francisco and New York than in Moncton, New Brunswick. A fourth variable might be environmental attractiveness: Vancouver may be more enticing than other towns in Canada. A fifth variable might be the climate.
House prices – evidence
These and other variables could form the basis of a theory of house prices. A model of house prices, as explained in Chapter 1, focuses upon what we would consider to be the most important subset of these variables. In the limit, we could have an extremely simple model that specified a dependence between the price of housing and the mortgage rate alone. To test such a simple model we need data on house prices and mortgage rates. The final column of Table 2.1 contains data on the 5-year fixed-rate mortgage for the period in question. Since our simple model proposes that prices depend (primarily) upon mortgage rates, in Figure 2.3 we plot the house price series on the vertical axis, and the mortgage rate on the horizontal axis, for each year from 2001 to 2011. As before, each point (shown as a '+') represents a pair of price and mortgage rate values.
Figure 2.3 Price of housing
The resulting plot (called a scatter diagram) suggests that there is a negative relationship between these two variables. That is, higher prices are correlated with lower mortgage rates. Such a correlation is consistent with our theory of house prices, and so we might conclude that changes in mortgage rates cause changes in house prices. Or at least the data suggest that we should not reject the idea that such causation is in the data.
House prices – inference
To summarize the relationship between these variables, the pattern suggests that a straight line through the scatter plot would provide a reasonably good description of the relationship between these variables. Obviously it is important to define the most appropriate line – one that 'fits' the data well.1 The line we have drawn through the data points is informative, because it relates the two variables in a quantitative manner. It is called a regression line. It predicts that, on average, if the mortgage rate increases, the price of housing will respond in the downward direction. This particular line states that a one point change in the mortgage rate will move prices in the opposing direction by \$105,000. This is easily verified by considering the dollar value corresponding to say a mortgage value of 6.5, and then the value corresponding to a mortgage value of 7.5. Projecting vertically to the regression line from each of these points on the horizontal axis, and from there across to the vertical axis will produce a change in price of \$105,000.
Note that the line is not at all a 'perfect' fit. For example, the mortgage rate declined between 2008 and 2009, but the price declined also – contrary to our theory. The model is not a perfect predictor; it states that on average a change in the magnitude of the x-axis variable leads to a change of a specific amount in the magnitude of the y-axis variable.
In this instance the slope of the line is given by -105,000/1, which is the vertical distance divided by the corresponding horizontal distance. Since the line is straight, this slope is unchanging.
Regression line: representation of the average relationship between two variables in a scatter diagram.
Road fatalities – theory, evidence and inference
Table 2.3 contains data on annual road fatalities per 100,000 drivers for various age groups. In the background, we have a theory, proposing that driver fatalities depend upon the age of the driver, the quality of roads and signage, speed limits, the age of the automobile stock and perhaps some other variables. Our model focuses upon a subset of these variables, and in order to present the example in graphical terms we specify fatalities as being dependent upon a single variable – age of driver.
Table 2.3 Non-linearity: Driver fatality rates Canada, 2009
Age of driver Fatality rate
per 100,000 drivers
20-24 9.8
25-34 4.4
35-44 2.7
45-54 2.4
55-64 1.9
65+ 2.9
Source: Transport Canada, Canadian motor vehicle traffic collision statistics, 2009.
The scatter diagram is presented in Figure 2.4. Two aspects of this plot stand out. First, there is an exceedingly steep decline in the fatality rate when we go from the youngest age group to the next two age groups. The decline in fatalities between the youngest and second youngest groups is 5.4 points, and between the second and third age groups is 1.7 points. The decline between the third and fourth groups is minimal - just 0.3 points. Hence, behaviour is not the same throughout the age distribution. Second, we notice that fatalities increase for the oldest age group, perhaps indicating that the oldest drivers are not as good as middle-aged drivers.
These two features suggest that the relationship between fatalities and age differs across the age spectrum. Accordingly, a straight line would not be an accurate way of representing the behaviours in these data. A straight line through the plot implies that a given change in age should have a similar impact on fatalities, no matter the age group. Accordingly we have an example of a non-linear relationship. Such a non-linear relationship might be represented by the curve going through the plot. Clearly the slope of this line varies as we move from one age category to another.
Figure 2.4 Non-linearity: Driver fatality rates Canada, 2009
Fatality rates vary non-linearly with age: At first they decline, then increase again, relative to the youngest age group. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/02%3A_Theories_data_and_beliefs/2.02%3A_Data_theory_and_economic_models.txt |
Positive economics studies objective or scientific explanations of how the economy functions. Its aim is to understand and generate predictions about how the economy may respond to changes and policy initiatives. In this effort economists strive to act as detached scientists, regardless of political sympathies or ethical code. Personal judgments and preferences are (ideally) kept apart. In this particular sense, economics is similar to the natural sciences such as physics or biology. To date in this chapter we have been exploring economics primarily from a positive standpoint.
In contrast, normative economics offers recommendations based partly on value judgments. While economists of different political persuasions can agree that raising the income tax rate would lead to some reduction in the number of hours worked, they may yet differ in their views on the advisability of such a rise. One economist may believe that the additional revenue that may come in to government coffers is not worth the disincentives to work; another may think that, if such monies can be redistributed to benefit the needy, or provide valuable infrastructure, the negative impact on the workers paying the income tax is worth it.
Positive economics studies objective or scientific explanations of how the economy functions.
Normative economics offers recommendations that incorporate value judgments.
Scientific research can frequently resolve differences that arise in positive economics—not so in normative economics. For example, if we claim that "the elderly have high medical bills, and the government should cover all of the bills", we are making both a positive and a normative statement. The first part is positive, and its truth is easily established. The latter part is normative, and individuals of different beliefs may reasonably differ. Some people may believe that the money would be better spent on the environment and have the aged cover at least part of their own medical costs. Positive economics does not attempt to show that one of these views is correct and the other false. The views are based on value judgments, and are motivated by a concern for equity. Equity is a vital guiding principle in the formation of policy and is frequently, though not always, seen as being in competition with the drive for economic growth. Equity is driven primarily by normative considerations. Few economists would disagree with the assertion that a government should implement policies that improve the lot of the poor—but to what degree?
Economic equity is concerned with the distribution of well-being among members of the economy.
Application Box 2.1 Wealth Tax
US Senator Elizabeth Warren, in seeking her (Democratic) Party's nomination as candidate for the Presidency in 2020, proposed that individuals with high wealth should pay a wealth tax. Her proposal was to levy a tax of 2% on individual wealth holdings above \$50 million and a 6% tax on wealth above one billion dollars. This is clearly a normative approach to the issue of wealth concentration; it represented her ethical solution to what she perceived as socially unjust inequality.
In contrast, others in her party (Professor Larry Summers of Harvard for example) argued that the impact of such a tax would be to incentivize wealthy individuals to reclassify their wealth, or to give it to family members, or to offshore it, in order to avoid such a tax. If individuals behaved in this way the tax take would be far less than envisaged by Senator Warren. Such an analysis by Professor Summers is positive in nature; it attempts to define what might happen in response to the normative policy of Senator Warren. If he took the further step of saying that wealth should not be taxed, then he would be venturing into normative territory. Henry Aaron of the Brookings Institution argued that a more progressive inheritance tax than currently exists would be easier to implement, and would be more effective in both generating tax revenue and equalizing wealth holdings. Since he also advocated implementing such a proposal, as an alternative to Senator Warren's proposals, he was being both normative and positive.
Most economists hold normative views, sometimes very strongly. They frequently see themselves, not just as cold hearted scientists, but as champions for their (normative) cause in addition. Conservative economists see a smaller role for government than left-leaning economists.
Many economists see a conflict between equity and the efficiency considerations that we developed in Chapter 1. For example, high taxes may provide disincentives to work in the marketplace and therefore reduce the efficiency of the economy: Plumbers and gardeners may decide to do their own gardening and their own plumbing because, by staying out of the marketplace where monetary transactions are taxed, they can avoid the taxes. And avoiding the taxes may turn out to be as valuable as the efficiency gains they forgo.
In other areas the equity-efficiency trade-off is not so obvious: If taxes (that may have disincentive effects) are used to educate individuals who otherwise would not develop the skills that follow education, then economic growth may be higher as a result of the intervention.
Revisiting the definition of economics – core beliefs
This is an appropriate point at which to return to the definition of economics in Chapter 1 that we borrowed from Nobel Laureate Christopher Sims: Economics is a set of ideas and methods for the betterment of society.
If economics is concerned about the betterment of society, clearly there are ethical as well as efficiency considerations at play. And given the philosophical differences among scientists (including economists), can we define an approach to economics that is shared by the economics profession at large? Most economists would answer that the profession shares a set of beliefs, and that differences refer to the extent to which one consideration may collide with another.
• First of all we believe that markets are critical because they facilitate exchange and therefore encourage efficiency. Specialization and trade creates benefits for the trading parties. For example, Canada has not the appropriate climate for growing coffee beans, and Colombia has not the terrain for wheat. If Canada had to be self-sufficient, we might have to grow coffee beans in green-houses—a costly proposition. But with trade we can specialize, and then exchange some of our wheat for Colombian coffee. Similar benefits arise for the Colombians.
A frequent complaint against trade is that its modern-day form (globalization) does not benefit the poor. For example, workers in the Philippines may earn only a few dollars per day manufacturing clothing for Western markets. From this perspective, most of the gains from trade go to the Western consumers and capitalists, come at the expense of jobs to western workers, and provide Asian workers with meagre rewards.
• A corollary of the centrality of markets is that incentives matter. If the price of business class seats on your favourite airline is reduced, you may consider upgrading. Economists believe that the price mechanism influences behaviour, and therefore favour the use of price incentives in the marketplace and public policy more generally. Environmental economists, for example, advocate the use of pollution permits that can be traded at a price between users, or carbon taxes on the emission of greenhouse gases. We will develop such ideas in Principles of Microeconomics Chapter 5 more fully.
• In saying that economists believe in incentives, we are not proposing that human beings are purely mercenary. People have many motivations: Self-interest, a sense of public duty, kindness, etc. Acting out of a sense of self-interest does not imply that people are morally empty or have no altruistic sense.
• Economists believe universally in the importance of the rule of law, no matter where they sit on the political spectrum. Legal institutions that govern contracts are critical to the functioning of an economy. If goods and services are to be supplied in a market economy, the suppliers must be guaranteed that they will be remunerated. And this requires a developed legal structure with penalties imposed on individuals or groups who violate contracts. Markets alone will not function efficiently.
Modern development economics sees the implementation of the rule of law as perhaps the central challenge facing poorer economies. There is a strong correlation between economic growth and national wealth on the one hand, and an effective judicial and policing system on the other. The consequence on the world stage is that numerous 'economic' development projects now focus upon training jurists, police officers and bureaucrats in the rule of law!
• Finally, economists believe in the centrality of government. Governments can solve a number of problems that arise in market economies that cannot be addressed by the private market place. For example, governments can best address the potential abuses of monopoly power. Monopoly power, as we shall see in Microeconomics Chapter 10, not only has equity impacts it may also reduce economic efficiency. Governments are also best positioned to deal with environmental or other types of externalities – the impact of economic activity on sectors of the economy that are not directly involved in the activity under consideration.
In summary, governments have a variety of roles to play in the economy. These roles involve making the economy more equitable and more efficient by using their many powers. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/02%3A_Theories_data_and_beliefs/2.03%3A_Ethics_efficiency_and_beliefs.txt |
Variables: measures that can take on different sizes.
Data: recorded values of variables.
Time series data: a set of measurements made sequentially at different points in time.
High (low) frequency data series have short (long) intervals between observations.
Cross-section data: values for different variables recorded at a point in time.
Repeated cross-section data: cross-section data recorded at regular or irregular intervals.
Longitudinal data follow the same units of observation through time.
Percentage change.
Consumer price index: the average price level for consumer goods and services.
Inflation (deflation) rate: the annual percentage increase (decrease) in the level of consumer prices.
Real price: the actual price adjusted by the general (consumer) price level in the economy.
Index number: value for a variable, or an average of a set of variables, expressed relative to a given base value.
Regression line: representation of the average relationship between two variables in a scatter diagram.
Positive economics studies objective or scientific explanations of how the economy functions.
Normative economics offers recommendations that incorporate value judgments.
Economic equity is concerned with the distribution of well-being among members of the economy.
2.05: Exercises for Chapter 2
EXERCISE 2.1
An examination of a country's recent international trade flows yields the data in the table below.
Year National Income (\$b) Imports (\$b)
2011 1,500 550
2012 1,575 573
2013 1,701 610
2014 1,531 560
2015 1,638 591
1. Based on an examination of these data do you think the national income and imports are not related, positively related, or negatively related?
2. Plot each pair of observations in a two-dimensional line diagram to illustrate your view of the import/income relationship. Measure income on the horizontal axis and imports on the vertical axis. This can be done using graph paper or a spreadsheet-cum-graphics software.
EXERCISE 2.2
The average price of a medium coffee at Wakeup Coffee Shop in each of the past ten years is given in the table below.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
\$1.05 \$1.10 \$1.14 \$1.20 \$1.25 \$1.25 \$1.33 \$1.35 \$1.45 \$1.49
1. Construct an annual 'coffee price index' for this time period using 2005 as the base year. [Hint: follow the procedure detailed in the chapter – divide each yearly price by the base year price.]
2. Based on your price index, what was the percentage change in the price of a medium coffee from 2005 to 2012?
3. Based on your index, what was the average annual percentage change in the price of coffee from 2005 to 2010?
4. Assuming the inflation rate in this economy was 2% every year, what was the real change in the price of coffee between 2007 and 2008; and between 2009 and 2010?
EXERCISE 2.3
The following table shows hypothetical consumption spending by households and income of households in billions of dollars.
Year Income Consumption
2006 476 434
2007 482 447
2008 495 454
2009 505 471
2010 525 489
2011 539 509
2012 550 530
2013 567 548
1. Plot the scatter diagram with consumption on the vertical axis and income on the horizontal axis.
2. Fit a line through these points.
3. Does the line indicate that these two variables are related to each other?
4. How would you describe the causal relationship between income and consumption?
EXERCISE 2.4
Using the data from Exercise 2.3, compute the percentage change in consumption and the percentage change in income for each pair of adjoining years between 2006 and 2013.
EXERCISE 2.5
You are told that the relationship between two variables, X and Y, has the form Y=10+2X. By trying different values for X you can obtain the corresponding predicted value for Y (e.g., if X=3, then ). For values of X between 0 and 12, compute the matching value of Y and plot the scatter diagram.
EXERCISE 2.6
For the data below, plot a scatter diagram with variable Y on the vertical axis and variable X on the horizontal axis.
Y 40 33 29 56 81 19 20
X 5 7 9 3 1 11 10
1. Is the relationship between the variables positive or negative?
2. Do you think that a linear or non-linear line better describes the relationship? | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/02%3A_Theories_data_and_beliefs/2.04%3A_Key_Terms.txt |
Chapter 3: The classical marketplace – demand and supply
In this chapter we will explore:
3.1
The marketplace – trading
3.2
The market's building blocks
3.3
Demand curves and supply curves
3.4
Non-price determinants of demand
3.5
Non-price determinants of supply
3.6
Simultaneous demand and supply movements
3.7
Free and managed markets – interventions
3.8
From individuals to markets
3.9
Useful techniques – demand and supply equations
3.1 The marketplace – trading
The marketplace in today's economy has evolved from earlier times. It no longer has a unique form – one where buyers and sellers physically come together for the purpose of exchange. Indeed, supermarkets usually require individuals to be physically present to make their purchases. But when purchasing an airline ticket, individuals simply go online and interact with perhaps a number of different airlines (suppliers) simultaneously. Or again, individuals may simply give an instruction to their stock broker, who will execute a purchase on their behalf – the broker performs the role of a middleman, who may additionally give advice to the purchaser. Or a marketing agency may decide to subcontract work to a translator or graphic artist who resides in Mumbai. The advent of the coronavirus has shifted grocery purchases from in-store presence to home delivery for many buyers. In pure auctions (where a single work of art or a single residence is offered for sale) buyers compete one against the other for the single item supplied. Accommodations in private homes are supplied to potential visitors (buyers) through Airbnb. Taxi rides are mediated through Lyft or Uber. These institutions are all different types of markets; they serve the purpose of facilitating exchange and trade.
Not all goods and services in the modern economy are obtained through the marketplace. Schooling and health care are allocated in Canada primarily by government decree. In some instances the market plays a supporting role: Universities and colleges may levy fees, and most individuals must pay, at least in part, for their pharmaceuticals. In contrast, broadcasting services may carry a price of zero; Buzzfeed or other news and social media come free of payment. Furthermore, some markets have no price, yet they find a way of facilitating an exchange. For example, graduating medical students need to be matched with hospitals for their residencies. Matching mechanisms are a form of market in that they bring together suppliers and demanders. We explore their operation in Chapter 11.
The importance of the marketplace springs from its role as an allocating mechanism. Elevated prices effectively send a signal to suppliers that the buyers in the market place a high value on the product being traded; conversely when prices are low. Accordingly, suppliers may decide to cease supplying markets where prices do not remunerate them sufficiently, and redirect their energies and the productive resources under their control to other markets – markets where the product being traded is more highly valued, and where the buyer is willing to pay more.
Whatever their form, the marketplace is central to the economy we live in. Not only does it facilitate trade, it also provides a means of earning a livelihood. Suppliers must hire resources – human and non-human – in order to bring their supplies to market and these resources must be paid a return: income is generated.
In this chapter we will examine the process of price formation – how the prices that we observe in the marketplace come to be what they are. We will illustrate that the price for a good is inevitably linked to the quantity of a good; price and quantity are different sides of the same coin and cannot generally be analyzed separately. To understand this process more fully, we need to model a typical market. The essentials are demand and supply.
3.2 The market's building blocks
In economics we use the terminology that describes trade in a particular manner. Non-economists frequently describe microeconomics by saying "it's all about supply and demand". While this is largely true we need to define exactly what we mean by these two central words. Demand is the quantity of a good or service that buyers wish to purchase at each conceivable price, with all other influences on demand remaining unchanged. It reflects a multitude of values, not a single value. It is not a single or unique quantity such as two cell phones, but rather a full description of the quantity of a good or service that buyers would purchase at various prices.
Demand is the quantity of a good or service that buyers wish to purchase at each possible price, with all other influences on demand remaining unchanged.
As a hypothetical example, the first column of Table 3.1 shows the price of natural gas per cubic foot. The second column shows the quantity that would be purchased in a given time period at each price. It is therefore a schedule of quantities demanded at various prices. For example, at a price \$6 per unit, buyers would like to purchase 4 units, whereas at the lower price of \$3 buyers would like to purchase 7 units. Note also that this is a homogeneous good. A cubit foot of natural gas is considered to be the same product no matter which supplier brings it to the market. In contrast, accommodations supplied through Airbnb are heterogeneous – they vary in size and quality.
Table 3.1 Demand and supply for natural gas
Price (\$) Demand (thousands Supply (thousands Excess
of cu feet) of cu feet)
10 0 18 Excess Supply
9 1 16
8 2 14
7 3 12
6 4 10
5 5 8
4 6 6 Equilibrium
3 7 4 Excess Demand
2 8 2
1 9 0
0 10 0
Supply is interpreted in a similar manner. It is not a single value; we say that supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged. Such a supply schedule is defined in the third column of the table. It is assumed that no supplier can make a profit (on account of their costs) unless the price is at least \$2 per unit, and therefore a zero quantity is supplied below that price. The higher price is more profitable, and therefore induces a greater quantity supplied, perhaps by attracting more suppliers. This is reflected in the data. For example, at a price of \$3 suppliers are willing to supply 4 units, whereas with a price of \$7 they are willing to supply 12 units. There is thus a positive relationship between price and quantity for the supplier – a higher price induces a greater quantity; whereas on the demand side of the market a higher price induces a lower quantity demanded – a negative relationship.
Supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged.
We can now identify a key difference in terminology – between the words demand and quantity demanded, and between supply and quantity supplied. While the words demand and supply refer to the complete schedules of demand and supply, the terms quantity demanded and quantity supplied each define a single value of demand or supply at a particular price.
Quantity demanded defines the amount purchased at a particular price.
Quantity supplied refers to the amount supplied at a particular price.
Thus while the non-economist may say that when some fans did not get tickets to the Stanley Cup it was a case of demand exceeding supply, as economists we say that the quantity demanded exceeded the quantity supplied at the going price of tickets. In this instance, had every ticket been offered at a sufficiently high price, the market could have generated an excess supply rather than an excess demand. A higher ticket price would reduce the quantity demanded; yet would not change demand, because demand refers to the whole schedule of possible quantities demanded at different prices.
Other things equal – ceteris paribus
The demand and supply schedules rest on the assumption that all other influences on supply and demand remain the same as we move up and down the possible price values. The expression other things being equal, or its Latin counterpart ceteris paribus, describes this constancy of other influences. For example, we assume on the demand side that the prices of other goods remain constant, and that tastes and incomes are unchanging. On the supply side we assume, for example, that there is no technological change in production methods. If any of these elements change then the market supply or demand schedules will reflect such changes. For example, if coal or oil prices increase (decline) then some buyers may switch to (away from) gas or solar power. This will be reflected in the data: At any given price more (or less) will be demanded. We will illustrate this in graphic form presently.
Market equilibrium
Let us now bring the demand and supply schedules together in an attempt to analyze what the marketplace will produce – will a single price emerge that will equate supply and demand? We will keep other things constant for the moment, and explore what materializes at different prices. At low prices, the data in Table 3.1 indicate that the quantity demanded exceeds the quantity supplied – for example, verify what happens when the price is \$3 per unit. The opposite occurs when the price is high – what would happen if the price were \$8? Evidently, there exists an intermediate price, where the quantity demanded equals the quantity supplied. At this point we say that the market is in equilibrium. The equilibrium price equates demand and supply – it clears the market.
The equilibrium price equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.
In Table 3.1 the equilibrium price is \$4, and the equilibrium quantity is 6 thousand cubic feet of gas (we use the notation 'k' to denote thousands). At higher prices there is an excess supply—suppliers wish to sell more than buyers wish to buy. Conversely, at lower prices there is an excess demand. Only at the equilibrium price is the quantity supplied equal to the quantity demanded.
Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.
Excess demand exists when the quantity demanded exceeds the quantity supplied at the going price.
Does the market automatically reach equilibrium? To answer this question, suppose initially that the sellers choose a price of \$10. Here suppliers would like to supply 18k cubic feet, but there are no buyers—a situation of extreme excess supply. At the price of \$7 the excess supply is reduced to 9k, because both the quantity demanded is now higher at 3k units, and the quantity supplied is lower at 12k. But excess supply means that there are suppliers willing to supply at a lower price, and this willingness exerts continual downward pressure on any price above the price that equates demand and supply.
At prices below the equilibrium there is, conversely, an excess demand. In this situation, suppliers could force the price upward, knowing that buyers will continue to buy at a price at which the suppliers are willing to sell. Such upward pressure would continue until the excess demand is eliminated.
In general then, above the equilibrium price excess supply exerts downward pressure on price, and below the equilibrium excess demand exerts upward pressure on price. This process implies that the buyers and sellers have information on the various elements that make up the marketplace.
We will explore later in this chapter some specific circumstances in which trading could take place at prices above or below the equilibrium price. In such situations the quantity actually traded always corresponds to the short side of the market: this means that at high prices the quantity demanded is less than the quantity supplied, and it is the quantity demanded that is traded because buyers will not buy the amount suppliers would like to supply. Correspondingly, at low prices the quantity demanded exceeds quantity supplied, and it is the amount that suppliers are willing to sell that is traded. In sum, when trading takes place at prices other than the equilibrium price it is always the lesser of the quantity demanded or supplied that is traded. Hence we say that at non-equilibrium prices the short side dominates. We will return to this in a series of examples later in this chapter.
The short side of the market determines outcomes at prices other than the equilibrium.
Supply and the nature of costs
Before progressing to a graphical analysis, we should add a word about costs. The supply schedules are based primarily on the cost of producing the product in question, and we frequently assume that all of the costs associated with supply are incorporated in the supply schedules. In Chapter 6 we will explore cases where costs additional to those incurred by producers may be relevant. For example, coal burning power plants emit pollutants into the atmosphere; but the individual supplier may not take account of these pollutants, which are costs to society at large, in deciding how much to supply at different prices. Stated another way, the private costs of production would not reflect the total, or full social costs of production. Conversely, if some individuals immunize themselves against a rampant virus, other individuals gain from that action because they become less likely to contract the virus - the social value thus exceeds the private value. For the moment the assumption is that no such additional costs are associated with the markets we analyze.
3.3 Demand and supply curves
The demand curve is a graphical expression of the relationship between price and quantity demanded, holding other things constant. Figure 3.1 measures price on the vertical axis and quantity on the horizontal axis. The curve D represents the data from the first two columns of Table 3.1. Each combination of price and quantity demanded lies on the curve. In this case the curve is linear—it is a straight line. The demand curve slopes downward (technically we say that its slope is negative), reflecting the fact that buyers wish to purchase more when the price is less.
Figure 3.1 Measuring price & quantity
To derive this demand curve we take each price-quantity combination from the demand schedule in Table 3.1 and insert a point that corresponds to those combinations. For example, point h defines the combination , the point l denotes the combination . If we join all such points we obtain the demand curve in Figure 3.2.The same process yields the supply curve in Figure 3.2. In this example the supply and the demand curves are each linear. There is no reason why this linear property characterizes demand and supply curves in the real world; they are frequently found to have curvature. But straight lines are easier to work with, so we continue with them for the moment.
The demand curve is a graphical expression of the relationship between price and quantity demanded, with other influences remaining unchanged.
The supply curve is a graphical representation of the relationship between price and quantity supplied, holding other things constant. The supply curve S in Figure 3.2 is based on the data from columns 1 and 3 in Table 3.1. It has a positive slope indicating that suppliers wish to supply more at higher prices.
The supply curve is a graphical expression of the relationship between price and quantity supplied, with other influences remaining unchanged.
Figure 3.2 Supply, demand, equilibrium
The demand and supply curves intersect at point E0, corresponding to a price of \$4 which, as illustrated above, is the equilibrium price for this market. At any price below this the horizontal distance between the supply and demand curves represents excess demand, because demand exceeds supply. Conversely, at any price above \$4 there is an excess supply that is again measured by the horizontal distance between the two curves. Market forces tend to eliminate excess demand and excess supply as we explained above. In the final section of the chapter we illustrate how the supply and demand curves can be 'solved' for the equilibrium price and quantity.
3.4 Non-price influences on demand
We have emphasized several times the importance of the ceteris paribus assumption when exploring the impact of different prices on the quantity demanded: We assume all other influences on the purchase decision are unchanged (at least momentarily). These other influences fall into several broad categories: The prices of related goods; the incomes of buyers; buyer tastes; and expectations about the future. Before proceeding, note that we are dealing with market demand rather than demand by one individual (the precise relationship between the two is developed later in this chapter).
The prices of related goods – oil and gas, Kindle and paperbacks
We expect that the price of other forms of energy would impact the price of natural gas. For example, if hydro-electricity, oil or solar becomes less expensive we would expect some buyers to switch to these other products. Alternatively, if gas-burning furnaces experience a technological breakthrough that makes them more efficient and cheaper we would expect some users of other fuels to move to gas. Among these examples, oil and electricity are substitute fuels for gas; in contrast a more fuel-efficient new gas furnace complements the use of gas. We use these terms, substitutes and complements, to describe products that influence the demand for the primary good.
Substitute goods: when a price reduction (rise) for a related product reduces (increases) the demand for a primary product, it is a substitute for the primary product.
Complementary goods: when a price reduction (rise) for a related product increases (reduces) the demand for a primary product, it is a complement for the primary product.
Clearly electricity is a substitute for gas in the power market, whereas a gas furnace is a complement for gas as a fuel. The words substitutes and complements immediately suggest the nature of the relationships. Every product has complements and substitutes. As another example: Electronic readers and tablets are substitutes for paper-form books; a rise in the price of paper books should increase the demand for electronic readers at any given price for electronic readers. In graphical terms, the demand curve shifts in response to changes in the prices of other goods – an increase in the price of paper-form books shifts the demand for electronic readers outward, because more electronic readers will be demanded at any price.
Buyer incomes – which goods to buy
The demand for most goods increases in response to income growth. Given this, the demand curve for gas will shift outward if household incomes in the economy increase. Household incomes may increase either because there are more households in the economy or because the incomes of the existing households grow.
Most goods are demanded in greater quantity in response to higher incomes at any given price. But there are exceptions. For example, public transit demand may decline at any price when household incomes rise, because some individuals move to cars. Or the demand for laundromats may decline in response to higher incomes, as households purchase more of their own consumer durables – washers and driers. We use the term inferior good to define these cases: An inferior good is one whose demand declines in response to increasing incomes, whereas a normal good experiences an increase in demand in response to rising incomes.
An inferior good is one whose demand falls in response to higher incomes.
A normal good is one whose demand increases in response to higher incomes.
There is a further sense in which consumer incomes influence demand, and this relates to how the incomes are distributed in the economy. In the discussion above we stated that higher total incomes shift demand curves outwards when goods are normal. But think of the difference in the demand for electronic readers between Portugal and Saudi Arabia. These economies have roughly the same average per-person income, but incomes are distributed more unequally in Saudi Arabia. It does not have a large middle class that can afford electronic readers or iPads, despite the huge wealth held by the elite. In contrast, Portugal has a relatively larger middle class that can afford such goods. Consequently, the distribution of income can be an important determinant of the demand for many commodities and services.
Tastes and networks – hemlines, lapels and homogeneity
While demand functions are drawn on the assumption that tastes are constant, in an evolving world they are not. We are all subject to peer pressure, the fashion industry, marketing, and a desire to maintain our image. If the fashion industry dictates that lapels on men's suits or long skirts are de rigueur for the coming season, some fashion-conscious individuals will discard a large segment of their wardrobe, even though the clothes may be in perfectly good condition: Their demand is influenced by the dictates of current fashion.
Correspondingly, the items that other individuals buy or use frequently determine our own purchases. Businesses frequently decide that all of their employees will have the same type of computer and software on account of network economies: It is easier to communicate if equipment is compatible, and it is less costly to maintain infrastructure where the variety is less.
Expectations – betting on the future
In our natural gas example, if households expected that the price of natural gas was going to stay relatively low for many years – perhaps on account of the discovery of large deposits – then they would be tempted to purchase a gas burning furnace rather than one based upon an alternative fuel. In this example, it is more than the current price that determines choices; the prices that are expected to prevail in the future also determine current demand.
Expectations are particularly important in stock markets. When investors anticipate that corporations will earn high rewards in the future they will buy a stock today. If enough people believe this, the price of the stock will be driven upward on the market, even before profitable earnings are registered.
Shifts in demand
The demand curve in Figure 3.2 is drawn for a given level of other prices, incomes, tastes, and expectations. Movements along the demand curve reflect solely the impact of different prices for the good in question, holding other influences constant. But changes in any of these other factors will change the position of the demand curve. Figure 3.3 illustrates a shift in the demand curve. This shift could result from a rise in household incomes that increase the quantity demanded at every price. This is illustrated by an outward shift in the demand curve. With supply conditions unchanged, there is a new equilibrium at , indicating a greater quantity of purchases accompanied by a higher price. The new equilibrium reflects a change in quantity supplied and a change in demand.
Figure 3.3 Demand shift and new equilibrium
The outward shift in demand leads to a new equilibrium E1.
We may well ask why so much emphasis in our diagrams and analysis is placed on the relationship between price and quantity, rather than on the relationship between quantity and its other determinants. The answer is that we could indeed draw diagrams with quantity on the horizontal axis and a measure of one of these other influences on the vertical axis. But the price mechanism plays a very important role. Variations in price are what equilibrate the market. By focusing primarily upon the price, we see the self-correcting mechanism by which the market reacts to excess supply or excess demand.
In addition, this analysis illustrates the method of comparative statics—examining the impact of changing one of the other things that are assumed constant in the supply and demand diagrams.
Comparative static analysis compares an initial equilibrium with a new equilibrium, where the difference is due to a change in one of the other things that lie behind the demand curve or the supply curve.
'Comparative' obviously denotes the idea of a comparison, and static means that we are not in a state of motion. Hence we use these words in conjunction to indicate that we compare one outcome with another, without being concerned too much about the transition from an initial equilibrium to a new equilibrium. The transition would be concerned with dynamics rather than statics. In Figure 3.3 we explain the difference between the points E0 and E1 by indicating that there has been a change in incomes or in the price of a substitute good. We do not attempt to analyze the details of this move or the exact path from E0 to E1.
Application Box 3.1 Corn prices and demand shifts
In the middle of its second mandate, the Bush Administration in the US decided to encourage the production of ethanol – a fuel that is less polluting than gasoline. The target production was 35 billion for 2017 – from a base of 1 billion gallons in 2000. Corn is the principal input in ethanol production. It is also used as animal feed, as a sweetener and as a food for humans. The target was to be met with the help of a subsidy to producers and a tariff on imports of Brazil's sugar-cane based ethanol.
The impact on corn prices was immediate; from a farm-gate price of \$2 per bushel in 2005, the price reached the \$4 range two years later. In 2012 the price rose temporarily to \$7. While other factors were in play - growing incomes and possibly speculation by commodity investors, ethanol is seen as the main price driver: demand for corn increased and the supply could not be increased to keep up with the demand without an increase in price.
The wider impact of these developments was that the prices of virtually all grains increased in tandem with corn: the prices of sorghum and barley increased because of a switch in land use towards corn on account of its profitability.
While farmers benefited from the price rise, consumers – particularly those in less developed economies – experienced a dramatic increase in their basic living costs. Visit the site of the United Nations' Food and Agricultural Organization for an assessment. Since hitting \$7 per bushel in 2012, the price has dropped and averaged \$3.50 in 2016.
In terms of supply and demand shifts: the demand side has dominated, particularly in the short run. The ethanol drive, combined with secular growth in the demand for food, means that the demand for grains shifted outward faster than the supply. In the period 2013–2016, supply has increased and the price has moderated.
3.5 Non-price influences on supply
To date we have drawn supply curves with an upward slope. Is this a reasonable representation of supply in view of what is frequently observed in markets? We suggested earlier that the various producers of a particular good or service may have different levels of efficiency. If so, only the more efficient producers can make a profit at a low price, whereas at higher prices more producers or suppliers enter the market – producers who may not be as lean and efficient as those who can survive in a lower-price environment. This view of the world yields a positively-sloping supply curve.
As a second example, consider Uber or Lyft taxi drivers. Some drivers may be in serious need of income and may be willing to drive for a low hourly rate. For other individuals driving may be a secondary source of income, and such drivers are less likely to want to drive unless the hourly wage is higher. Consequently if these ride sharing services need a large number of drivers at any one time it may be necessary to pay a higher wage – and charge a higher fare to passengers, to induce more drivers to take their taxis onto the road. This phenomenon corresponds to a positively-sloped supply curve.
In contrast to these two examples, some suppliers simply choose a unique price and let buyers purchase as much as they want at that price. This is the practice of most retailers. For example, the price of Samsung's Galaxy is typically fixed, no matter how many are purchased – and tens of millions are sold at a fixed price when a new model is launched. Apple also sets a price, and buyers purchase as many as they desire at that price. This practice corresponds to a horizontal supply curve: The price does not vary and the market equilibrium occurs where the demand curve intersects this supply curve.
In yet other situations supply is fixed. This happens in auctions. Bidders at the auction simply determine the price to be paid. At a real estate auction a given property is put on the market and the price is determined by the bidding process. In this case the supply of a single property is represented by a vertical supply at a quantity of 1 unit.
Regardless of the type of market we encounter, however, it is safe to assume that supply curves rarely slope downward. So, for the moment, we adopt the stance that supply curves are generally upward sloping – somewhere between the extremes of being vertical or horizontal – as we have drawn them to this point.
Next, we examine those other influences that underlie supply curves. Technology, input costs, the prices of competing goods, expectations and the number of suppliers are the most important.
Technology – computers and fracking
A technological advance may involve an idea that allows more output to be produced with the same inputs, or an equal output with fewer inputs. A good example is just-in-time technology. Before the modern era, virtually all manufacturers kept large stocks of components in their production facilities, but developments in communications and computers at that time made it possible for manufacturers to link directly with their input suppliers. Nowadays auto assembly plants place their order for, say, seat delivery to their local seat supplier well ahead of assembly time. The seats swing into the assembly area hours or minutes before assembly—just in time. The result is that the assembler reduces her seat inventory (an input) and thereby reduces production cost.
Such a technology-induced cost saving is represented by moving the supply curve downward or outward: The supplier is now able and willing to supply the same quantity at a lower price because of the technological innovation. Or, saying the same thing slightly differently, suppliers will supply more at a given price than before.
A second example relates to the extraction of natural gas. The development of 'fracking' means that companies involved in gas recovery can now do so at a lower cost. Hence they are willing to supply any given quantity at a lower price. A third example concerns aluminum cans. Today they weigh a fraction of what they weighed 20 years ago. This is a technology-based cost saving.
Input costs
Input costs can vary independently of technology. For example, a wage negotiation that grants workers a substantial pay raise will increase the cost of production. This is reflected in a leftward, or upward, supply shift: Any quantity supplied is now priced higher; alternatively, suppliers are willing to supply less at the going price.
Production costs may increase as a result of higher required standards in production. As governments implement new safety or product-stress standards, costs may increase. In this instance the increase in costs is not a 'bad' outcome for the buyer. She may be purchasing a higher quality good as a result.
Competing products – Airbnb versus hotels
If competing products improve in quality or fall in price, a supplier may be forced to follow suit. For example, Asus and Dell are constantly watching each other's pricing policies. If Dell brings out a new generation of computers at a lower price, Asus may lower its prices in turn—which is to say that Asus' supply curve will shift downward. Likewise, Samsung and Apple each responds to the other's pricing and technology behaviours. The arrival of new products in the marketplace also impacts the willingness of suppliers to supply goods at a given price. New intermediaries such as Airbnb and Vacation Rentals by Owner have shifted the supply curves of hotel rooms downward.
These are some of the many factors that influence the position of the supply curve in a given market.
Application Box 3.2 The price of light
Technological developments have had a staggering impact on many price declines. Professor William Nordhaus of Yale University is an expert on measuring technological change. He has examined the trend in the real price of lighting. Originally, light was provided by whale oil and gas lamps and these sources of lumens (the scientific measure of the amount of light produced) were costly. In his research, Professor Nordhaus pieced together evidence on the actual historic cost of light produced at various times, going all the way back to 1800. He found that light in 1800 cost about 100 times more than in 1900, and light in the year 2000 was a fraction of its cost in 1900. A rough calculation suggests that light was five hundred times more expensive at the start of this 200-year period than at the end, and this was before the arrival of LEDs.
In terms of supply and demand analysis, light has been subject to very substantial downward supply shifts. Despite the long-term growth in demand, the technologically-induced supply changes have been the dominant factor in its price determination.
For further information, visit Professor Nordhaus's website in the Department of Economics at Yale University.
Shifts in supply
Whenever technology changes, or the costs of production change, or the prices of competing products adjust, then one of our ceteris paribus assumptions is violated. Such changes are generally reflected by shifting the supply curve. Figure 3.4 illustrates the impact of the arrival of just-in-time technology. The supply curve shifts, reflecting the ability of suppliers to supply the same output at a reduced price. The resulting new equilibrium price is lower, since production costs have fallen. At this reduced price more gas is traded at a lower price.
Figure 3.4 Supply shift and new equilibrium
The supply curve shifts due to lower production costs. A new equilibrium E1 is attained in the market at a lower price.
3.6 Simultaneous supply and demand impacts
In the real world, demand and supply frequently shift at the same time. We present such a case in Figure 3.5. It is based upon real estate data describing the housing market in a small Montreal municipality. Vertical curves define the supply side of the market. Such vertical curves mean that a given number of homeowners decide to put their homes on the market, and these suppliers just take whatever price results in the market. In this example, fewer houses were offered for sale in 2002 (less than 50) than in 1997 (more than 70). We are assuming in this market that the houses traded were similar; that is, we are not lumping together mansions with row houses.
During this time period household incomes increased substantially and, also, mortgage rates fell. Both of these developments shifted the demand curve upward/outward: Buyers were willing to pay more for housing in 2002 than in 1997, both because their incomes were on average higher and because they could borrow more cheaply.
The shifts on both sides of the market resulted in a higher average price. And each of these shifts compounded the other: The outward shift in demand would lead to a higher price on its own, and a reduction in supply would do likewise. Hence both forces acted to push up the price in 2002. If, instead, the supply had been greater in 2002 than in 1997 this would have acted to reduce the equilibrium price. And with the demand and supply shifts operating in opposing directions, it is not possible to say in general whether the price would increase or decrease. If the demand shift were strong and the supply shift weak then the demand forces would have dominated and led to a higher price. Conversely, if the supply forces were stronger than the demand forces.
Figure 3.5 A model of the housing market with shifts in demand and supply
The vertical supply denotes a fixed number of houses supplied each year. Demand was stronger in 2002 than in 1997 both on account of higher incomes and lower mortgage rates. Thus the higher price in 2002 is due to both a reduction in supply and an increase in demand.
3.7 Market interventions – governments and interest groups
The freely functioning markets that we have developed certainly do not describe all markets. For example, minimum wages characterize the labour market, most agricultural markets have supply restrictions, apartments are subject to rent controls, and blood is not a freely traded market commodity in Canada. In short, price controls and quotas characterize many markets. Price controls are government rules or laws that inhibit the formation of market-determined prices. Quotas are physical restrictions on how much output can be brought to the market.
Price controls are government rules or laws that inhibit the formation of market-determined prices.
Quotas are physical restrictions on output.
Price controls come in the form of either floors or ceilings. Price floors are frequently accompanied by marketing boards.
Price ceilings – rental boards
Ceilings mean that suppliers cannot legally charge more than a specific price. Limits on apartment rents are one form of ceiling. In times of emergency – such as flooding or famine, price controls are frequently imposed on foodstuffs, in conjunction with rationing, to ensure that access is not determined by who has the most income. The problem with price ceilings, however, is that they leave demand unsatisfied, and therefore they must be accompanied by some other allocation mechanism.
Consider an environment where, for some reason – perhaps a sudden and unanticipated growth in population – rents increase. Let the resulting equilibrium be defined by the point E0 in Figure 3.6. If the government were to decide that this is an unfair price because it places hardships on low- and middle-income households, it might impose a price limit, or ceiling, of Pc. The problem with such a limit is that excess demand results: Individuals want to rent more apartments than are available in the city. In a free market the price would adjust upward to eliminate the excess demand, but in this controlled environment it cannot. So some other way of allocating the available supply between demanders must evolve.
In reality, most apartments are allocated to those households already occupying them. But what happens when such a resident household decides to purchase a home or move to another city? In a free market, the landlord could increase the rent in accordance with market pressures. But in a controlled market a city's rental tribunal may restrict the annual rent increase to just a couple of percent and the demand may continue to outstrip supply. So how does the stock of apartments get allocated between the potential renters? One allocation method is well known: The existing tenant informs her friends of her plan to move, and the friends are the first to apply to the landlord to occupy the apartment. But that still leaves much unmet demand. If this is a student rental market, students whose parents live nearby may simply return 'home'. Others may chose to move to a part of the city where rents are more affordable.
Figure 3.6 The effect of a price ceiling
The free market equilibrium occurs at E0. A price ceiling at Pc holds down the price but leads to excess demand EcB, because Qc is the quantity traded. A price ceiling above P0 is irrelevant since the free market equilibrium E0 can still be attained.
However, rent controls sometimes yield undesirable outcomes. Rent controls are widely studied in economics, and the consequences are well understood: Landlords tend not to repair or maintain their rental units in good condition if they cannot obtain the rent they believe they are entitled to. Accordingly, the residential rental stock deteriorates. In addition, builders realize that more money is to be made in building condominium units than rental units, or in converting rental units to condominiums. The frequent consequence is thus a reduction in supply and a reduced quality. Market forces are hard to circumvent because, as we emphasized in Chapter 1, economic players react to the incentives they face. These outcomes are examples of what we call the law of unintended consequences.
Price floors – minimum wages
An effective price floor sets the price above the market-clearing price. A minimum wage is the most widespread example in the Canadian economy. Provinces each set their own minimum, and it is seen as a way of protecting the well-being of low-skill workers. Such a floor is illustrated in Figure 3.7. The free-market equilibrium is again E0, but the effective market outcome is the combination of price and quantity corresponding to the point Ef at the price floor, Pf. In this instance, there is excess supply equal to the amount EfC.
Figure 3.7 Price floor – minimum wage
In a free market the equilibrium is E0. A minimum wage of Pf raises the hourly wage, but reduces the hours demanded to Qf. Thus EfC is the excess supply.
Note that there is a similarity between the outcomes defined in the floor and ceiling cases: The quantity actually traded is the lesser of the supply quantity and demand quantity at the going price: The short side dominates.
If price floors, in the form of minimum wages, result in some workers going unemployed, why do governments choose to put them in place? The excess supply in this case corresponds to unemployment – more individuals are willing to work for the going wage than buyers (employers) wish to employ. The answer really depends upon the magnitude of the excess supply. In particular, suppose, in Figure 3.7 that the supply and demand curves going through the equilibrium E0 were more 'vertical'. This would result in a smaller excess supply than is represented with the existing supply and demand curves. This would mean in practice that a higher wage could go to workers, making them better off, without causing substantial unemployment. This is the trade off that governments face: With a view to increasing the purchasing power of generally lower-skill individuals, a minimum wage is set, hoping that the negative impact on employment will be small. We will return to this in the next chapter, where we examine the responsiveness of supply and demand curves to different prices.
Quotas – agricultural supply
A quota represents the right to supply a specified quantity of a good to the market. It is a means of keeping prices higher than the free-market equilibrium price. As an alternative to imposing a price floor, the government can generate a high price by restricting supply.
Agricultural markets abound with examples. In these markets, farmers can supply only what they are permitted by the quota they hold, and there is usually a market for these quotas. For example, in several Canadian provinces it currently costs in the region of \$30,000 to purchase a quota granting the right to sell the milk of one cow. The cost of purchasing quotas can thus easily outstrip the cost of a farm and herd. Canadian cheese importers must pay for the right to import cheese from abroad. Restrictions also apply to poultry. The impact of all of these restrictions is to raise the domestic price above the free market price.
In Figure 3.8, the free-market equilibrium is at E0. In order to raise the price above P0, the government restricts supply to Qq by granting quotas, which permit producers to supply a limited amount of the good in question. This supply is purchased at the price equal to Pq. From the standpoint of farmers, a higher price might be beneficial, even if they get to supply a smaller quantity, provided the amount of revenue they get as a result is as great as the revenue in the free market.
Figure 3.8 The effect of a quota
The government decides that the equilibrium price P0 is too low. It decides to boost price by reducing supply from Q0 to Qq. It achieves this by requiring producers to have a production quota. This is equivalent to fixing supply at Sq.
Marketing boards – milk and maple syrup
A marketing board is a means of insuring that a quota or price floor can be maintained. Quotas are frequent in the agriculture sector of the economy. One example is maple syrup in Quebec. The Federation of Maple Syrup Producers of Quebec has the sole right to market maple syrup. All producers must sell their syrup through this marketing board. The board thus has a particular type of power in the market: it has control of the market at the wholesale end, because it is a sole buyer. The Federation increases the total revenue going to producers by artificially restricting the supply to the market. The Federation calculates that by reducing supply and selling it at a higher price, more revenue will accrue to the producers. This is illustrated in Figure 3.8. The market equilibrium is given by E0, but the Federation restricts supply to the quantity Qq, which is sold to buyers at price Pq. To make this possible the total supply must be restricted; otherwise producers would supply the amount given by the point C on the supply curve, and this would result in excess supply in the amount EqC. In order to restrict supply to Qq in total, individual producers are limited in what they can sell to the Federation; they have a quota, which gives them the right to produce and sell no more than a specified amount. This system of quotas is necessary to eliminate the excess supply that would emerge at the above-equilibrium price Pq.
We will return to this topic in Chapter 4. For the moment, to see that this type of revenue-increasing outcome is possible, examine Table 3.1 again. At this equilibrium price of \$4 the quantity traded is 6 units, yielding a total expenditure by buyers (revenue to suppliers) of \$24. However, if the supply were restricted and a price of \$5 were set, the expenditure by buyers (revenue to suppliers) would rise to \$25.
3.8 Individual and market functions
Markets are made up of many individual participants on the demand and supply side. The supply and demand functions that we have worked with in this chapter are those for the total of all participants on each side of the market. But how do we arrive at such market functions when the economy is composed of individuals? We can illustrate how, with the help of Figure 3.9.
Figure 3.9 Summing individual demands
At P1 individual A purchases and B purchases . The total demand is the sum of these individual demands at this price (Q1). At P2 individual demands are summed to Q2. Since the points Q1 and Q2 define the demands of the market participants it follows that market demand is the horizontal sum of these curves.
To concentrate on the essentials, imagine that there are just two buyers of chocolate cookies in the economy. A has a stronger preference for cookies than B, so his demand is greater. To simplify, let the two demands have the same intercept on the vertical axis. The curves DA and DB indicate how many cookies A and B, respectively, will buy at each price. The market demand indicates how much they buy together at any price. Accordingly, at P1, A and B purchase the quantities and respectively. Thus . At a price P2, they purchase and . Thus . The market demand is therefore the horizontal sum of the individual demands at these prices. In the figure this is defined by .
Market demand: the horizontal sum of individual demands.
3.9 Useful techniques – demand and supply equations
The supply and demand functions, or equations, underlying Table 3.1 and Figure 3.2 can be written in their mathematical form:
A straight line is represented completely by the intercept and slope. In particular, if the variable P is on the vertical axis and Q on the horizontal axis, the straight-line equation relating P and Q is defined by P=a+bQ. Where the line is negatively sloped, as in the demand equation, the parameter b must take a negative value. By observing either the data in Table 3.1 or Figure 3.2 it is clear that the vertical intercept, a, takes a value of \$10. The vertical intercept corresponds to a zero-value for the Q variable. Next we can see from Figure 3.2 that the slope (given by the rise over the run) is 10/10 and hence has a value of –1. Accordingly the demand equation takes the form P=10–Q.
On the supply side the price-axis intercept, from either the figure or the table, is clearly 1. The slope is one half, because a two-unit change in quantity is associated with a one-unit change in price. This is a positive relationship obviously so the supply curve can be written as P=1+(1/2)Q.
Where the supply and demand curves intersect is the market equilibrium; that is, the price-quantity combination is the same for both supply and demand where the supply curve takes on the same values as the demand curve. This unique price-quantity combination is obtained by equating the two curves: If Demand=Supply, then
10–Q=1+(1/2)Q.
Gathering the terms involving Q to one side and the numerical terms to the other side of the equation results in 9=1.5Q. This implies that the equilibrium quantity must be 6 units. And this quantity must trade at a price of \$4. That is, when the price is \$4 both the quantity demanded and the quantity supplied take a value of 6 units.
Modelling market interventions using equations
To illustrate the impact of market interventions examined in Section 3.7 on our numerical market model for natural gas, suppose that the government imposes a minimum price of \$6 – above the equilibrium price obviously. We can easily determine the quantity supplied and demanded at such a price. Given the supply equation
P=1+(1/2)Q,
it follows that at P=6 the quantity supplied is 10. This follows by solving the relationship 6=1+(1/2)Q for the value of Q. Accordingly, suppliers would like to supply 10 units at this price.
Correspondingly on the demand side, given the demand curve
P=10–Q,
with a price given by , it must be the case that Q=4. So buyers would like to buy 4 units at that price: There is excess supply. But we know that the short side of the market will win out, and so the actual amount traded at this restricted price will be 4 units.
Conclusion
We have covered a lot of ground in this chapter. It is intended to open up the vista of economics to the new student in the discipline. Economics is powerful and challenging, and the ideas we have developed here will serve as conceptual foundations for our exploration of the subject. Our next chapter deals with measurement and responsiveness.
Key Terms
Demand is the quantity of a good or service that buyers wish to purchase at each possible price, with all other influences on demand remaining unchanged.
Supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged.
Quantity demanded defines the amount purchased at a particular price.
Quantity supplied refers to the amount supplied at a particular price.
Equilibrium price: equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.
Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.
Excess demand exists when the quantity demanded exceeds quantity supplied at the going price.
Short side of the market determines outcomes at prices other than the equilibrium.
Demand curve is a graphical expression of the relationship between price and quantity demanded, with other influences remaining unchanged.
Supply curve is a graphical expression of the relationship between price and quantity supplied, with other influences remaining unchanged.
Substitute goods: when a price reduction (rise) for a related product reduces (increases) the demand for a primary product, it is a substitute for the primary product.
Complementary goods: when a price reduction (rise) for a related product increases (reduces) the demand for a primary product, it is a complement for the primary product.
Inferior good is one whose demand falls in response to higher incomes.
Normal good is one whose demand increases in response to higher incomes.
Comparative static analysis compares an initial equilibrium with a new equilibrium, where the difference is due to a change in one of the other things that lie behind the demand curve or the supply curve.
Price controls are government rules or laws that inhibit the formation of market-determined prices.
Quotas are physical restrictions on output.
Market demand: the horizontal sum of individual demands.
Exercises for Chapter 3
EXERCISE 3.1
The supply and demand for concert tickets are given in the table below.
Price (\$) 0 4 8 12 16 20 24 28 32 36 40
Quantity demanded 15 14 13 12 11 10 9 8 7 6 5
Quantity supplied 0 0 0 0 0 1 3 5 7 9 11
1. Plot the supply and demand curves to scale and establish the equilibrium price and quantity.
2. What is the excess supply or demand when price is \$24? When price is \$36?
3. Describe the market adjustments in price induced by these two prices.
4. Optional: The functions underlying the example in the table are linear and can be presented as P=18+2Q (supply) and P=60–4Q (demand). Solve the two equations for the equilibrium price and quantity values.
EXERCISE 3.2
Illustrate in a supply/demand diagram, by shifting the demand curve appropriately, the effect on the demand for flights between Calgary and Winnipeg as a result of:
1. Increasing the annual government subsidy to Via Rail.
2. Improving the Trans-Canada highway between the two cities.
3. The arrival of a new budget airline on the scene.
EXERCISE 3.3
A new trend in US high schools is the widespread use of chewing tobacco. A recent survey indicates that 15 percent of males in upper grades now use it – a figure not far below the use rate for cigarettes. This development came about in response to the widespread implementation by schools of regulations that forbade cigarette smoking on and around school property. Draw a supply-demand equilibrium for each of the cigarette and chewing tobacco markets before and after the introduction of the regulations.
EXERCISE 3.4
The following table describes the demand and supply conditions for labour.
Price (\$) = wage rate 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170
Quantity demanded 1020 960 900 840 780 720 660 600 540 480 420 360 300 240 180 120 60 0
Quantity supplied 0 0 0 0 0 0 30 60 90 120 150 180 210 240 270 300 330 360
1. Graph the functions and find the equilibrium price and quantity by equating demand and supply.
2. Suppose a price ceiling is established by the government at a price of \$120. This price is below the equilibrium price that you have obtained in part (a). Calculate the amount that would be demanded and supplied and then calculate the excess demand.
EXERCISE 3.5
In Exercise 3.4, suppose that the supply and demand describe an agricultural market rather than a labour market, and the government implements a price floor of \$140. This is greater than the equilibrium price.
1. Estimate the quantity supplied and the quantity demanded at this price, and calculate the excess supply.
2. Suppose the government instead chose to maintain a price of \$140 by implementing a system of quotas. What quantity of quotas should the government make available to the suppliers?
EXERCISE 3.6
In Exercise 3.5, suppose that, at the minimum price, the government buys up all of the supply that is not demanded, and exports it at a price of \$80 per unit. Compute the cost to the government of this operation.
EXERCISE 3.7
Let us sum two demand curves to obtain a 'market' demand curve. We will suppose there are just two buyers in the market. Each of the individual demand curves has a price intercept of \$42. One has a quantity intercept of 126, the other 84.
1. Draw the demands either to scale or in an Excel spreadsheet, and label the intercepts on both the price and quantity axes.
2. Determine how much would be purchased in the market at prices \$10, \$20, and \$30.
3. Optional: Since you know the intercepts of the market (total) demand curve, can you write an equation for it?
EXERCISE 3.8
In Exercise 3.7 the demand curves had the same price intercept. Suppose instead that the first demand curve has a price intercept of \$36 and a quantity intercept of 126; the other individual has a demand curve defined by a price intercept of \$42 and a quantity intercept of 84. Graph these curves and illustrate the market demand curve.
EXERCISE 3.9
Here is an example of a demand curve that is not linear:
Price (\$) 4 3 2 1 0
Quantity demanded 25 100 225 400 625
1. Plot this demand curve to scale or in Excel.
2. If the supply function in this market is P=2, plot this function in the same diagram.
3. Determine the equilibrium quantity traded in this market.
EXERCISE 3.10
The football stadium of the University of the North West Territories has 30 seats. The demand curve for tickets has a price intercept of \$36 and a quantity intercept of 72.
1. Draw the supply and demand curves to scale in a graph or in Excel. (This demand curve has the form .)
2. Determine the equilibrium admission price, and the amount of revenue generated from ticket sales for each game.
3. A local alumnus and benefactor offers to install 6 more seats at no cost to the University. Compute the price that would be charged with this new supply and compute the revenue that would accrue at this new equilibrium price. Should the University accept the offer to install the seats?
4. Redo the previous part of this question, assuming that the initial number of seats is 40, and the University has the option to increase capacity to 46 at no cost to itself. Should the University accept the offer in this case?
EXERCISE 3.11
Suppose farm workers in Mexico are successful in obtaining a substantial wage increase. Illustrate the effect of this on the price of lettuce in the Canadian winter, using a supply and demand diagram, on the assumption that all lettuce in Canada is imported during its winter.
03: The classical marketplace demand and supply
The marketplace in today's economy has evolved from earlier times. It no longer has a unique form – one where buyers and sellers physically come together for the purpose of exchange. Indeed, supermarkets usually require individuals to be physically present to make their purchases. But when purchasing an airline ticket, individuals simply go online and interact with perhaps a number of different airlines (suppliers) simultaneously. Or again, individuals may simply give an instruction to their stock broker, who will execute a purchase on their behalf – the broker performs the role of a middleman, who may additionally give advice to the purchaser. Or a marketing agency may decide to subcontract work to a translator or graphic artist who resides in Mumbai. The advent of the coronavirus has shifted grocery purchases from in-store presence to home delivery for many buyers. In pure auctions (where a single work of art or a single residence is offered for sale) buyers compete one against the other for the single item supplied. Accommodations in private homes are supplied to potential visitors (buyers) through Airbnb. Taxi rides are mediated through Lyft or Uber. These institutions are all different types of markets; they serve the purpose of facilitating exchange and trade.
Not all goods and services in the modern economy are obtained through the marketplace. Schooling and health care are allocated in Canada primarily by government decree. In some instances the market plays a supporting role: Universities and colleges may levy fees, and most individuals must pay, at least in part, for their pharmaceuticals. In contrast, broadcasting services may carry a price of zero; Buzzfeed or other news and social media come free of payment. Furthermore, some markets have no price, yet they find a way of facilitating an exchange. For example, graduating medical students need to be matched with hospitals for their residencies. Matching mechanisms are a form of market in that they bring together suppliers and demanders. We explore their operation in Chapter 11.
The importance of the marketplace springs from its role as an allocating mechanism. Elevated prices effectively send a signal to suppliers that the buyers in the market place a high value on the product being traded; conversely when prices are low. Accordingly, suppliers may decide to cease supplying markets where prices do not remunerate them sufficiently, and redirect their energies and the productive resources under their control to other markets – markets where the product being traded is more highly valued, and where the buyer is willing to pay more.
Whatever their form, the marketplace is central to the economy we live in. Not only does it facilitate trade, it also provides a means of earning a livelihood. Suppliers must hire resources – human and non-human – in order to bring their supplies to market and these resources must be paid a return: income is generated.
In this chapter we will examine the process of price formation – how the prices that we observe in the marketplace come to be what they are. We will illustrate that the price for a good is inevitably linked to the quantity of a good; price and quantity are different sides of the same coin and cannot generally be analyzed separately. To understand this process more fully, we need to model a typical market. The essentials are demand and supply. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.01%3A_The_marketplace_-_trading.txt |
In economics we use the terminology that describes trade in a particular manner. Non-economists frequently describe microeconomics by saying "it's all about supply and demand". While this is largely true we need to define exactly what we mean by these two central words. Demand is the quantity of a good or service that buyers wish to purchase at each conceivable price, with all other influences on demand remaining unchanged. It reflects a multitude of values, not a single value. It is not a single or unique quantity such as two cell phones, but rather a full description of the quantity of a good or service that buyers would purchase at various prices.
Demand is the quantity of a good or service that buyers wish to purchase at each possible price, with all other influences on demand remaining unchanged.
As a hypothetical example, the first column of Table 3.1 shows the price of natural gas per cubic foot. The second column shows the quantity that would be purchased in a given time period at each price. It is therefore a schedule of quantities demanded at various prices. For example, at a price \$6 per unit, buyers would like to purchase 4 units, whereas at the lower price of \$3 buyers would like to purchase 7 units. Note also that this is a homogeneous good. A cubit foot of natural gas is considered to be the same product no matter which supplier brings it to the market. In contrast, accommodations supplied through Airbnb are heterogeneous – they vary in size and quality.
Table 3.1 Demand and supply for natural gas
Price (\$) Demand (thousands Supply (thousands Excess
of cu feet) of cu feet)
10 0 18 Excess Supply
9 1 16
8 2 14
7 3 12
6 4 10
5 5 8
4 6 6 Equilibrium
3 7 4 Excess Demand
2 8 2
1 9 0
0 10 0
Supply is interpreted in a similar manner. It is not a single value; we say that supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged. Such a supply schedule is defined in the third column of the table. It is assumed that no supplier can make a profit (on account of their costs) unless the price is at least \$2 per unit, and therefore a zero quantity is supplied below that price. The higher price is more profitable, and therefore induces a greater quantity supplied, perhaps by attracting more suppliers. This is reflected in the data. For example, at a price of \$3 suppliers are willing to supply 4 units, whereas with a price of \$7 they are willing to supply 12 units. There is thus a positive relationship between price and quantity for the supplier – a higher price induces a greater quantity; whereas on the demand side of the market a higher price induces a lower quantity demanded – a negative relationship.
Supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged.
We can now identify a key difference in terminology – between the words demand and quantity demanded, and between supply and quantity supplied. While the words demand and supply refer to the complete schedules of demand and supply, the terms quantity demanded and quantity supplied each define a single value of demand or supply at a particular price.
Quantity demanded defines the amount purchased at a particular price.
Quantity supplied refers to the amount supplied at a particular price.
Thus while the non-economist may say that when some fans did not get tickets to the Stanley Cup it was a case of demand exceeding supply, as economists we say that the quantity demanded exceeded the quantity supplied at the going price of tickets. In this instance, had every ticket been offered at a sufficiently high price, the market could have generated an excess supply rather than an excess demand. A higher ticket price would reduce the quantity demanded; yet would not change demand, because demand refers to the whole schedule of possible quantities demanded at different prices.
Other things equal – ceteris paribus
The demand and supply schedules rest on the assumption that all other influences on supply and demand remain the same as we move up and down the possible price values. The expression other things being equal, or its Latin counterpart ceteris paribus, describes this constancy of other influences. For example, we assume on the demand side that the prices of other goods remain constant, and that tastes and incomes are unchanging. On the supply side we assume, for example, that there is no technological change in production methods. If any of these elements change then the market supply or demand schedules will reflect such changes. For example, if coal or oil prices increase (decline) then some buyers may switch to (away from) gas or solar power. This will be reflected in the data: At any given price more (or less) will be demanded. We will illustrate this in graphic form presently.
Market equilibrium
Let us now bring the demand and supply schedules together in an attempt to analyze what the marketplace will produce – will a single price emerge that will equate supply and demand? We will keep other things constant for the moment, and explore what materializes at different prices. At low prices, the data in Table 3.1 indicate that the quantity demanded exceeds the quantity supplied – for example, verify what happens when the price is \$3 per unit. The opposite occurs when the price is high – what would happen if the price were \$8? Evidently, there exists an intermediate price, where the quantity demanded equals the quantity supplied. At this point we say that the market is in equilibrium. The equilibrium price equates demand and supply – it clears the market.
The equilibrium price equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.
In Table 3.1 the equilibrium price is \$4, and the equilibrium quantity is 6 thousand cubic feet of gas (we use the notation 'k' to denote thousands). At higher prices there is an excess supply—suppliers wish to sell more than buyers wish to buy. Conversely, at lower prices there is an excess demand. Only at the equilibrium price is the quantity supplied equal to the quantity demanded.
Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.
Excess demand exists when the quantity demanded exceeds the quantity supplied at the going price.
Does the market automatically reach equilibrium? To answer this question, suppose initially that the sellers choose a price of \$10. Here suppliers would like to supply 18k cubic feet, but there are no buyers—a situation of extreme excess supply. At the price of \$7 the excess supply is reduced to 9k, because both the quantity demanded is now higher at 3k units, and the quantity supplied is lower at 12k. But excess supply means that there are suppliers willing to supply at a lower price, and this willingness exerts continual downward pressure on any price above the price that equates demand and supply.
At prices below the equilibrium there is, conversely, an excess demand. In this situation, suppliers could force the price upward, knowing that buyers will continue to buy at a price at which the suppliers are willing to sell. Such upward pressure would continue until the excess demand is eliminated.
In general then, above the equilibrium price excess supply exerts downward pressure on price, and below the equilibrium excess demand exerts upward pressure on price. This process implies that the buyers and sellers have information on the various elements that make up the marketplace.
We will explore later in this chapter some specific circumstances in which trading could take place at prices above or below the equilibrium price. In such situations the quantity actually traded always corresponds to the short side of the market: this means that at high prices the quantity demanded is less than the quantity supplied, and it is the quantity demanded that is traded because buyers will not buy the amount suppliers would like to supply. Correspondingly, at low prices the quantity demanded exceeds quantity supplied, and it is the amount that suppliers are willing to sell that is traded. In sum, when trading takes place at prices other than the equilibrium price it is always the lesser of the quantity demanded or supplied that is traded. Hence we say that at non-equilibrium prices the short side dominates. We will return to this in a series of examples later in this chapter.
The short side of the market determines outcomes at prices other than the equilibrium.
Supply and the nature of costs
Before progressing to a graphical analysis, we should add a word about costs. The supply schedules are based primarily on the cost of producing the product in question, and we frequently assume that all of the costs associated with supply are incorporated in the supply schedules. In Chapter 6 we will explore cases where costs additional to those incurred by producers may be relevant. For example, coal burning power plants emit pollutants into the atmosphere; but the individual supplier may not take account of these pollutants, which are costs to society at large, in deciding how much to supply at different prices. Stated another way, the private costs of production would not reflect the total, or full social costs of production. Conversely, if some individuals immunize themselves against a rampant virus, other individuals gain from that action because they become less likely to contract the virus - the social value thus exceeds the private value. For the moment the assumption is that no such additional costs are associated with the markets we analyze. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.02%3A_The_market%27s_building_blocks.txt |
In economics we use the terminology that describes trade in a particular manner. Non-economists frequently describe microeconomics by saying "it's all about supply and demand". While this is largely true we need to define exactly what we mean by these two central words. Demand is the quantity of a good or service that buyers wish to purchase at each conceivable price, with all other influences on demand remaining unchanged. It reflects a multitude of values, not a single value. It is not a single or unique quantity such as two cell phones, but rather a full description of the quantity of a good or service that buyers would purchase at various prices.
Demand is the quantity of a good or service that buyers wish to purchase at each possible price, with all other influences on demand remaining unchanged.
As a hypothetical example, the first column of Table 3.1 shows the price of natural gas per cubic foot. The second column shows the quantity that would be purchased in a given time period at each price. It is therefore a schedule of quantities demanded at various prices. For example, at a price \$6 per unit, buyers would like to purchase 4 units, whereas at the lower price of \$3 buyers would like to purchase 7 units. Note also that this is a homogeneous good. A cubit foot of natural gas is considered to be the same product no matter which supplier brings it to the market. In contrast, accommodations supplied through Airbnb are heterogeneous – they vary in size and quality.
Table 3.1 Demand and supply for natural gas
Price (\$) Demand (thousands Supply (thousands Excess
of cu feet) of cu feet)
10 0 18 Excess Supply
9 1 16
8 2 14
7 3 12
6 4 10
5 5 8
4 6 6 Equilibrium
3 7 4 Excess Demand
2 8 2
1 9 0
0 10 0
Supply is interpreted in a similar manner. It is not a single value; we say that supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged. Such a supply schedule is defined in the third column of the table. It is assumed that no supplier can make a profit (on account of their costs) unless the price is at least \$2 per unit, and therefore a zero quantity is supplied below that price. The higher price is more profitable, and therefore induces a greater quantity supplied, perhaps by attracting more suppliers. This is reflected in the data. For example, at a price of \$3 suppliers are willing to supply 4 units, whereas with a price of \$7 they are willing to supply 12 units. There is thus a positive relationship between price and quantity for the supplier – a higher price induces a greater quantity; whereas on the demand side of the market a higher price induces a lower quantity demanded – a negative relationship.
Supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged.
We can now identify a key difference in terminology – between the words demand and quantity demanded, and between supply and quantity supplied. While the words demand and supply refer to the complete schedules of demand and supply, the terms quantity demanded and quantity supplied each define a single value of demand or supply at a particular price.
Quantity demanded defines the amount purchased at a particular price.
Quantity supplied refers to the amount supplied at a particular price.
Thus while the non-economist may say that when some fans did not get tickets to the Stanley Cup it was a case of demand exceeding supply, as economists we say that the quantity demanded exceeded the quantity supplied at the going price of tickets. In this instance, had every ticket been offered at a sufficiently high price, the market could have generated an excess supply rather than an excess demand. A higher ticket price would reduce the quantity demanded; yet would not change demand, because demand refers to the whole schedule of possible quantities demanded at different prices.
Other things equal – ceteris paribus
The demand and supply schedules rest on the assumption that all other influences on supply and demand remain the same as we move up and down the possible price values. The expression other things being equal, or its Latin counterpart ceteris paribus, describes this constancy of other influences. For example, we assume on the demand side that the prices of other goods remain constant, and that tastes and incomes are unchanging. On the supply side we assume, for example, that there is no technological change in production methods. If any of these elements change then the market supply or demand schedules will reflect such changes. For example, if coal or oil prices increase (decline) then some buyers may switch to (away from) gas or solar power. This will be reflected in the data: At any given price more (or less) will be demanded. We will illustrate this in graphic form presently.
Market equilibrium
Let us now bring the demand and supply schedules together in an attempt to analyze what the marketplace will produce – will a single price emerge that will equate supply and demand? We will keep other things constant for the moment, and explore what materializes at different prices. At low prices, the data in Table 3.1 indicate that the quantity demanded exceeds the quantity supplied – for example, verify what happens when the price is \$3 per unit. The opposite occurs when the price is high – what would happen if the price were \$8? Evidently, there exists an intermediate price, where the quantity demanded equals the quantity supplied. At this point we say that the market is in equilibrium. The equilibrium price equates demand and supply – it clears the market.
The equilibrium price equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.
In Table 3.1 the equilibrium price is \$4, and the equilibrium quantity is 6 thousand cubic feet of gas (we use the notation 'k' to denote thousands). At higher prices there is an excess supply—suppliers wish to sell more than buyers wish to buy. Conversely, at lower prices there is an excess demand. Only at the equilibrium price is the quantity supplied equal to the quantity demanded.
Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.
Excess demand exists when the quantity demanded exceeds the quantity supplied at the going price.
Does the market automatically reach equilibrium? To answer this question, suppose initially that the sellers choose a price of \$10. Here suppliers would like to supply 18k cubic feet, but there are no buyers—a situation of extreme excess supply. At the price of \$7 the excess supply is reduced to 9k, because both the quantity demanded is now higher at 3k units, and the quantity supplied is lower at 12k. But excess supply means that there are suppliers willing to supply at a lower price, and this willingness exerts continual downward pressure on any price above the price that equates demand and supply.
At prices below the equilibrium there is, conversely, an excess demand. In this situation, suppliers could force the price upward, knowing that buyers will continue to buy at a price at which the suppliers are willing to sell. Such upward pressure would continue until the excess demand is eliminated.
In general then, above the equilibrium price excess supply exerts downward pressure on price, and below the equilibrium excess demand exerts upward pressure on price. This process implies that the buyers and sellers have information on the various elements that make up the marketplace.
We will explore later in this chapter some specific circumstances in which trading could take place at prices above or below the equilibrium price. In such situations the quantity actually traded always corresponds to the short side of the market: this means that at high prices the quantity demanded is less than the quantity supplied, and it is the quantity demanded that is traded because buyers will not buy the amount suppliers would like to supply. Correspondingly, at low prices the quantity demanded exceeds quantity supplied, and it is the amount that suppliers are willing to sell that is traded. In sum, when trading takes place at prices other than the equilibrium price it is always the lesser of the quantity demanded or supplied that is traded. Hence we say that at non-equilibrium prices the short side dominates. We will return to this in a series of examples later in this chapter.
The short side of the market determines outcomes at prices other than the equilibrium.
Supply and the nature of costs
Before progressing to a graphical analysis, we should add a word about costs. The supply schedules are based primarily on the cost of producing the product in question, and we frequently assume that all of the costs associated with supply are incorporated in the supply schedules. In Chapter 6 we will explore cases where costs additional to those incurred by producers may be relevant. For example, coal burning power plants emit pollutants into the atmosphere; but the individual supplier may not take account of these pollutants, which are costs to society at large, in deciding how much to supply at different prices. Stated another way, the private costs of production would not reflect the total, or full social costs of production. Conversely, if some individuals immunize themselves against a rampant virus, other individuals gain from that action because they become less likely to contract the virus - the social value thus exceeds the private value. For the moment the assumption is that no such additional costs are associated with the markets we analyze.
3.03: Demand and supply curves
The demand curve is a graphical expression of the relationship between price and quantity demanded, holding other things constant. Figure 3.1 measures price on the vertical axis and quantity on the horizontal axis. The curve D represents the data from the first two columns of Table 3.1. Each combination of price and quantity demanded lies on the curve. In this case the curve is linear—it is a straight line. The demand curve slopes downward (technically we say that its slope is negative), reflecting the fact that buyers wish to purchase more when the price is less.
Figure 3.1 Measuring price & quantity
To derive this demand curve we take each price-quantity combination from the demand schedule in Table 3.1 and insert a point that corresponds to those combinations. For example, point h defines the combination , the point l denotes the combination . If we join all such points we obtain the demand curve in Figure 3.2.The same process yields the supply curve in Figure 3.2. In this example the supply and the demand curves are each linear. There is no reason why this linear property characterizes demand and supply curves in the real world; they are frequently found to have curvature. But straight lines are easier to work with, so we continue with them for the moment.
The demand curve is a graphical expression of the relationship between price and quantity demanded, with other influences remaining unchanged.
The supply curve is a graphical representation of the relationship between price and quantity supplied, holding other things constant. The supply curve S in Figure 3.2 is based on the data from columns 1 and 3 in Table 3.1. It has a positive slope indicating that suppliers wish to supply more at higher prices.
The supply curve is a graphical expression of the relationship between price and quantity supplied, with other influences remaining unchanged.
Figure 3.2 Supply, demand, equilibrium
The demand and supply curves intersect at point E0, corresponding to a price of \$4 which, as illustrated above, is the equilibrium price for this market. At any price below this the horizontal distance between the supply and demand curves represents excess demand, because demand exceeds supply. Conversely, at any price above \$4 there is an excess supply that is again measured by the horizontal distance between the two curves. Market forces tend to eliminate excess demand and excess supply as we explained above. In the final section of the chapter we illustrate how the supply and demand curves can be 'solved' for the equilibrium price and quantity. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.02%3A_The_market's_building_blocks.txt |
We have emphasized several times the importance of the ceteris paribus assumption when exploring the impact of different prices on the quantity demanded: We assume all other influences on the purchase decision are unchanged (at least momentarily). These other influences fall into several broad categories: The prices of related goods; the incomes of buyers; buyer tastes; and expectations about the future. Before proceeding, note that we are dealing with market demand rather than demand by one individual (the precise relationship between the two is developed later in this chapter).
The prices of related goods – oil and gas, Kindle and paperbacks
We expect that the price of other forms of energy would impact the price of natural gas. For example, if hydro-electricity, oil or solar becomes less expensive we would expect some buyers to switch to these other products. Alternatively, if gas-burning furnaces experience a technological breakthrough that makes them more efficient and cheaper we would expect some users of other fuels to move to gas. Among these examples, oil and electricity are substitute fuels for gas; in contrast a more fuel-efficient new gas furnace complements the use of gas. We use these terms, substitutes and complements, to describe products that influence the demand for the primary good.
Substitute goods: when a price reduction (rise) for a related product reduces (increases) the demand for a primary product, it is a substitute for the primary product.
Complementary goods: when a price reduction (rise) for a related product increases (reduces) the demand for a primary product, it is a complement for the primary product.
Clearly electricity is a substitute for gas in the power market, whereas a gas furnace is a complement for gas as a fuel. The words substitutes and complements immediately suggest the nature of the relationships. Every product has complements and substitutes. As another example: Electronic readers and tablets are substitutes for paper-form books; a rise in the price of paper books should increase the demand for electronic readers at any given price for electronic readers. In graphical terms, the demand curve shifts in response to changes in the prices of other goods – an increase in the price of paper-form books shifts the demand for electronic readers outward, because more electronic readers will be demanded at any price.
Buyer incomes – which goods to buy
The demand for most goods increases in response to income growth. Given this, the demand curve for gas will shift outward if household incomes in the economy increase. Household incomes may increase either because there are more households in the economy or because the incomes of the existing households grow.
Most goods are demanded in greater quantity in response to higher incomes at any given price. But there are exceptions. For example, public transit demand may decline at any price when household incomes rise, because some individuals move to cars. Or the demand for laundromats may decline in response to higher incomes, as households purchase more of their own consumer durables – washers and driers. We use the term inferior good to define these cases: An inferior good is one whose demand declines in response to increasing incomes, whereas a normal good experiences an increase in demand in response to rising incomes.
An inferior good is one whose demand falls in response to higher incomes.
A normal good is one whose demand increases in response to higher incomes.
There is a further sense in which consumer incomes influence demand, and this relates to how the incomes are distributed in the economy. In the discussion above we stated that higher total incomes shift demand curves outwards when goods are normal. But think of the difference in the demand for electronic readers between Portugal and Saudi Arabia. These economies have roughly the same average per-person income, but incomes are distributed more unequally in Saudi Arabia. It does not have a large middle class that can afford electronic readers or iPads, despite the huge wealth held by the elite. In contrast, Portugal has a relatively larger middle class that can afford such goods. Consequently, the distribution of income can be an important determinant of the demand for many commodities and services.
Tastes and networks – hemlines, lapels and homogeneity
While demand functions are drawn on the assumption that tastes are constant, in an evolving world they are not. We are all subject to peer pressure, the fashion industry, marketing, and a desire to maintain our image. If the fashion industry dictates that lapels on men's suits or long skirts are de rigueur for the coming season, some fashion-conscious individuals will discard a large segment of their wardrobe, even though the clothes may be in perfectly good condition: Their demand is influenced by the dictates of current fashion.
Correspondingly, the items that other individuals buy or use frequently determine our own purchases. Businesses frequently decide that all of their employees will have the same type of computer and software on account of network economies: It is easier to communicate if equipment is compatible, and it is less costly to maintain infrastructure where the variety is less.
Expectations – betting on the future
In our natural gas example, if households expected that the price of natural gas was going to stay relatively low for many years – perhaps on account of the discovery of large deposits – then they would be tempted to purchase a gas burning furnace rather than one based upon an alternative fuel. In this example, it is more than the current price that determines choices; the prices that are expected to prevail in the future also determine current demand.
Expectations are particularly important in stock markets. When investors anticipate that corporations will earn high rewards in the future they will buy a stock today. If enough people believe this, the price of the stock will be driven upward on the market, even before profitable earnings are registered.
Shifts in demand
The demand curve in Figure 3.2 is drawn for a given level of other prices, incomes, tastes, and expectations. Movements along the demand curve reflect solely the impact of different prices for the good in question, holding other influences constant. But changes in any of these other factors will change the position of the demand curve. Figure 3.3 illustrates a shift in the demand curve. This shift could result from a rise in household incomes that increase the quantity demanded at every price. This is illustrated by an outward shift in the demand curve. With supply conditions unchanged, there is a new equilibrium at , indicating a greater quantity of purchases accompanied by a higher price. The new equilibrium reflects a change in quantity supplied and a change in demand.
Figure 3.3 Demand shift and new equilibrium
The outward shift in demand leads to a new equilibrium E1.
We may well ask why so much emphasis in our diagrams and analysis is placed on the relationship between price and quantity, rather than on the relationship between quantity and its other determinants. The answer is that we could indeed draw diagrams with quantity on the horizontal axis and a measure of one of these other influences on the vertical axis. But the price mechanism plays a very important role. Variations in price are what equilibrate the market. By focusing primarily upon the price, we see the self-correcting mechanism by which the market reacts to excess supply or excess demand.
In addition, this analysis illustrates the method of comparative statics—examining the impact of changing one of the other things that are assumed constant in the supply and demand diagrams.
Comparative static analysis compares an initial equilibrium with a new equilibrium, where the difference is due to a change in one of the other things that lie behind the demand curve or the supply curve.
'Comparative' obviously denotes the idea of a comparison, and static means that we are not in a state of motion. Hence we use these words in conjunction to indicate that we compare one outcome with another, without being concerned too much about the transition from an initial equilibrium to a new equilibrium. The transition would be concerned with dynamics rather than statics. In Figure 3.3 we explain the difference between the points E0 and E1 by indicating that there has been a change in incomes or in the price of a substitute good. We do not attempt to analyze the details of this move or the exact path from E0 to E1.
Application Box 3.1 Corn prices and demand shifts
In the middle of its second mandate, the Bush Administration in the US decided to encourage the production of ethanol – a fuel that is less polluting than gasoline. The target production was 35 billion for 2017 – from a base of 1 billion gallons in 2000. Corn is the principal input in ethanol production. It is also used as animal feed, as a sweetener and as a food for humans. The target was to be met with the help of a subsidy to producers and a tariff on imports of Brazil's sugar-cane based ethanol.
The impact on corn prices was immediate; from a farm-gate price of \$2 per bushel in 2005, the price reached the \$4 range two years later. In 2012 the price rose temporarily to \$7. While other factors were in play - growing incomes and possibly speculation by commodity investors, ethanol is seen as the main price driver: demand for corn increased and the supply could not be increased to keep up with the demand without an increase in price.
The wider impact of these developments was that the prices of virtually all grains increased in tandem with corn: the prices of sorghum and barley increased because of a switch in land use towards corn on account of its profitability.
While farmers benefited from the price rise, consumers – particularly those in less developed economies – experienced a dramatic increase in their basic living costs. Visit the site of the United Nations' Food and Agricultural Organization for an assessment. Since hitting \$7 per bushel in 2012, the price has dropped and averaged \$3.50 in 2016.
In terms of supply and demand shifts: the demand side has dominated, particularly in the short run. The ethanol drive, combined with secular growth in the demand for food, means that the demand for grains shifted outward faster than the supply. In the period 2013–2016, supply has increased and the price has moderated. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.04%3A_Non-price_influences_on_demand.txt |
To date we have drawn supply curves with an upward slope. Is this a reasonable representation of supply in view of what is frequently observed in markets? We suggested earlier that the various producers of a particular good or service may have different levels of efficiency. If so, only the more efficient producers can make a profit at a low price, whereas at higher prices more producers or suppliers enter the market – producers who may not be as lean and efficient as those who can survive in a lower-price environment. This view of the world yields a positively-sloping supply curve.
As a second example, consider Uber or Lyft taxi drivers. Some drivers may be in serious need of income and may be willing to drive for a low hourly rate. For other individuals driving may be a secondary source of income, and such drivers are less likely to want to drive unless the hourly wage is higher. Consequently if these ride sharing services need a large number of drivers at any one time it may be necessary to pay a higher wage – and charge a higher fare to passengers, to induce more drivers to take their taxis onto the road. This phenomenon corresponds to a positively-sloped supply curve.
In contrast to these two examples, some suppliers simply choose a unique price and let buyers purchase as much as they want at that price. This is the practice of most retailers. For example, the price of Samsung's Galaxy is typically fixed, no matter how many are purchased – and tens of millions are sold at a fixed price when a new model is launched. Apple also sets a price, and buyers purchase as many as they desire at that price. This practice corresponds to a horizontal supply curve: The price does not vary and the market equilibrium occurs where the demand curve intersects this supply curve.
In yet other situations supply is fixed. This happens in auctions. Bidders at the auction simply determine the price to be paid. At a real estate auction a given property is put on the market and the price is determined by the bidding process. In this case the supply of a single property is represented by a vertical supply at a quantity of 1 unit.
Regardless of the type of market we encounter, however, it is safe to assume that supply curves rarely slope downward. So, for the moment, we adopt the stance that supply curves are generally upward sloping – somewhere between the extremes of being vertical or horizontal – as we have drawn them to this point.
Next, we examine those other influences that underlie supply curves. Technology, input costs, the prices of competing goods, expectations and the number of suppliers are the most important.
Technology – computers and fracking
A technological advance may involve an idea that allows more output to be produced with the same inputs, or an equal output with fewer inputs. A good example is just-in-time technology. Before the modern era, virtually all manufacturers kept large stocks of components in their production facilities, but developments in communications and computers at that time made it possible for manufacturers to link directly with their input suppliers. Nowadays auto assembly plants place their order for, say, seat delivery to their local seat supplier well ahead of assembly time. The seats swing into the assembly area hours or minutes before assembly—just in time. The result is that the assembler reduces her seat inventory (an input) and thereby reduces production cost.
Such a technology-induced cost saving is represented by moving the supply curve downward or outward: The supplier is now able and willing to supply the same quantity at a lower price because of the technological innovation. Or, saying the same thing slightly differently, suppliers will supply more at a given price than before.
A second example relates to the extraction of natural gas. The development of 'fracking' means that companies involved in gas recovery can now do so at a lower cost. Hence they are willing to supply any given quantity at a lower price. A third example concerns aluminum cans. Today they weigh a fraction of what they weighed 20 years ago. This is a technology-based cost saving.
Input costs
Input costs can vary independently of technology. For example, a wage negotiation that grants workers a substantial pay raise will increase the cost of production. This is reflected in a leftward, or upward, supply shift: Any quantity supplied is now priced higher; alternatively, suppliers are willing to supply less at the going price.
Production costs may increase as a result of higher required standards in production. As governments implement new safety or product-stress standards, costs may increase. In this instance the increase in costs is not a 'bad' outcome for the buyer. She may be purchasing a higher quality good as a result.
Competing products – Airbnb versus hotels
If competing products improve in quality or fall in price, a supplier may be forced to follow suit. For example, Asus and Dell are constantly watching each other's pricing policies. If Dell brings out a new generation of computers at a lower price, Asus may lower its prices in turn—which is to say that Asus' supply curve will shift downward. Likewise, Samsung and Apple each responds to the other's pricing and technology behaviours. The arrival of new products in the marketplace also impacts the willingness of suppliers to supply goods at a given price. New intermediaries such as Airbnb and Vacation Rentals by Owner have shifted the supply curves of hotel rooms downward.
These are some of the many factors that influence the position of the supply curve in a given market.
Application Box 3.2 The price of light
Technological developments have had a staggering impact on many price declines. Professor William Nordhaus of Yale University is an expert on measuring technological change. He has examined the trend in the real price of lighting. Originally, light was provided by whale oil and gas lamps and these sources of lumens (the scientific measure of the amount of light produced) were costly. In his research, Professor Nordhaus pieced together evidence on the actual historic cost of light produced at various times, going all the way back to 1800. He found that light in 1800 cost about 100 times more than in 1900, and light in the year 2000 was a fraction of its cost in 1900. A rough calculation suggests that light was five hundred times more expensive at the start of this 200-year period than at the end, and this was before the arrival of LEDs.
In terms of supply and demand analysis, light has been subject to very substantial downward supply shifts. Despite the long-term growth in demand, the technologically-induced supply changes have been the dominant factor in its price determination.
For further information, visit Professor Nordhaus's website in the Department of Economics at Yale University.
Shifts in supply
Whenever technology changes, or the costs of production change, or the prices of competing products adjust, then one of our ceteris paribus assumptions is violated. Such changes are generally reflected by shifting the supply curve. Figure 3.4 illustrates the impact of the arrival of just-in-time technology. The supply curve shifts, reflecting the ability of suppliers to supply the same output at a reduced price. The resulting new equilibrium price is lower, since production costs have fallen. At this reduced price more gas is traded at a lower price.
Figure 3.4 Supply shift and new equilibrium
The supply curve shifts due to lower production costs. A new equilibrium E1 is attained in the market at a lower price.
3.06: Simultaneous supply and demand impacts
In the real world, demand and supply frequently shift at the same time. We present such a case in Figure 3.5. It is based upon real estate data describing the housing market in a small Montreal municipality. Vertical curves define the supply side of the market. Such vertical curves mean that a given number of homeowners decide to put their homes on the market, and these suppliers just take whatever price results in the market. In this example, fewer houses were offered for sale in 2002 (less than 50) than in 1997 (more than 70). We are assuming in this market that the houses traded were similar; that is, we are not lumping together mansions with row houses.
During this time period household incomes increased substantially and, also, mortgage rates fell. Both of these developments shifted the demand curve upward/outward: Buyers were willing to pay more for housing in 2002 than in 1997, both because their incomes were on average higher and because they could borrow more cheaply.
The shifts on both sides of the market resulted in a higher average price. And each of these shifts compounded the other: The outward shift in demand would lead to a higher price on its own, and a reduction in supply would do likewise. Hence both forces acted to push up the price in 2002. If, instead, the supply had been greater in 2002 than in 1997 this would have acted to reduce the equilibrium price. And with the demand and supply shifts operating in opposing directions, it is not possible to say in general whether the price would increase or decrease. If the demand shift were strong and the supply shift weak then the demand forces would have dominated and led to a higher price. Conversely, if the supply forces were stronger than the demand forces.
Figure 3.5 A model of the housing market with shifts in demand and supply
The vertical supply denotes a fixed number of houses supplied each year. Demand was stronger in 2002 than in 1997 both on account of higher incomes and lower mortgage rates. Thus the higher price in 2002 is due to both a reduction in supply and an increase in demand. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.05%3A_Non-price_influences_on_supply.txt |
The freely functioning markets that we have developed certainly do not describe all markets. For example, minimum wages characterize the labour market, most agricultural markets have supply restrictions, apartments are subject to rent controls, and blood is not a freely traded market commodity in Canada. In short, price controls and quotas characterize many markets. Price controls are government rules or laws that inhibit the formation of market-determined prices. Quotas are physical restrictions on how much output can be brought to the market.
Price controls are government rules or laws that inhibit the formation of market-determined prices.
Quotas are physical restrictions on output.
Price controls come in the form of either floors or ceilings. Price floors are frequently accompanied by marketing boards.
Price ceilings – rental boards
Ceilings mean that suppliers cannot legally charge more than a specific price. Limits on apartment rents are one form of ceiling. In times of emergency – such as flooding or famine, price controls are frequently imposed on foodstuffs, in conjunction with rationing, to ensure that access is not determined by who has the most income. The problem with price ceilings, however, is that they leave demand unsatisfied, and therefore they must be accompanied by some other allocation mechanism.
Consider an environment where, for some reason – perhaps a sudden and unanticipated growth in population – rents increase. Let the resulting equilibrium be defined by the point E0 in Figure 3.6. If the government were to decide that this is an unfair price because it places hardships on low- and middle-income households, it might impose a price limit, or ceiling, of Pc. The problem with such a limit is that excess demand results: Individuals want to rent more apartments than are available in the city. In a free market the price would adjust upward to eliminate the excess demand, but in this controlled environment it cannot. So some other way of allocating the available supply between demanders must evolve.
In reality, most apartments are allocated to those households already occupying them. But what happens when such a resident household decides to purchase a home or move to another city? In a free market, the landlord could increase the rent in accordance with market pressures. But in a controlled market a city's rental tribunal may restrict the annual rent increase to just a couple of percent and the demand may continue to outstrip supply. So how does the stock of apartments get allocated between the potential renters? One allocation method is well known: The existing tenant informs her friends of her plan to move, and the friends are the first to apply to the landlord to occupy the apartment. But that still leaves much unmet demand. If this is a student rental market, students whose parents live nearby may simply return 'home'. Others may chose to move to a part of the city where rents are more affordable.
Figure 3.6 The effect of a price ceiling
The free market equilibrium occurs at E0. A price ceiling at Pc holds down the price but leads to excess demand EcB, because Qc is the quantity traded. A price ceiling above P0 is irrelevant since the free market equilibrium E0 can still be attained.
However, rent controls sometimes yield undesirable outcomes. Rent controls are widely studied in economics, and the consequences are well understood: Landlords tend not to repair or maintain their rental units in good condition if they cannot obtain the rent they believe they are entitled to. Accordingly, the residential rental stock deteriorates. In addition, builders realize that more money is to be made in building condominium units than rental units, or in converting rental units to condominiums. The frequent consequence is thus a reduction in supply and a reduced quality. Market forces are hard to circumvent because, as we emphasized in Chapter 1, economic players react to the incentives they face. These outcomes are examples of what we call the law of unintended consequences.
Price floors – minimum wages
An effective price floor sets the price above the market-clearing price. A minimum wage is the most widespread example in the Canadian economy. Provinces each set their own minimum, and it is seen as a way of protecting the well-being of low-skill workers. Such a floor is illustrated in Figure 3.7. The free-market equilibrium is again E0, but the effective market outcome is the combination of price and quantity corresponding to the point Ef at the price floor, Pf. In this instance, there is excess supply equal to the amount EfC.
Figure 3.7 Price floor – minimum wage
In a free market the equilibrium is E0. A minimum wage of Pf raises the hourly wage, but reduces the hours demanded to Qf. Thus EfC is the excess supply.
Note that there is a similarity between the outcomes defined in the floor and ceiling cases: The quantity actually traded is the lesser of the supply quantity and demand quantity at the going price: The short side dominates.
If price floors, in the form of minimum wages, result in some workers going unemployed, why do governments choose to put them in place? The excess supply in this case corresponds to unemployment – more individuals are willing to work for the going wage than buyers (employers) wish to employ. The answer really depends upon the magnitude of the excess supply. In particular, suppose, in Figure 3.7 that the supply and demand curves going through the equilibrium E0 were more 'vertical'. This would result in a smaller excess supply than is represented with the existing supply and demand curves. This would mean in practice that a higher wage could go to workers, making them better off, without causing substantial unemployment. This is the trade off that governments face: With a view to increasing the purchasing power of generally lower-skill individuals, a minimum wage is set, hoping that the negative impact on employment will be small. We will return to this in the next chapter, where we examine the responsiveness of supply and demand curves to different prices.
Quotas – agricultural supply
A quota represents the right to supply a specified quantity of a good to the market. It is a means of keeping prices higher than the free-market equilibrium price. As an alternative to imposing a price floor, the government can generate a high price by restricting supply.
Agricultural markets abound with examples. In these markets, farmers can supply only what they are permitted by the quota they hold, and there is usually a market for these quotas. For example, in several Canadian provinces it currently costs in the region of \$30,000 to purchase a quota granting the right to sell the milk of one cow. The cost of purchasing quotas can thus easily outstrip the cost of a farm and herd. Canadian cheese importers must pay for the right to import cheese from abroad. Restrictions also apply to poultry. The impact of all of these restrictions is to raise the domestic price above the free market price.
In Figure 3.8, the free-market equilibrium is at E0. In order to raise the price above P0, the government restricts supply to Qq by granting quotas, which permit producers to supply a limited amount of the good in question. This supply is purchased at the price equal to Pq. From the standpoint of farmers, a higher price might be beneficial, even if they get to supply a smaller quantity, provided the amount of revenue they get as a result is as great as the revenue in the free market.
Figure 3.8 The effect of a quota
The government decides that the equilibrium price P0 is too low. It decides to boost price by reducing supply from Q0 to Qq. It achieves this by requiring producers to have a production quota. This is equivalent to fixing supply at Sq.
Marketing boards – milk and maple syrup
A marketing board is a means of insuring that a quota or price floor can be maintained. Quotas are frequent in the agriculture sector of the economy. One example is maple syrup in Quebec. The Federation of Maple Syrup Producers of Quebec has the sole right to market maple syrup. All producers must sell their syrup through this marketing board. The board thus has a particular type of power in the market: it has control of the market at the wholesale end, because it is a sole buyer. The Federation increases the total revenue going to producers by artificially restricting the supply to the market. The Federation calculates that by reducing supply and selling it at a higher price, more revenue will accrue to the producers. This is illustrated in Figure 3.8. The market equilibrium is given by E0, but the Federation restricts supply to the quantity Qq, which is sold to buyers at price Pq. To make this possible the total supply must be restricted; otherwise producers would supply the amount given by the point C on the supply curve, and this would result in excess supply in the amount EqC. In order to restrict supply to Qq in total, individual producers are limited in what they can sell to the Federation; they have a quota, which gives them the right to produce and sell no more than a specified amount. This system of quotas is necessary to eliminate the excess supply that would emerge at the above-equilibrium price Pq.
We will return to this topic in Chapter 4. For the moment, to see that this type of revenue-increasing outcome is possible, examine Table 3.1 again. At this equilibrium price of \$4 the quantity traded is 6 units, yielding a total expenditure by buyers (revenue to suppliers) of \$24. However, if the supply were restricted and a price of \$5 were set, the expenditure by buyers (revenue to suppliers) would rise to \$25. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.07%3A_Market_interventions_-_governments_and_interest_groups.txt |
Markets are made up of many individual participants on the demand and supply side. The supply and demand functions that we have worked with in this chapter are those for the total of all participants on each side of the market. But how do we arrive at such market functions when the economy is composed of individuals? We can illustrate how, with the help of Figure 3.9.
Figure 3.9 Summing individual demands
At P1 individual A purchases and B purchases . The total demand is the sum of these individual demands at this price (Q1). At P2 individual demands are summed to Q2. Since the points Q1 and Q2 define the demands of the market participants it follows that market demand is the horizontal sum of these curves.
To concentrate on the essentials, imagine that there are just two buyers of chocolate cookies in the economy. A has a stronger preference for cookies than B, so his demand is greater. To simplify, let the two demands have the same intercept on the vertical axis. The curves DA and DB indicate how many cookies A and B, respectively, will buy at each price. The market demand indicates how much they buy together at any price. Accordingly, at P1, A and B purchase the quantities and respectively. Thus . At a price P2, they purchase and . Thus . The market demand is therefore the horizontal sum of the individual demands at these prices. In the figure this is defined by .
Market demand: the horizontal sum of individual demands.
3.09: Useful techniques - demand and supply equations
The supply and demand functions, or equations, underlying Table 3.1 and Figure 3.2 can be written in their mathematical form:
A straight line is represented completely by the intercept and slope. In particular, if the variable P is on the vertical axis and Q on the horizontal axis, the straight-line equation relating P and Q is defined by P=a+bQ. Where the line is negatively sloped, as in the demand equation, the parameter b must take a negative value. By observing either the data in Table 3.1 or Figure 3.2 it is clear that the vertical intercept, a, takes a value of \$10. The vertical intercept corresponds to a zero-value for the Q variable. Next we can see from Figure 3.2 that the slope (given by the rise over the run) is 10/10 and hence has a value of –1. Accordingly the demand equation takes the form P=10–Q.
On the supply side the price-axis intercept, from either the figure or the table, is clearly 1. The slope is one half, because a two-unit change in quantity is associated with a one-unit change in price. This is a positive relationship obviously so the supply curve can be written as P=1+(1/2)Q.
Where the supply and demand curves intersect is the market equilibrium; that is, the price-quantity combination is the same for both supply and demand where the supply curve takes on the same values as the demand curve. This unique price-quantity combination is obtained by equating the two curves: If Demand=Supply, then
10–Q=1+(1/2)Q.
Gathering the terms involving Q to one side and the numerical terms to the other side of the equation results in 9=1.5Q. This implies that the equilibrium quantity must be 6 units. And this quantity must trade at a price of \$4. That is, when the price is \$4 both the quantity demanded and the quantity supplied take a value of 6 units.
Modelling market interventions using equations
To illustrate the impact of market interventions examined in Section 3.7 on our numerical market model for natural gas, suppose that the government imposes a minimum price of \$6 – above the equilibrium price obviously. We can easily determine the quantity supplied and demanded at such a price. Given the supply equation
P=1+(1/2)Q,
it follows that at P=6 the quantity supplied is 10. This follows by solving the relationship 6=1+(1/2)Q for the value of Q. Accordingly, suppliers would like to supply 10 units at this price.
Correspondingly on the demand side, given the demand curve
P=10–Q,
with a price given by , it must be the case that Q=4. So buyers would like to buy 4 units at that price: There is excess supply. But we know that the short side of the market will win out, and so the actual amount traded at this restricted price will be 4 units.
3.10: Conclusion
We have covered a lot of ground in this chapter. It is intended to open up the vista of economics to the new student in the discipline. Economics is powerful and challenging, and the ideas we have developed here will serve as conceptual foundations for our exploration of the subject. Our next chapter deals with measurement and responsiveness.
3.11: Key Terms
Demand is the quantity of a good or service that buyers wish to purchase at each possible price, with all other influences on demand remaining unchanged.
Supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged.
Quantity demanded defines the amount purchased at a particular price.
Quantity supplied refers to the amount supplied at a particular price.
Equilibrium price: equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.
Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.
Excess demand exists when the quantity demanded exceeds quantity supplied at the going price.
Short side of the market determines outcomes at prices other than the equilibrium.
Demand curve is a graphical expression of the relationship between price and quantity demanded, with other influences remaining unchanged.
Supply curve is a graphical expression of the relationship between price and quantity supplied, with other influences remaining unchanged.
Substitute goods: when a price reduction (rise) for a related product reduces (increases) the demand for a primary product, it is a substitute for the primary product.
Complementary goods: when a price reduction (rise) for a related product increases (reduces) the demand for a primary product, it is a complement for the primary product.
Inferior good is one whose demand falls in response to higher incomes.
Normal good is one whose demand increases in response to higher incomes.
Comparative static analysis compares an initial equilibrium with a new equilibrium, where the difference is due to a change in one of the other things that lie behind the demand curve or the supply curve.
Price controls are government rules or laws that inhibit the formation of market-determined prices.
Quotas are physical restrictions on output.
Market demand: the horizontal sum of individual demands. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.08%3A_Individual_and_market_functions.txt |
EXERCISE 3.1
The supply and demand for concert tickets are given in the table below.
Price (\$) 0 4 8 12 16 20 24 28 32 36 40
Quantity demanded 15 14 13 12 11 10 9 8 7 6 5
Quantity supplied 0 0 0 0 0 1 3 5 7 9 11
1. Plot the supply and demand curves to scale and establish the equilibrium price and quantity.
2. What is the excess supply or demand when price is \$24? When price is \$36?
3. Describe the market adjustments in price induced by these two prices.
4. Optional: The functions underlying the example in the table are linear and can be presented as P=18+2Q (supply) and P=60–4Q (demand). Solve the two equations for the equilibrium price and quantity values.
EXERCISE 3.2
Illustrate in a supply/demand diagram, by shifting the demand curve appropriately, the effect on the demand for flights between Calgary and Winnipeg as a result of:
1. Increasing the annual government subsidy to Via Rail.
2. Improving the Trans-Canada highway between the two cities.
3. The arrival of a new budget airline on the scene.
EXERCISE 3.3
A new trend in US high schools is the widespread use of chewing tobacco. A recent survey indicates that 15 percent of males in upper grades now use it – a figure not far below the use rate for cigarettes. This development came about in response to the widespread implementation by schools of regulations that forbade cigarette smoking on and around school property. Draw a supply-demand equilibrium for each of the cigarette and chewing tobacco markets before and after the introduction of the regulations.
EXERCISE 3.4
The following table describes the demand and supply conditions for labour.
Price (\$) = wage rate 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170
Quantity demanded 1020 960 900 840 780 720 660 600 540 480 420 360 300 240 180 120 60 0
Quantity supplied 0 0 0 0 0 0 30 60 90 120 150 180 210 240 270 300 330 360
1. Graph the functions and find the equilibrium price and quantity by equating demand and supply.
2. Suppose a price ceiling is established by the government at a price of \$120. This price is below the equilibrium price that you have obtained in part (a). Calculate the amount that would be demanded and supplied and then calculate the excess demand.
EXERCISE 3.5
In Exercise 3.4, suppose that the supply and demand describe an agricultural market rather than a labour market, and the government implements a price floor of \$140. This is greater than the equilibrium price.
1. Estimate the quantity supplied and the quantity demanded at this price, and calculate the excess supply.
2. Suppose the government instead chose to maintain a price of \$140 by implementing a system of quotas. What quantity of quotas should the government make available to the suppliers?
EXERCISE 3.6
In Exercise 3.5, suppose that, at the minimum price, the government buys up all of the supply that is not demanded, and exports it at a price of \$80 per unit. Compute the cost to the government of this operation.
EXERCISE 3.7
Let us sum two demand curves to obtain a 'market' demand curve. We will suppose there are just two buyers in the market. Each of the individual demand curves has a price intercept of \$42. One has a quantity intercept of 126, the other 84.
1. Draw the demands either to scale or in an Excel spreadsheet, and label the intercepts on both the price and quantity axes.
2. Determine how much would be purchased in the market at prices \$10, \$20, and \$30.
3. Optional: Since you know the intercepts of the market (total) demand curve, can you write an equation for it?
EXERCISE 3.8
In Exercise 3.7 the demand curves had the same price intercept. Suppose instead that the first demand curve has a price intercept of \$36 and a quantity intercept of 126; the other individual has a demand curve defined by a price intercept of \$42 and a quantity intercept of 84. Graph these curves and illustrate the market demand curve.
EXERCISE 3.9
Here is an example of a demand curve that is not linear:
Price (\$) 4 3 2 1 0
Quantity demanded 25 100 225 400 625
1. Plot this demand curve to scale or in Excel.
2. If the supply function in this market is P=2, plot this function in the same diagram.
3. Determine the equilibrium quantity traded in this market.
EXERCISE 3.10
The football stadium of the University of the North West Territories has 30 seats. The demand curve for tickets has a price intercept of \$36 and a quantity intercept of 72.
1. Draw the supply and demand curves to scale in a graph or in Excel. (This demand curve has the form .)
2. Determine the equilibrium admission price, and the amount of revenue generated from ticket sales for each game.
3. A local alumnus and benefactor offers to install 6 more seats at no cost to the University. Compute the price that would be charged with this new supply and compute the revenue that would accrue at this new equilibrium price. Should the University accept the offer to install the seats?
4. Redo the previous part of this question, assuming that the initial number of seats is 40, and the University has the option to increase capacity to 46 at no cost to itself. Should the University accept the offer in this case?
EXERCISE 3.11
Suppose farm workers in Mexico are successful in obtaining a substantial wage increase. Illustrate the effect of this on the price of lettuce in the Canadian winter, using a supply and demand diagram, on the assumption that all lettuce in Canada is imported during its winter. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/01%3A_The_Building_Blocks/03%3A_The_classical_marketplace__demand_and_supply/3.12%3A_Exercises_for_Chapter_3.txt |
Chapter 4: Measures of response: Elasticities
In this chapter we will explore:
4.1
Responsiveness as elasticities
4.2
Demand elasticities and public policy
4.3
The time horizon and inflation
4.4
Cross-price elasticities
4.5
Income elasticity of demand
4.6
Supply side responses
4.7
Tax incidence
4.8
Technical tricks with elasticities
4.1 Price responsiveness of demand
Put yourself in the position of an entrepreneur. One of your many challenges is to price your product appropriately. You may be Michael Dell choosing a price for your latest computer, or the local restaurant owner pricing your table d'hôte, or you may be pricing your part-time snow-shoveling service. A key component of the pricing decision is to know how responsive your market is to variations in your pricing. How we measure responsiveness is the subject matter of this chapter.
We begin by analyzing the responsiveness of consumers to price changes. For example, consumers tend not to buy much more or much less food in response to changes in the general price level of food. This is because food is a pretty basic item for our existence. In contrast, if the price of new textbooks becomes higher, students may decide to search for a second-hand copy, or make do with lecture notes from their friends or downloads from the course web site. In the latter case students have ready alternatives to the new text book, and so their expenditure patterns can be expected to reflect these options, whereas it is hard to find alternatives to food. In the case of food consumers are not very responsive to price changes; in the case of textbooks they are. The word 'elasticity' that appears in this chapter title is just another term for this concept of responsiveness. Elasticity has many different uses and interpretations, and indeed more than one way of being measured in any given situation. Let us start by developing a suitable numerical measure.
The slope of the demand curve suggests itself as one measure of responsiveness: If we lowered the price of a good by \$1, for example, how many more units would we sell? The difficulty with this measure is that it does not serve us well when comparing different products. One dollar may be a substantial part of the price of your morning coffee and croissant, but not very important if buying a computer or tablet. Accordingly, when goods and services are measured in different units (croissants versus tablets), or when their prices are very different, it is often best to use a percentage change measure, which is unit-free.
The price elasticity of demand is measured as the percentage change in quantity demanded, divided by the percentage change in price. Although we introduce several other elasticity measures later, when economists speak of the demand elasticity they invariably mean the price elasticity of demand defined in this way.
The price elasticity of demand is measured as the percentage change in quantity demanded, divided by the percentage change in price.
The price elasticity of demand can be written in different forms. We will use the Greek letter epsilon, , as a shorthand symbol, with a subscript d to denote demand, and the capital delta, , to denote a change. Therefore, we can write
or, using a shortened expression,
(4.1)
Calculating the value of the elasticity is not difficult. If we are told that a 10 percent price increase reduces the quantity demanded by 20 percent, then the elasticity value is The negative sign denotes that price and quantity move in opposite directions, but for brevity the negative sign is often omitted.
Consider now the data in Table 4.1 and the accompanying Figure 4.1. These data reflect the demand relation for natural gas that we introduced in Chapter 3. Note first that, when the price and quantity change, we must decide what reference price and quantity to use in the percentage change calculation in the definition above. We could use the initial or final price-quantity combination, or an average of the two. Each choice will yield a slightly different numerical value for the elasticity. The best convention is to use the midpoint of the price values and the corresponding midpoint of the quantity values. This ensures that the elasticity value is the same regardless of whether we start at the higher price or the lower price. Using the subscript 1 to denote the initial value and 2 the final value:
Table 4.1 The demand for natural gas: Elasticities and revenue
Price (\$) Quantity Elasticity Total
demanded value revenue (\$)
10 0 0
9 1 -9.0 9
8 2 16
7 3 -2.33 21
6 4 24
5 5 -1.0 25
4 6 24
3 7 -0.43 21
2 8 16
1 9 -0.11 9
0 10 0
Elasticity calculations are based upon \$2 price changes.
Figure 4.1 Elasticity variation with linear demand
In the high-price region of the demand curve the elasticity takes on a high value. At the midpoint of a linear demand curve the elasticity takes on a value of one, and at lower prices the elasticity value continues to fall.
Using this rule, consider now the value of when price drops from \$10.00 to \$8.00. The change in price is \$2.00 and the average price is therefore . On the quantity side, demand goes from zero to 2 units (measured in thousands of cubic feet), and the average quantity demanded is therefore (0+2)/2=1. Putting these numbers into the formula yields:
Note that the price has declined in this instance and thus the change in price is negative. Continuing down the table in this fashion yields the full set of elasticity values in the third column.
The demand elasticity is said to be high if it is a large negative number; the large number denotes a high degree of sensitivity. Conversely, the elasticity is low if it is a small negative number. High and low refer to the size of the number, ignoring the negative sign. The term arc elasticity is also used to define what we have just measured, indicating that it defines consumer responsiveness over a segment or arc of the demand curve.
It is helpful to analyze this numerical example by means of the corresponding demand curve that is plotted in Figure 4.1, and which we used in Chapter 3. It is a straight-line demand curve; but, despite this, the elasticity is not constant. At high prices the elasticity is high; at low prices it is low. The intuition behind this pattern is as follows. When the price is high, a given price change represents a small percentage change, because the average price in the price-term denominator is large. At high prices the quantity demanded is small and therefore the percentage quantity change tends to be large due to the small quantity value in its denominator. In sum, at high prices the elasticity is large; it contains a large numerator and a small denominator. By the same reasoning, at low prices the elasticity is small.
We can carry this reasoning one step further to see what happens when the demand curve intersects the axes. At the horizontal axis the average price is tending towards zero. Since this extremely small value appears in the denominator of the price term it means that the price term as a whole is extremely large. Accordingly, with an extremely large value in the denominator of the elasticity expression, the whole ratio is tending towards a zero value. By the same reasoning the elasticity value at the vertical intercept is tending towards an infinitely large value.
Extreme cases
The elasticity decreases in going from high prices to low prices. This is true for most non-linear demand curves also. Two exceptions are when the demand curve is horizontal and when it is vertical.
When the demand curve is vertical, no quantity change results from a change in price from P1 to P2, as illustrated in Figure 4.2 using the demand curve Dv. Therefore, the numerator in Equation 4.1 is zero, and the elasticity has a zero value.
Figure 4.2 Limiting cases of price elasticity
When the demand curve is vertical (Dv), the elasticity is zero: A change in price from P1 to P2 has no impact on the quantity demanded because the numerator in the elasticity formula has a zero value. When D becomes more horizontal the elasticity becomes larger and larger at P1, eventually becoming infinite.
In the horizontal case, we say that the elasticity is infinite, which means that any percentage price change brings forth an infinite quantity change! This case is also illustrated in Figure 4.2 using the demand curve Dh. As with the vertical demand curve, this is not immediately obvious. So consider a demand curve that is almost horizontal, such as instead of Dh. In this instance, we can achieve large changes in quantity demanded by implementing very small price changes. In terms of Equation 4.1, the numerator is large and the denominator small, giving rise to a large elasticity. Now imagine that this demand curve becomes ever more elastic (horizontal). The same quantity response can be obtained with a smaller price change, and hence the elasticity is larger. Pursuing this idea, we can say that, as the demand curve becomes ever more elastic, the elasticity value tends towards infinity.
A non-linear demand curve is illustrated in Figure 4.3. If price increases from P0 to P1, the corresponding quantity change is given by (Q0Q1). When the price declines to P2 the quantity increases from Q0 to Q2. When statisticians study data to determine how responsive purchases are to price changes they do not always find a linear relationship between price and quantity. But a linear relationship is frequently a good approximation or representation of actual data and we will continue to analyze responsiveness in a linear framework in this chapter.
Figure 4.3 Non-linear demand curves
When the demand curve is non-linear the slope changes with the price. Hence, equal price changes do not lead to equal quantity changes: The quantity change associated with a change in price from P0 to P1 is smaller than the change in quantity associated with the same change in price from P0 to P2.
Elastic and inelastic demands
While the elasticity value falls as we move down the demand curve, an important dividing line occurs at the value of –1. This is illustrated in Table 4.1, and is a property of all straight-line demand curves. Disregarding the negative sign, demand is said to be elastic if the price elasticity is greater than unity, and inelastic if the value lies between unity and 0. It is unit elastic if the value is exactly one.
Demand is elastic if the price elasticity is greater than unity. It is inelastic if the value lies between unity and 0. It is unit elastic if the value is exactly one.
Economists frequently talk of goods as having a "high" or "low" demand elasticity. What does this mean, given that the elasticity varies throughout the length of a demand curve? It signifies that, at the price usually charged, the elasticity has a high or low value. For example, your weekly demand for regular coffee at Starbucks might be unresponsive to variations in price around the value of \$3.00, but if the price were \$6, you might be more responsive to price variations. Likewise, when we stated at the beginning of this chapter that the demand for food tends to be inelastic, we really meant that at the price we customarily face for food, demand is inelastic.
Determinants of price elasticity
Why is it that the price elasticities for some goods and services are high and for others low?
• One answer lies in tastes: If a good or service is a basic necessity in one's life, then price variations have a minimal effect on the quantity demanded, and these products thus have a relatively inelastic demand.
• A second answer lies in the ease with which we can substitute alternative goods or services for the product in question. If Apple Corporation had no serious competition in the smart-phone market, it could price its products even higher than in the presence of Samsung and Google, who also supply smart phones. A supplier who increases her price will lose more sales if there are ready substitutes to which buyers can switch, than if no such substitutes exist. It follows that a critical role for the marketing department in a firm is to convince buyers of the uniqueness of the firm's product.
• Where product groups are concerned, the price elasticity of demand for one product is necessarily higher than for the group as a whole: Suppose the price of one computer tablet brand alone falls. Buyers would be expected to substitute towards this product in large numbers – its manufacturer would find demand to be highly responsive. But if all brands are reduced in price, the increase in demand for any one will be more muted. In essence, the one tablet whose price falls has several close substitutes, but tablets in the aggregate do not.
• Finally, there is a time dimension to responsiveness, and this is explored in Section 4.3.
4.2 Price elasticities and public policy
In Chapter 3 we explored the implications of putting price floors and supply quotas in place. We saw that price floors can lead to excess supply. An important public policy question therefore is why these policies actually exist. It turns out that we can understand why with the help of elasticity concepts.
Price elasticity and expenditure
Let us return to Table 4.1 and explore what happens to total expenditure/revenue as the price varies. Since total revenue is simply the product of price times quantity it can be computed from the first two columns. The result is given in the final column. We see immediately that total expenditure on the good is highest at the midpoint of the demand curve corresponding to these data. At a price of \$5 expenditure is \$25. No other price yields more expenditure or revenue. Obviously the value \$5 is midway between the zero value and the price or quantity intercept of the demand curve in Figure 4.1. This is a general result for linear demand curves: Expenditure is greatest at the midpoint, and the mid-price corresponds to the mid-quantity on the horizontal axis.
Geometrically this can be seen from Figure 4.1. Since expenditure is the product of price and quantity, in geometric terms it is the area of the rectangle mapped out by any price-quantity combination. For example, at total expenditure is \$16 – the area of the rectangle bounded by these price and quantity values. Following this line of reasoning, if we were to compute the area bounded by a price of \$7 and a corresponding quantity of 3 units we get a larger rectangle – a value of \$21. This example indicates that the largest rectangle occurs at the midpoint of the demand curve. As a general geometric rule this is always the case. Hence we can conclude that the price that generates the greatest expenditure is the midpoint of a linear demand curve.
Let us now apply this rule to pricing in the market place. If our existing price is high and our goal is to generate more revenue, then we should reduce the price. Conversely, if our price is low and our goal is again to increase revenue we should raise the price. Starting from a high price let us see why this is so. By lowering the price we induce an increase in quantity demanded. Of course the lower price reduces the revenue obtained on the units already being sold at the initial high price. But since total expenditure increases at the new lower price, it must be the case that the additional sales caused by the lower price more than compensate for this loss on the units being sold at the initial high price. But there comes a point when this process ceases. Eventually the loss in revenue on the units being sold at the higher price is not offset by the revenue from additional quantity. We lose a margin on so many existing units that the additional sales cannot compensate. Accordingly revenue falls.
Note next that the top part of the demand curve is elastic and the lower part is inelastic. So, as a general rule we can state that:
A price decline (quantity increase) on an elastic segment of a demand curve necessarily increases revenue, and a price increase (quantity decline) on an inelastic segment also increases revenue.
The result is mapped in Figure 4.4, which plots total revenue as a function of the quantity demanded – columns 2 and 4 from Table 4.1. At low quantity values the price is high and the demand is elastic; at high quantity values the price is low and the demand is inelastic. The revenue maximizing point is the midpoint of the demand curve.
Figure 4.4 Total revenue and elasticity
Based upon the data in Table 4.1, revenue increases with quantity sold up to sales of 5 units. Beyond this output, the decline in price that must accompany additional sales causes revenue to decline.
We now have a general conclusion: In order to maximize the possible revenue from the sale of a good or service, it should be priced where the demand elasticity is unity.
Does this conclusion mean that every entrepreneur tries to find this magic region of the demand curve in pricing her product? Not necessarily: Most businesses seek to maximize their profit rather than their revenue, and so they have to focus on cost in addition to sales. We will examine this interaction in later chapters. Secondly, not every firm has control over the price they charge; the price corresponding to the unit elasticity may be too high relative to their competitors' price choices. Nonetheless, many firms, especially in the early phase of their life-cycle, focus on revenue growth rather than profit, and so, if they have any power over their price, the choice of the unit-elastic price may be appropriate.
The agriculture problem
We are now in a position to address the question we posed above: Why are price floors frequently found in agricultural markets? The answer is that governments believe that the pressures of competition would force farm/food prices so low that many farmers would not be able to earn a reasonable income from farming. Accordingly, governments impose price floors. Keep in mind that price floors are prices above the market equilibrium and therefore lead to excess supply.
Since the demand for foodstuffs is inelastic we know that a higher price will induce more revenue, even with a lower quantity being sold. The government can force this outcome on the market by a policy of supply management. It can force farmers in the aggregate to bring only a specific amount of product to the market, and thus ensure that the price floor does not lead to excess supply. This is the system of supply management we observe in dairy markets in Canada, for example, and that we examined in the case of maple syrup in Chapter 3. Its supporters praise it because it helps farmers, its critics point out that higher food prices hurt lower-income households more than high-income households, and therefore it is not a good policy.
Elasticity values are frequently more informative than diagrams and figures. Our natural inclination is to view demand curves with a somewhat vertical profile as being inelastic, and demand curves with a flatter profile as elastic. But we must keep in mind that, as explained in Chapter 2, the vertical and horizontal axis of any diagram can be scaled in such a way as to change the visual impact of the data underlying the curves. But a numerical elasticity value will never deceive in this way. If its value is less than unity it is inelastic, regardless of the visual aspect of the demand curve.
At the same time, if we have two demand curves intersecting at a particular price-quantity combination, we can say that the curve with the more vertical profile is relatively more elastic, or less inelastic. This is illustrated in Figure 4.5. It is clear that, at the price-quantity combination where they intersect, the demand curve will yield a greater (percentage) quantity change than the demand curve D, for a given (percentage) price change. Hence, on the basis of diagrams, we can compare demand elasticities in relative terms at a point where the two intersect.
Figure 4.5 The impact of elasticity on quantity fluctuations
In the lower part of the demand curve D, demand is inelastic: At the point A, a shift in supply from S1 to S2 induces a large percentage increase in price, and a small percentage decrease in quantity demanded. In contrast, for the demand curve that goes through the original equilibrium, the region A is now an elastic region, and the impact of the supply shift is contrary: The % is smaller and the % is larger.
4.3 The time horizon and inflation
The price elasticity of demand is frequently lower in the short run than in the long run. For example, a rise in the price of home heating oil may ultimately induce consumers to switch to natural gas or electricity, but such a transition may require a considerable amount of time. Time is required for decision-making and investment in new heating equipment. A further example is the elasticity of demand for tobacco. Some adults who smoke may be seriously dependent and find quitting almost impossible. Higher prices may provide a stronger incentive to reduce or quit, but successful quitters usually require several attempts before being successful. Several years may be required for the impact of a price increase to be fully apparent. Accordingly when we talk of the short run and the long run, there is no simple rule for defining how long the long run actually is in terms of months or years. In some cases, adjustment may be complete in weeks, in other cases years.
In Chapter 2 we distinguished between real and nominal variables. The former adjust for inflation; the latter do not. Suppose all nominal variables double in value: Every good and service costs twice as much, wage rates double, dividends and rent double, etc. This implies that whatever bundle of goods was previously affordable is still affordable. Nothing has really changed. Demand behaviour is unaltered by this doubling of all prices and all incomes.
How do we reconcile this with the idea that own-price elasticities measure changes in quantity demanded as prices change? Keep in mind that elasticities measure the impact of changing one variable alone, holding constant all of the others. But when all variables are changing simultaneously, it is incorrect to think that the impact on quantity of one price or income change is a true measure of responsiveness or elasticity. The price changes that go into measuring elasticities are therefore changes in prices relative to inflation.
4.4 Cross-price elasticities – cable or satellite
The price elasticity of demand tells us about consumer responses to price changes in different regions of the demand curve, holding constant all other influences. One of those influences is the price of other goods and services. A cross-price elasticity indicates how demand is influenced by changes in the prices of other products.
The cross-price elasticity of demand is the percentage change in the quantity demanded of a product divided by the percentage change in the price of another.
We write the cross price elasticity of the demand for x due to a change in the price of y as
For example, if the price of cable-supply internet services declines, by how much will the demand for satellite-supply services change? The cross-price elasticity may be positive or negative. These particular goods are clearly substitutable, and this is reflected in a positive value of this cross-price elasticity: The percentage change in satellite subscribers will be negative in response to a decline in the price of cable; a negative divided by a negative is positive. In contrast, a change in the price of tablets or electronic readers should induce an opposing change in the quantity of e-books purchased: Lower tablet prices will induce greater e-book purchases. In this case the price and quantity movements are in opposite directions and the elasticity is therefore negative – the goods are complements.
Application Box 4.1 Cross-price elasticity of demand between legal and illegal marijuana
In November 2016 Canada's Parliamentary Budget Office produced a research paper on the challenges associated with pricing legalized marijuana. They proposed that taxes should be low rather than high on this product, surprising many health advocates. Specifically they argued that the legal price of marijuana should be just fractionally higher than the price in the illegal market. Otherwise marijuana users would avail of the illegal market supply, which is widely available and of high quality. Effectively their research pointed to a very high cross-price elasticity of demand. This recommendation may mean that tax revenue from marijuana sales will be small, but the size of the illegal market will decline substantially, thereby attaining a prime objective of legalization.
4.5 The income elasticity of demand
In Chapter 3 we stated that higher incomes tend to increase the quantity demanded at any price. To measure the responsiveness of demand to income changes, a unit-free measure exists: The income elasticity of demand. The income elasticity of demand is the percentage change in quantity demanded divided by a percentage change in income.
The income elasticity of demand is the percentage change in quantity demanded divided by a percentage change in income.
Let us use the Greek letter eta, , to define the income elasticity of demand and I to denote income. Then,
As an example, if monthly income increases by 10 percent, and the quantity of magazines purchased increases by 15 percent, then the income elasticity of demand for magazines is 1.5 in value . The income elasticity is generally positive, but not always – let us see why.
Normal, inferior, necessary, and luxury goods
The income elasticity of demand, in diagrammatic terms, is a percentage measure of how far the demand curve shifts in response to a change in income. Figure 4.6 shows two possible shifts. Suppose the demand curve is initially the one defined by D, and then income increases. In this example the supply curve is horizontal at the price P0. If the demand curve shifts to D1 as a result, the change in quantity demanded at the existing price is (Q1Q0). However, if instead the demand curve shifts to D2, that shift denotes a larger change in quantity (Q2Q0). Since the shift in demand denoted by D2 exceeds the shift to D1, the D2 shift is more responsive to income, and therefore implies a higher income elasticity.
Figure 4.6 Income elasticity and shifts in demand
At the price P0, the income elasticity measures the percentage horizontal shift in demand caused by some percentage income increase. A shift from A to B reflects a lower income elasticity than a shift to C. A leftward shift in the demand curve in response to an income increase would denote a negative income elasticity – an inferior good.
In this example, the good is a normal good, as defined in Chapter 3, because the demand for it increases in response to income increases. If the demand curve were to shift back to the left in response to an increase in income, then the income elasticity would be negative. In such cases the goods or services are inferior, as defined in Chapter 3.
Finally, we distinguish between luxuries and necessities. A luxury good or service is one whose income elasticity equals or exceeds unity. A necessity is one whose income elasticity is greater than zero but less than unity. If quantity demanded is so responsive to an income increase that the percentage increase in quantity demanded exceeds the percentage increase in income, then the elasticity value is in excess of 1, and the good or service is called a luxury. In contrast, if the percentage change in quantity demanded is less than the percentage increase in income, the value is less than unity, and we call the good or service a necessity.
A luxury good or service is one whose income elasticity equals or exceeds unity.
A necessity is one whose income elasticity is greater than zero and less than unity.
Luxuries and necessities can also be defined in terms of their share of a typical budget. An income elasticity greater than unity means that the share of an individual's budget being allocated to the product is increasing. In contrast, if the elasticity is less than unity, the budget share is falling. This makes intuitive sense—luxury cars are luxury goods by this definition because they take up a larger share of the incomes of the rich than the non-rich.
Inferior goods are those for which there exist higher-quality, more expensive, substitutes. For example, lower-income households tend to satisfy their travel needs by using public transit. As income rises, households may reduce their reliance on public transit in favour of automobile use (despite the congestion and environmental impacts). Likewise, laundromats are inferior goods in the sense that, as income increases, individuals tend to purchase their own appliances and therefore use laundromat services less. Inferior goods, therefore, have a negative income elasticity: In the income elasticity equation definition, the numerator has a sign opposite to that of the denominator.
Inferior goods have negative income elasticity.
Empirical research indicates that goods like food and fuel have income elasticities less than 1; durable goods and services have elasticities slightly greater than 1; leisure goods and foreign holidays have elasticities very much greater than 1.
Income elasticities are useful in forecasting the demand for particular services and goods in a growing economy. Suppose real income is forecast to grow by 15% over the next five years. If we know that the income elasticity of demand for smart phones is 2.0, we could estimate the anticipated growth in demand by using the income elasticity formula: Since in this case and it follows that . Therefore the predicted demand change must be 30%.
4.6 Elasticity of supply
Now that we have developed the various dimensions of elasticity on the demand side, the analysis of elasticities on the supply side is straightforward. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price.
The elasticity of supply measures the responsiveness of quantity supplied to a change in the price.
The subscript s denotes supply. This is exactly the same formula as for the demand curve, except that the quantities now come from a supply curve. Furthermore, and in contrast to the demand elasticity, the supply elasticity is generally a positive value because of the positive relationship between price and quantity supplied. The more elastic, or the more responsive, is supply to a given price change, the larger will be the elasticity value. In diagrammatic terms, this means that "flatter" supply curves have a greater elasticity than more "vertical" curves at a given price and quantity combination. Numerically the flatter curve has a larger value than the more vertical supply – try drawing a supply diagram similar to Figure 4.2. Technically, a completely vertical supply curve has a zero elasticity and a horizontal supply curve has an infinite elasticity – just as in the demand cases.
As always we keep in mind the danger of interpreting too much about the value of this elasticity from looking at the visual profiles of supply curves.
Application Box 4.2 The price of oil and the coronavirus
In January 2020, the price of oil in the US traded at \$60 per barrel. The coronavirus then struck the world economy, transport declined dramatically, and by the beginning of April the price had dropped to \$20 per barrel. The quantity of oil traded on world markets fell from approximately 100 million barrels per day in January to 65 million barrels by the start of April, a drop of 35% relative to its January level. This scenario is displayed in Figure 4.7 below.
Figure 4.7 Supply elasticity in the short run and the long run; the oil market in 2020
Demand drops suddenly between January and April. Equilibrium moves from point A to B. In the long run some producers exit and the supply curve shifts towards the origin. Following this, the equilibrium is C. Joining points such as A and C yields a long run supply curve; it is more elastic than the short run supply, when the number of suppliers is fixed.
The January equilibrium is at the point A, and the April equilibrium at point B. The move from A to B was caused by a collapse in demand as illustrated by the shift in the demand curve. We can compute the supply elasticity readily from this example. Note that it was demand that shifted rather than supply so we are observing two points on the supply curve. The supply elasticity, using arc values, is given by (35/82.5)/(\$40/\$40) = 0.42. So the supply curve is inelastic.
Can all oil producers survive in this bear market? The answer is no. It is inexpensive to pump oil in Saudi Arabia, but more costly to produce it from shale or tar sands, and thus some producers are not covering their costs with the price at \$20 per barrel. They do not want to shut their operations because closing down and reopening is expensive. They hang on in the hope that the price will return towards \$60. If demand does not recover, some suppliers exit the industry with the passage of time. With fewer suppliers the supply curve shifts towards the origin and ultimately another equilibrium price and quantity are established. Call this new equilibrium point C.
The supply elasticity takes on a different value in the short run than in the long run. Supply is more inelastic in the short run. A line through the points A and C would represent the long-run supply curve for the industry. It must be more elastic than the short run supply because the industry has had time to adjust - it is more flexible with the passage of time.
4.7 Elasticities and tax incidence
Elasticity values are critical in determining the impact of a government's taxation policies. The spending and taxing activities of the government influence the use of the economy's resources. By taxing cigarettes, alcohol and fuel, the government can restrict their use; by taxing income, the government influences the amount of time people choose to work. Taxes have a major impact on almost every sector of the Canadian economy.
To illustrate the role played by demand and supply elasticities in tax analysis, we take the example of a sales tax. These can be of the specific or ad valorem type. A specific tax involves a fixed dollar levy per unit of a good sold (e.g., \$10 per airport departure). An ad valorem tax is a percentage levy, such as Canada's Goods and Services tax (e.g., 5 percent on top of the retail price of goods and services). The impact of each type of tax is similar, and we will use the specific tax in our example below.
A layperson's view of a sales tax is that the tax is borne by the consumer. That is to say, if no sales tax were imposed on the good or service in question, the price paid by the consumer would be the same net of tax price as exists when the tax is in place. Interestingly, this is not always the case. The study of the incidence of taxes is the study of who really bears the tax burden, and this in turn depends upon supply and demand elasticities.
Tax Incidence describes how the burden of a tax is shared between buyer and seller.
Consider Figures 4.8 and 4.9, which define an imaginary market for inexpensive wine. Let us suppose that, without a tax, the equilibrium price of a bottle of wine is \$5, and Q0 is the equilibrium quantity traded. The pre-tax equilibrium is at the point A. The government now imposes a specific tax of \$4 per bottle. The impact of the tax is represented by an upward shift in supply of \$4: Regardless of the price that the consumer pays, \$4 of that price must be remitted to the government. As a consequence, the price paid to the supplier must be \$4 less than the consumer price, and this is represented by twin supply curves: One defines the price at which the supplier is willing to supply (S), and the other is the tax-inclusive supply curve that the consumer faces (St).
Figure 4.8 Tax incidence with elastic supply
The imposition of a specific tax of \$4 shifts the supply curve vertically by \$4. The final price at B (Pt) increases by \$3 over the equilibrium price at A. At the new quantity traded, Qt, the supplier gets \$4 per unit (), the government gets \$4 also and the consumer pays \$8. The greater part of the incidence is upon the buyer, on account of the relatively elastic supply curve: His price increases by \$3 of the \$4 tax.
The introduction of the tax in Figure 4.8 means that consumers now face the supply curve St. The new equilibrium is at point B. Note that the price has increased by less than the full amount of the tax—in this example it has increased by \$3. This is because the reduced quantity at B is provided at a lower supply price: The supplier is willing to supply the quantity Qt at a price defined by C (\$4), which is lower than the price at A (\$5).
So what is the incidence of the \$4 tax? Since the market price has increased from \$5 to \$8, and the price obtained by the supplier has fallen by \$1, we say that the incidence of the tax falls mainly on the consumer: The price to the consumer has risen by three dollars and the price received by the supplier has fallen by just one dollar.
Consider now Figure 4.9, where the supply curve is less elastic, and the demand curve is unchanged. Again the supply curve must shift upward with the imposition of the specific tax. But here the price received by the supplier is lower than in Figure 4.8, and the price paid by the consumer does not rise as much – the incidence is different. The consumer faces a price increase that is one-half, rather than three-quarters, of the tax value. The supplier faces a lower supply price, and bears a higher share of the tax.
Figure 4.9 Tax incidence with inelastic supply
The imposition of a specific tax of \$4 shifts the supply curve vertically by \$4. The final price at B (Pt) increases by \$2 over the no-tax price at A. At the new quantity traded, Qt, the supplier gets \$3 per unit (), the government gets \$4 also and the consumer pays \$7. The incidence is shared equally by suppliers and demanders.
We can conclude from this example that, for any given demand, the more elastic is supply, the greater is the price increase in response to a given tax. Furthermore, a more elastic supply curve means that the incidence falls more on the consumer; while a less elastic supply curve means the incidence falls more on the supplier. This conclusion can be verified by drawing a third version of Figure 4.8 and 4.9, in which the supply curve is horizontal – perfectly elastic. When the tax is imposed the price to the consumer increases by the full value of the tax, and the full incidence falls on the buyer. While this case corresponds to the layperson's intuition of the incidence of a tax, economists recognize it as a special case of the more general outcome, where the incidence falls on both the supply side and the demand side.
These are key results in the theory of taxation. It is equally the case that the incidence of the tax depends upon the demand elasticity. In Figure 4.8 and 4.9 we used the same demand curve. However, it is not difficult to see that, if we were to redo the exercise with a demand curve of a different elasticity, the incidence would not be identical. At the same time, the general result on supply elasticities still holds. We will return to this material in Chapter 5.
Statutory incidence
In the above example the tax is analyzed by means of shifting the supply curve. This implies that the supplier is obliged to charge the consumer a tax and then return this tax revenue to the government. But suppose the supplier did not bear the obligation to collect the revenue; instead the buyer is required to send the tax revenue to the government, as in the case of employers who are required to deduct income tax from their employees' pay packages (the employers here are the demanders). If this were the case we could analyze the impact of the tax by reducing the market demand curve by the \$4. This is because the demand curve reflects what buyers are willing to pay, and when suppliers are paid in the presence of the tax they will be paid the buyers' demand price minus the tax that the buyers must pay. It is not difficult to show that whether we move the supply curve upward (to reflect the responsibility of the supplier to pay the government) or move the demand curve downward, the outcome is the same – in the sense that the same price and quantity will be traded in each case. Furthermore the incidence of the tax, measured by how the price change is apportioned between the buyers and sellers is also unchanged.
Tax revenues and tax rates
It is useful to relate elasticity values to the policy question of the impact of higher or lower taxes on government tax revenue. Consider a situation in which a tax is already in place and the government considers increasing the rate of tax. Can an understanding of elasticities inform us on the likely outcome? The answer is yes. Suppose that at the initial tax-inclusive price demand is inelastic. We know immediately that a tax rate increase that increases the price must increase total expenditure. Hence the outcome is that the government will get a higher share of an increased total expenditure. In contrast, if demand is elastic at the initial tax-inclusive price a tax rate increase that leads to a higher price will decrease total expenditure. In this case the government will get a larger share of a smaller pie – not as valuable from a tax-revenue standpoint as a larger share of a larger pie.
4.8 Technical tricks with elasticities
We can easily compute elasticities at any point on a demand curve, rather than over a range or arc, by using the explicit formula for the demand curve. To see this note that we can rewrite Equation 4.1 as:
The first term in the final form of this expression is obtained from the slope of the demand curve, and the second term (P/Q) is defined by the point on the curve that interests us. For example if our demand curve is , then . Inverting this to get yields –1 also. So, the point elasticity value at is . This formula provides the elasticity value at a particular point on the demand curve, rather than over a range of values or an arc. Consequently it is called the point elasticity of demand. And obviously we could apply it to a demand curve that is not linear provided we know the mathematical form and are able to establish the slope.
Key Terms
Price elasticity of demand is measured as the percentage change in quantity demanded, divided by the percentage change in price.
Demand is elastic if the price elasticity is greater than unity. It is inelastic if the value lies between unity and 0. It is unit elastic if the value is exactly one.
Cross-price elasticity of demand is the percentage change in the quantity demanded of a product divided by the percentage change in the price of another.
Income elasticity of demand is the percentage change in quantity demanded divided by a percentage change in income.
Luxury good or service is one whose income elasticity equals or exceeds unity.
Necessity is one whose income elasticity is greater than zero and is less than unity.
Inferior goods have a negative income elasticity.
Elasticity of supply is defined as the percentage change in quantity supplied divided by the percentage change in price.
Tax Incidence describes how the burden of a tax is shared between buyer and seller.
Exercises for Chapter 4
EXERCISE 4.1
Consider the information in the table below that describes the demand for movie rentals from your on-line supplier Instant Flicks.
Price per movie (\$) Quantity demanded Total revenue Elasticity of demand
2 1200
3 1100
4 1000
5 900
6 800
7 700
8 600
1. Either on graph paper or a spreadsheet, map out the demand curve.
2. In column 3, insert the total revenue generated at each price.
3. At what price is total revenue maximized?
4. In column 4, compute the elasticity of demand corresponding to each \$1 price reduction, using the average price and quantity at each state.
5. Do you see a connection between your answers in parts (c) and (d)?
EXERCISE 4.2
Your fruit stall has 100 ripe bananas that must be sold today. Your supply curve is therefore vertical. From past experience, you know that these 100 bananas will all be sold if the price is set at 40 cents per unit.
1. Draw a supply and demand diagram illustrating the market equilibrium price and quantity.
2. The demand elasticity is -0.5 at the equilibrium price. But you now discover that 10 of your bananas are rotten and cannot be sold. Draw the new supply curve and calculate the percentage price increase that will be associate with the new equilibrium, on the basis of your knowledge of the demand elasticity.
EXERCISE 4.3
University fees in the State of Nirvana have been frozen in real terms for 10 years. During this period enrolments increased by 20 percent, reflecting an increase in demand. This means the supply curve is horizontal at a given price.
1. Draw a supply curve and two demand curves to represent the two equilibria described.
2. Can you estimate a price elasticity of demand for university education in this market?
3. In contrast, during the same time period fees in a neighbouring state (where supply is also horizontal) increased by 60 percent and enrolments increased by 15 percent. Illustrate this situation in a diagram, where supply is again horizontal.
EXERCISE 4.4
Consider the demand curve defined by the information in the table below.
Price of movies Quantity demanded Total revenue Elasticity of demand
2 200
3 150
4 120
5 100
1. Plot the demand curve to scale and note that it is non-linear.
2. Compute the total revenue at each price.
3. Compute the arc elasticity of demand for each of the three price segments.
EXERCISE 4.5
Waterson Power Corporation's regulator has just allowed a rate increase from 9 to 11 cents per kilowatt hour of electricity. The short-run demand elasticity is -0.6 and the long-run demand elasticity is -1.2 at the current price..
1. What will be the percentage reduction in power demanded in the short run (use the midpoint 'arc' elasticity formula)?
2. What will be the percentage reduction in power demanded in the long run?
3. Will revenues increase or decrease in the short and long runs?
EXERCISE 4.6
Consider the own- and cross-price elasticity data in the table below.
% change in price
CDs Magazines Cappuccinos
% change in quantity CDs -0.25 0.06 0.01
Magazines -0.13 -1.20 0.27
Cappuccinos 0.07 0.41 -0.85
1. For which of the goods is demand elastic and for which is it inelastic?
2. What is the effect of an increase in the price of CDs on the purchase of magazines and cappuccinos? What does this suggest about the relationship between CDs and these other commodities; are they substitutes or complements?
3. In graphical terms, if the price of CDs or the price of cappuccinos increases, illustrate how the demand curve for magazines shifts.
EXERCISE 4.7
You are responsible for running the Speedy Bus Company and have information about the elasticity of demand for bus travel: The own-price elasticity is -1.4 at the current price. A friend who works in the competing railway company also tells you that she has estimated the cross-price elasticity of train-travel demand with respect to the price of bus travel to be 1.7.
1. As an economic analyst, would you advocate an increase or decrease in the price of bus tickets if you wished to increase revenue for Speedy?
2. Would your price decision have any impact on train ridership?
EXERCISE 4.8
A household's income and restaurant visits are observed at different points in time. The table below describes the pattern.
Income (\$) Restaurant visits Income elasticity of demand
16,000 10
24,000 15
32,000 18
40,000 20
48,000 22
56,000 23
64,000 24
1. Construct a scatter diagram showing quantity on the vertical axis and income on the horizontal axis.
2. Is there a positive or negative relationship between these variables?
3. Compute the income elasticity for each income increase, using midpoint values.
4. Are restaurant meals a normal or inferior good?
EXERCISE 4.9
The demand for bags of candy is given by P=48–0.2Q, and the supply by P=Q. The demand intercepts here are and Q=240; the supply curve is a 45 degree straight line through the origin.
1. Illustrate the resulting market equilibrium in a diagram knowing that the demand intercepts are , and that the supply curve is a 45 degree line through the origin.
2. If the government now puts a \$12 tax on all such candy bags, illustrate on a diagram how the supply curve will change.
3. Instead of the specific tax imposed in part (b), a percentage tax (ad valorem) equal to 30 percent is imposed. Illustrate how the supply curve would change.
EXERCISE 4.10
Optional: Consider the demand curve P=100–2Q. The supply curve is given by P=30.
1. Draw the supply and demand curves to scale, knowing that the demand curve intercepts are \$100 and 50, and compute the equilibrium price and quantity in this market.
2. If the government imposes a tax of \$10 per unit, draw the new equilibrium and compute the new quantity traded and the amount of tax revenue generated.
3. Is demand elastic or inelastic in this price range? [Hint: you should be able to answer this without calculations, by observing the figure you have constructed.]
EXERCISE 4.11
Optional: The supply of Henry's hamburgers is given by P=2+0.5Q; demand is given by Q=20.
1. Illustrate and compute the market equilibrium, knowing that the supply curve has an intercept of \$2 and a slope of 0.5.
2. A specific tax of \$3 per unit is subsequently imposed and that shifts the supply curve upwards and parallel by \$3, to become P=5+0.5Q. Solve for the equilibrium price and quantity after the tax.
3. Insert the post-tax supply curve along with the pre-tax supply curve, and determine who bears the burden of the tax.
04: Measures of response- Elasticities
Put yourself in the position of an entrepreneur. One of your many challenges is to price your product appropriately. You may be Michael Dell choosing a price for your latest computer, or the local restaurant owner pricing your table d'hôte, or you may be pricing your part-time snow-shoveling service. A key component of the pricing decision is to know how responsive your market is to variations in your pricing. How we measure responsiveness is the subject matter of this chapter.
We begin by analyzing the responsiveness of consumers to price changes. For example, consumers tend not to buy much more or much less food in response to changes in the general price level of food. This is because food is a pretty basic item for our existence. In contrast, if the price of new textbooks becomes higher, students may decide to search for a second-hand copy, or make do with lecture notes from their friends or downloads from the course web site. In the latter case students have ready alternatives to the new text book, and so their expenditure patterns can be expected to reflect these options, whereas it is hard to find alternatives to food. In the case of food consumers are not very responsive to price changes; in the case of textbooks they are. The word 'elasticity' that appears in this chapter title is just another term for this concept of responsiveness. Elasticity has many different uses and interpretations, and indeed more than one way of being measured in any given situation. Let us start by developing a suitable numerical measure.
The slope of the demand curve suggests itself as one measure of responsiveness: If we lowered the price of a good by \$1, for example, how many more units would we sell? The difficulty with this measure is that it does not serve us well when comparing different products. One dollar may be a substantial part of the price of your morning coffee and croissant, but not very important if buying a computer or tablet. Accordingly, when goods and services are measured in different units (croissants versus tablets), or when their prices are very different, it is often best to use a percentage change measure, which is unit-free.
The price elasticity of demand is measured as the percentage change in quantity demanded, divided by the percentage change in price. Although we introduce several other elasticity measures later, when economists speak of the demand elasticity they invariably mean the price elasticity of demand defined in this way.
The price elasticity of demand is measured as the percentage change in quantity demanded, divided by the percentage change in price.
The price elasticity of demand can be written in different forms. We will use the Greek letter epsilon, , as a shorthand symbol, with a subscript d to denote demand, and the capital delta, , to denote a change. Therefore, we can write
or, using a shortened expression,
(4.1)
Calculating the value of the elasticity is not difficult. If we are told that a 10 percent price increase reduces the quantity demanded by 20 percent, then the elasticity value is The negative sign denotes that price and quantity move in opposite directions, but for brevity the negative sign is often omitted.
Consider now the data in Table 4.1 and the accompanying Figure 4.1. These data reflect the demand relation for natural gas that we introduced in Chapter 3. Note first that, when the price and quantity change, we must decide what reference price and quantity to use in the percentage change calculation in the definition above. We could use the initial or final price-quantity combination, or an average of the two. Each choice will yield a slightly different numerical value for the elasticity. The best convention is to use the midpoint of the price values and the corresponding midpoint of the quantity values. This ensures that the elasticity value is the same regardless of whether we start at the higher price or the lower price. Using the subscript 1 to denote the initial value and 2 the final value:
Table 4.1 The demand for natural gas: Elasticities and revenue
Price (\$) Quantity Elasticity Total
demanded value revenue (\$)
10 0 0
9 1 -9.0 9
8 2 16
7 3 -2.33 21
6 4 24
5 5 -1.0 25
4 6 24
3 7 -0.43 21
2 8 16
1 9 -0.11 9
0 10 0
Elasticity calculations are based upon \$2 price changes.
Figure 4.1 Elasticity variation with linear demand
In the high-price region of the demand curve the elasticity takes on a high value. At the midpoint of a linear demand curve the elasticity takes on a value of one, and at lower prices the elasticity value continues to fall.
Using this rule, consider now the value of when price drops from \$10.00 to \$8.00. The change in price is \$2.00 and the average price is therefore . On the quantity side, demand goes from zero to 2 units (measured in thousands of cubic feet), and the average quantity demanded is therefore (0+2)/2=1. Putting these numbers into the formula yields:
Note that the price has declined in this instance and thus the change in price is negative. Continuing down the table in this fashion yields the full set of elasticity values in the third column.
The demand elasticity is said to be high if it is a large negative number; the large number denotes a high degree of sensitivity. Conversely, the elasticity is low if it is a small negative number. High and low refer to the size of the number, ignoring the negative sign. The term arc elasticity is also used to define what we have just measured, indicating that it defines consumer responsiveness over a segment or arc of the demand curve.
It is helpful to analyze this numerical example by means of the corresponding demand curve that is plotted in Figure 4.1, and which we used in Chapter 3. It is a straight-line demand curve; but, despite this, the elasticity is not constant. At high prices the elasticity is high; at low prices it is low. The intuition behind this pattern is as follows. When the price is high, a given price change represents a small percentage change, because the average price in the price-term denominator is large. At high prices the quantity demanded is small and therefore the percentage quantity change tends to be large due to the small quantity value in its denominator. In sum, at high prices the elasticity is large; it contains a large numerator and a small denominator. By the same reasoning, at low prices the elasticity is small.
We can carry this reasoning one step further to see what happens when the demand curve intersects the axes. At the horizontal axis the average price is tending towards zero. Since this extremely small value appears in the denominator of the price term it means that the price term as a whole is extremely large. Accordingly, with an extremely large value in the denominator of the elasticity expression, the whole ratio is tending towards a zero value. By the same reasoning the elasticity value at the vertical intercept is tending towards an infinitely large value.
Extreme cases
The elasticity decreases in going from high prices to low prices. This is true for most non-linear demand curves also. Two exceptions are when the demand curve is horizontal and when it is vertical.
When the demand curve is vertical, no quantity change results from a change in price from P1 to P2, as illustrated in Figure 4.2 using the demand curve Dv. Therefore, the numerator in Equation 4.1 is zero, and the elasticity has a zero value.
Figure 4.2 Limiting cases of price elasticity
When the demand curve is vertical (Dv), the elasticity is zero: A change in price from P1 to P2 has no impact on the quantity demanded because the numerator in the elasticity formula has a zero value. When D becomes more horizontal the elasticity becomes larger and larger at P1, eventually becoming infinite.
In the horizontal case, we say that the elasticity is infinite, which means that any percentage price change brings forth an infinite quantity change! This case is also illustrated in Figure 4.2 using the demand curve Dh. As with the vertical demand curve, this is not immediately obvious. So consider a demand curve that is almost horizontal, such as instead of Dh. In this instance, we can achieve large changes in quantity demanded by implementing very small price changes. In terms of Equation 4.1, the numerator is large and the denominator small, giving rise to a large elasticity. Now imagine that this demand curve becomes ever more elastic (horizontal). The same quantity response can be obtained with a smaller price change, and hence the elasticity is larger. Pursuing this idea, we can say that, as the demand curve becomes ever more elastic, the elasticity value tends towards infinity.
A non-linear demand curve is illustrated in Figure 4.3. If price increases from P0 to P1, the corresponding quantity change is given by (Q0Q1). When the price declines to P2 the quantity increases from Q0 to Q2. When statisticians study data to determine how responsive purchases are to price changes they do not always find a linear relationship between price and quantity. But a linear relationship is frequently a good approximation or representation of actual data and we will continue to analyze responsiveness in a linear framework in this chapter.
Figure 4.3 Non-linear demand curves
When the demand curve is non-linear the slope changes with the price. Hence, equal price changes do not lead to equal quantity changes: The quantity change associated with a change in price from P0 to P1 is smaller than the change in quantity associated with the same change in price from P0 to P2.
Elastic and inelastic demands
While the elasticity value falls as we move down the demand curve, an important dividing line occurs at the value of –1. This is illustrated in Table 4.1, and is a property of all straight-line demand curves. Disregarding the negative sign, demand is said to be elastic if the price elasticity is greater than unity, and inelastic if the value lies between unity and 0. It is unit elastic if the value is exactly one.
Demand is elastic if the price elasticity is greater than unity. It is inelastic if the value lies between unity and 0. It is unit elastic if the value is exactly one.
Economists frequently talk of goods as having a "high" or "low" demand elasticity. What does this mean, given that the elasticity varies throughout the length of a demand curve? It signifies that, at the price usually charged, the elasticity has a high or low value. For example, your weekly demand for regular coffee at Starbucks might be unresponsive to variations in price around the value of \$3.00, but if the price were \$6, you might be more responsive to price variations. Likewise, when we stated at the beginning of this chapter that the demand for food tends to be inelastic, we really meant that at the price we customarily face for food, demand is inelastic.
Determinants of price elasticity
Why is it that the price elasticities for some goods and services are high and for others low?
• One answer lies in tastes: If a good or service is a basic necessity in one's life, then price variations have a minimal effect on the quantity demanded, and these products thus have a relatively inelastic demand.
• A second answer lies in the ease with which we can substitute alternative goods or services for the product in question. If Apple Corporation had no serious competition in the smart-phone market, it could price its products even higher than in the presence of Samsung and Google, who also supply smart phones. A supplier who increases her price will lose more sales if there are ready substitutes to which buyers can switch, than if no such substitutes exist. It follows that a critical role for the marketing department in a firm is to convince buyers of the uniqueness of the firm's product.
• Where product groups are concerned, the price elasticity of demand for one product is necessarily higher than for the group as a whole: Suppose the price of one computer tablet brand alone falls. Buyers would be expected to substitute towards this product in large numbers – its manufacturer would find demand to be highly responsive. But if all brands are reduced in price, the increase in demand for any one will be more muted. In essence, the one tablet whose price falls has several close substitutes, but tablets in the aggregate do not.
• Finally, there is a time dimension to responsiveness, and this is explored in Section 4.3. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/04%3A_Measures_of_response-_Elasticities/4.01%3A_Price_responsiveness_of_demand.txt |
In Chapter 3 we explored the implications of putting price floors and supply quotas in place. We saw that price floors can lead to excess supply. An important public policy question therefore is why these policies actually exist. It turns out that we can understand why with the help of elasticity concepts.
Price elasticity and expenditure
Let us return to Table 4.1 and explore what happens to total expenditure/revenue as the price varies. Since total revenue is simply the product of price times quantity it can be computed from the first two columns. The result is given in the final column. We see immediately that total expenditure on the good is highest at the midpoint of the demand curve corresponding to these data. At a price of \$5 expenditure is \$25. No other price yields more expenditure or revenue. Obviously the value \$5 is midway between the zero value and the price or quantity intercept of the demand curve in Figure 4.1. This is a general result for linear demand curves: Expenditure is greatest at the midpoint, and the mid-price corresponds to the mid-quantity on the horizontal axis.
Geometrically this can be seen from Figure 4.1. Since expenditure is the product of price and quantity, in geometric terms it is the area of the rectangle mapped out by any price-quantity combination. For example, at total expenditure is \$16 – the area of the rectangle bounded by these price and quantity values. Following this line of reasoning, if we were to compute the area bounded by a price of \$7 and a corresponding quantity of 3 units we get a larger rectangle – a value of \$21. This example indicates that the largest rectangle occurs at the midpoint of the demand curve. As a general geometric rule this is always the case. Hence we can conclude that the price that generates the greatest expenditure is the midpoint of a linear demand curve.
Let us now apply this rule to pricing in the market place. If our existing price is high and our goal is to generate more revenue, then we should reduce the price. Conversely, if our price is low and our goal is again to increase revenue we should raise the price. Starting from a high price let us see why this is so. By lowering the price we induce an increase in quantity demanded. Of course the lower price reduces the revenue obtained on the units already being sold at the initial high price. But since total expenditure increases at the new lower price, it must be the case that the additional sales caused by the lower price more than compensate for this loss on the units being sold at the initial high price. But there comes a point when this process ceases. Eventually the loss in revenue on the units being sold at the higher price is not offset by the revenue from additional quantity. We lose a margin on so many existing units that the additional sales cannot compensate. Accordingly revenue falls.
Note next that the top part of the demand curve is elastic and the lower part is inelastic. So, as a general rule we can state that:
A price decline (quantity increase) on an elastic segment of a demand curve necessarily increases revenue, and a price increase (quantity decline) on an inelastic segment also increases revenue.
The result is mapped in Figure 4.4, which plots total revenue as a function of the quantity demanded – columns 2 and 4 from Table 4.1. At low quantity values the price is high and the demand is elastic; at high quantity values the price is low and the demand is inelastic. The revenue maximizing point is the midpoint of the demand curve.
Figure 4.4 Total revenue and elasticity
Based upon the data in Table 4.1, revenue increases with quantity sold up to sales of 5 units. Beyond this output, the decline in price that must accompany additional sales causes revenue to decline.
We now have a general conclusion: In order to maximize the possible revenue from the sale of a good or service, it should be priced where the demand elasticity is unity.
Does this conclusion mean that every entrepreneur tries to find this magic region of the demand curve in pricing her product? Not necessarily: Most businesses seek to maximize their profit rather than their revenue, and so they have to focus on cost in addition to sales. We will examine this interaction in later chapters. Secondly, not every firm has control over the price they charge; the price corresponding to the unit elasticity may be too high relative to their competitors' price choices. Nonetheless, many firms, especially in the early phase of their life-cycle, focus on revenue growth rather than profit, and so, if they have any power over their price, the choice of the unit-elastic price may be appropriate.
The agriculture problem
We are now in a position to address the question we posed above: Why are price floors frequently found in agricultural markets? The answer is that governments believe that the pressures of competition would force farm/food prices so low that many farmers would not be able to earn a reasonable income from farming. Accordingly, governments impose price floors. Keep in mind that price floors are prices above the market equilibrium and therefore lead to excess supply.
Since the demand for foodstuffs is inelastic we know that a higher price will induce more revenue, even with a lower quantity being sold. The government can force this outcome on the market by a policy of supply management. It can force farmers in the aggregate to bring only a specific amount of product to the market, and thus ensure that the price floor does not lead to excess supply. This is the system of supply management we observe in dairy markets in Canada, for example, and that we examined in the case of maple syrup in Chapter 3. Its supporters praise it because it helps farmers, its critics point out that higher food prices hurt lower-income households more than high-income households, and therefore it is not a good policy.
Elasticity values are frequently more informative than diagrams and figures. Our natural inclination is to view demand curves with a somewhat vertical profile as being inelastic, and demand curves with a flatter profile as elastic. But we must keep in mind that, as explained in Chapter 2, the vertical and horizontal axis of any diagram can be scaled in such a way as to change the visual impact of the data underlying the curves. But a numerical elasticity value will never deceive in this way. If its value is less than unity it is inelastic, regardless of the visual aspect of the demand curve.
At the same time, if we have two demand curves intersecting at a particular price-quantity combination, we can say that the curve with the more vertical profile is relatively more elastic, or less inelastic. This is illustrated in Figure 4.5. It is clear that, at the price-quantity combination where they intersect, the demand curve will yield a greater (percentage) quantity change than the demand curve D, for a given (percentage) price change. Hence, on the basis of diagrams, we can compare demand elasticities in relative terms at a point where the two intersect.
Figure 4.5 The impact of elasticity on quantity fluctuations
In the lower part of the demand curve D, demand is inelastic: At the point A, a shift in supply from S1 to S2 induces a large percentage increase in price, and a small percentage decrease in quantity demanded. In contrast, for the demand curve that goes through the original equilibrium, the region A is now an elastic region, and the impact of the supply shift is contrary: The % is smaller and the % is larger. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/04%3A_Measures_of_response-_Elasticities/4.02%3A_Price_elasticities_and_public_policy.txt |
The price elasticity of demand is frequently lower in the short run than in the long run. For example, a rise in the price of home heating oil may ultimately induce consumers to switch to natural gas or electricity, but such a transition may require a considerable amount of time. Time is required for decision-making and investment in new heating equipment. A further example is the elasticity of demand for tobacco. Some adults who smoke may be seriously dependent and find quitting almost impossible. Higher prices may provide a stronger incentive to reduce or quit, but successful quitters usually require several attempts before being successful. Several years may be required for the impact of a price increase to be fully apparent. Accordingly when we talk of the short run and the long run, there is no simple rule for defining how long the long run actually is in terms of months or years. In some cases, adjustment may be complete in weeks, in other cases years.
In Chapter 2 we distinguished between real and nominal variables. The former adjust for inflation; the latter do not. Suppose all nominal variables double in value: Every good and service costs twice as much, wage rates double, dividends and rent double, etc. This implies that whatever bundle of goods was previously affordable is still affordable. Nothing has really changed. Demand behaviour is unaltered by this doubling of all prices and all incomes.
How do we reconcile this with the idea that own-price elasticities measure changes in quantity demanded as prices change? Keep in mind that elasticities measure the impact of changing one variable alone, holding constant all of the others. But when all variables are changing simultaneously, it is incorrect to think that the impact on quantity of one price or income change is a true measure of responsiveness or elasticity. The price changes that go into measuring elasticities are therefore changes in prices relative to inflation.
4.04: Cross-price elasticities - cable or satellite
The price elasticity of demand tells us about consumer responses to price changes in different regions of the demand curve, holding constant all other influences. One of those influences is the price of other goods and services. A cross-price elasticity indicates how demand is influenced by changes in the prices of other products.
The cross-price elasticity of demand is the percentage change in the quantity demanded of a product divided by the percentage change in the price of another.
We write the cross price elasticity of the demand for x due to a change in the price of y as
For example, if the price of cable-supply internet services declines, by how much will the demand for satellite-supply services change? The cross-price elasticity may be positive or negative. These particular goods are clearly substitutable, and this is reflected in a positive value of this cross-price elasticity: The percentage change in satellite subscribers will be negative in response to a decline in the price of cable; a negative divided by a negative is positive. In contrast, a change in the price of tablets or electronic readers should induce an opposing change in the quantity of e-books purchased: Lower tablet prices will induce greater e-book purchases. In this case the price and quantity movements are in opposite directions and the elasticity is therefore negative – the goods are complements.
Application Box 4.1 Cross-price elasticity of demand between legal and illegal marijuana
In November 2016 Canada's Parliamentary Budget Office produced a research paper on the challenges associated with pricing legalized marijuana. They proposed that taxes should be low rather than high on this product, surprising many health advocates. Specifically they argued that the legal price of marijuana should be just fractionally higher than the price in the illegal market. Otherwise marijuana users would avail of the illegal market supply, which is widely available and of high quality. Effectively their research pointed to a very high cross-price elasticity of demand. This recommendation may mean that tax revenue from marijuana sales will be small, but the size of the illegal market will decline substantially, thereby attaining a prime objective of legalization. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/04%3A_Measures_of_response-_Elasticities/4.03%3A_The_time_horizon_and_inflation.txt |
In Chapter 3 we stated that higher incomes tend to increase the quantity demanded at any price. To measure the responsiveness of demand to income changes, a unit-free measure exists: The income elasticity of demand. The income elasticity of demand is the percentage change in quantity demanded divided by a percentage change in income.
The income elasticity of demand is the percentage change in quantity demanded divided by a percentage change in income.
Let us use the Greek letter eta, , to define the income elasticity of demand and I to denote income. Then,
As an example, if monthly income increases by 10 percent, and the quantity of magazines purchased increases by 15 percent, then the income elasticity of demand for magazines is 1.5 in value . The income elasticity is generally positive, but not always – let us see why.
Normal, inferior, necessary, and luxury goods
The income elasticity of demand, in diagrammatic terms, is a percentage measure of how far the demand curve shifts in response to a change in income. Figure 4.6 shows two possible shifts. Suppose the demand curve is initially the one defined by D, and then income increases. In this example the supply curve is horizontal at the price P0. If the demand curve shifts to D1 as a result, the change in quantity demanded at the existing price is (Q1Q0). However, if instead the demand curve shifts to D2, that shift denotes a larger change in quantity (Q2Q0). Since the shift in demand denoted by D2 exceeds the shift to D1, the D2 shift is more responsive to income, and therefore implies a higher income elasticity.
Figure 4.6 Income elasticity and shifts in demand
At the price P0, the income elasticity measures the percentage horizontal shift in demand caused by some percentage income increase. A shift from A to B reflects a lower income elasticity than a shift to C. A leftward shift in the demand curve in response to an income increase would denote a negative income elasticity – an inferior good.
In this example, the good is a normal good, as defined in Chapter 3, because the demand for it increases in response to income increases. If the demand curve were to shift back to the left in response to an increase in income, then the income elasticity would be negative. In such cases the goods or services are inferior, as defined in Chapter 3.
Finally, we distinguish between luxuries and necessities. A luxury good or service is one whose income elasticity equals or exceeds unity. A necessity is one whose income elasticity is greater than zero but less than unity. If quantity demanded is so responsive to an income increase that the percentage increase in quantity demanded exceeds the percentage increase in income, then the elasticity value is in excess of 1, and the good or service is called a luxury. In contrast, if the percentage change in quantity demanded is less than the percentage increase in income, the value is less than unity, and we call the good or service a necessity.
A luxury good or service is one whose income elasticity equals or exceeds unity.
A necessity is one whose income elasticity is greater than zero and less than unity.
Luxuries and necessities can also be defined in terms of their share of a typical budget. An income elasticity greater than unity means that the share of an individual's budget being allocated to the product is increasing. In contrast, if the elasticity is less than unity, the budget share is falling. This makes intuitive sense—luxury cars are luxury goods by this definition because they take up a larger share of the incomes of the rich than the non-rich.
Inferior goods are those for which there exist higher-quality, more expensive, substitutes. For example, lower-income households tend to satisfy their travel needs by using public transit. As income rises, households may reduce their reliance on public transit in favour of automobile use (despite the congestion and environmental impacts). Likewise, laundromats are inferior goods in the sense that, as income increases, individuals tend to purchase their own appliances and therefore use laundromat services less. Inferior goods, therefore, have a negative income elasticity: In the income elasticity equation definition, the numerator has a sign opposite to that of the denominator.
Inferior goods have negative income elasticity.
Empirical research indicates that goods like food and fuel have income elasticities less than 1; durable goods and services have elasticities slightly greater than 1; leisure goods and foreign holidays have elasticities very much greater than 1.
Income elasticities are useful in forecasting the demand for particular services and goods in a growing economy. Suppose real income is forecast to grow by 15% over the next five years. If we know that the income elasticity of demand for smart phones is 2.0, we could estimate the anticipated growth in demand by using the income elasticity formula: Since in this case and it follows that . Therefore the predicted demand change must be 30%. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/04%3A_Measures_of_response-_Elasticities/4.05%3A_The_income_elasticity_of_demand.txt |
Now that we have developed the various dimensions of elasticity on the demand side, the analysis of elasticities on the supply side is straightforward. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price.
The elasticity of supply measures the responsiveness of quantity supplied to a change in the price.
The subscript s denotes supply. This is exactly the same formula as for the demand curve, except that the quantities now come from a supply curve. Furthermore, and in contrast to the demand elasticity, the supply elasticity is generally a positive value because of the positive relationship between price and quantity supplied. The more elastic, or the more responsive, is supply to a given price change, the larger will be the elasticity value. In diagrammatic terms, this means that "flatter" supply curves have a greater elasticity than more "vertical" curves at a given price and quantity combination. Numerically the flatter curve has a larger value than the more vertical supply – try drawing a supply diagram similar to Figure 4.2. Technically, a completely vertical supply curve has a zero elasticity and a horizontal supply curve has an infinite elasticity – just as in the demand cases.
As always we keep in mind the danger of interpreting too much about the value of this elasticity from looking at the visual profiles of supply curves.
Application Box 4.2 The price of oil and the coronavirus
In January 2020, the price of oil in the US traded at \$60 per barrel. The coronavirus then struck the world economy, transport declined dramatically, and by the beginning of April the price had dropped to \$20 per barrel. The quantity of oil traded on world markets fell from approximately 100 million barrels per day in January to 65 million barrels by the start of April, a drop of 35% relative to its January level. This scenario is displayed in Figure 4.7 below.
Figure 4.7 Supply elasticity in the short run and the long run; the oil market in 2020
Demand drops suddenly between January and April. Equilibrium moves from point A to B. In the long run some producers exit and the supply curve shifts towards the origin. Following this, the equilibrium is C. Joining points such as A and C yields a long run supply curve; it is more elastic than the short run supply, when the number of suppliers is fixed.
The January equilibrium is at the point A, and the April equilibrium at point B. The move from A to B was caused by a collapse in demand as illustrated by the shift in the demand curve. We can compute the supply elasticity readily from this example. Note that it was demand that shifted rather than supply so we are observing two points on the supply curve. The supply elasticity, using arc values, is given by (35/82.5)/(\$40/\$40) = 0.42. So the supply curve is inelastic.
Can all oil producers survive in this bear market? The answer is no. It is inexpensive to pump oil in Saudi Arabia, but more costly to produce it from shale or tar sands, and thus some producers are not covering their costs with the price at \$20 per barrel. They do not want to shut their operations because closing down and reopening is expensive. They hang on in the hope that the price will return towards \$60. If demand does not recover, some suppliers exit the industry with the passage of time. With fewer suppliers the supply curve shifts towards the origin and ultimately another equilibrium price and quantity are established. Call this new equilibrium point C.
The supply elasticity takes on a different value in the short run than in the long run. Supply is more inelastic in the short run. A line through the points A and C would represent the long-run supply curve for the industry. It must be more elastic than the short run supply because the industry has had time to adjust - it is more flexible with the passage of time. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/04%3A_Measures_of_response-_Elasticities/4.06%3A_Elasticity_of_supply.txt |
Elasticity values are critical in determining the impact of a government's taxation policies. The spending and taxing activities of the government influence the use of the economy's resources. By taxing cigarettes, alcohol and fuel, the government can restrict their use; by taxing income, the government influences the amount of time people choose to work. Taxes have a major impact on almost every sector of the Canadian economy.
To illustrate the role played by demand and supply elasticities in tax analysis, we take the example of a sales tax. These can be of the specific or ad valorem type. A specific tax involves a fixed dollar levy per unit of a good sold (e.g., \$10 per airport departure). An ad valorem tax is a percentage levy, such as Canada's Goods and Services tax (e.g., 5 percent on top of the retail price of goods and services). The impact of each type of tax is similar, and we will use the specific tax in our example below.
A layperson's view of a sales tax is that the tax is borne by the consumer. That is to say, if no sales tax were imposed on the good or service in question, the price paid by the consumer would be the same net of tax price as exists when the tax is in place. Interestingly, this is not always the case. The study of the incidence of taxes is the study of who really bears the tax burden, and this in turn depends upon supply and demand elasticities.
Tax Incidence describes how the burden of a tax is shared between buyer and seller.
Consider Figures 4.8 and 4.9, which define an imaginary market for inexpensive wine. Let us suppose that, without a tax, the equilibrium price of a bottle of wine is \$5, and Q0 is the equilibrium quantity traded. The pre-tax equilibrium is at the point A. The government now imposes a specific tax of \$4 per bottle. The impact of the tax is represented by an upward shift in supply of \$4: Regardless of the price that the consumer pays, \$4 of that price must be remitted to the government. As a consequence, the price paid to the supplier must be \$4 less than the consumer price, and this is represented by twin supply curves: One defines the price at which the supplier is willing to supply (S), and the other is the tax-inclusive supply curve that the consumer faces (St).
Figure 4.8 Tax incidence with elastic supply
The imposition of a specific tax of \$4 shifts the supply curve vertically by \$4. The final price at B (Pt) increases by \$3 over the equilibrium price at A. At the new quantity traded, Qt, the supplier gets \$4 per unit (), the government gets \$4 also and the consumer pays \$8. The greater part of the incidence is upon the buyer, on account of the relatively elastic supply curve: His price increases by \$3 of the \$4 tax.
The introduction of the tax in Figure 4.8 means that consumers now face the supply curve St. The new equilibrium is at point B. Note that the price has increased by less than the full amount of the tax—in this example it has increased by \$3. This is because the reduced quantity at B is provided at a lower supply price: The supplier is willing to supply the quantity Qt at a price defined by C (\$4), which is lower than the price at A (\$5).
So what is the incidence of the \$4 tax? Since the market price has increased from \$5 to \$8, and the price obtained by the supplier has fallen by \$1, we say that the incidence of the tax falls mainly on the consumer: The price to the consumer has risen by three dollars and the price received by the supplier has fallen by just one dollar.
Consider now Figure 4.9, where the supply curve is less elastic, and the demand curve is unchanged. Again the supply curve must shift upward with the imposition of the specific tax. But here the price received by the supplier is lower than in Figure 4.8, and the price paid by the consumer does not rise as much – the incidence is different. The consumer faces a price increase that is one-half, rather than three-quarters, of the tax value. The supplier faces a lower supply price, and bears a higher share of the tax.
Figure 4.9 Tax incidence with inelastic supply
The imposition of a specific tax of \$4 shifts the supply curve vertically by \$4. The final price at B (Pt) increases by \$2 over the no-tax price at A. At the new quantity traded, Qt, the supplier gets \$3 per unit (), the government gets \$4 also and the consumer pays \$7. The incidence is shared equally by suppliers and demanders.
We can conclude from this example that, for any given demand, the more elastic is supply, the greater is the price increase in response to a given tax. Furthermore, a more elastic supply curve means that the incidence falls more on the consumer; while a less elastic supply curve means the incidence falls more on the supplier. This conclusion can be verified by drawing a third version of Figure 4.8 and 4.9, in which the supply curve is horizontal – perfectly elastic. When the tax is imposed the price to the consumer increases by the full value of the tax, and the full incidence falls on the buyer. While this case corresponds to the layperson's intuition of the incidence of a tax, economists recognize it as a special case of the more general outcome, where the incidence falls on both the supply side and the demand side.
These are key results in the theory of taxation. It is equally the case that the incidence of the tax depends upon the demand elasticity. In Figure 4.8 and 4.9 we used the same demand curve. However, it is not difficult to see that, if we were to redo the exercise with a demand curve of a different elasticity, the incidence would not be identical. At the same time, the general result on supply elasticities still holds. We will return to this material in Chapter 5.
Statutory incidence
In the above example the tax is analyzed by means of shifting the supply curve. This implies that the supplier is obliged to charge the consumer a tax and then return this tax revenue to the government. But suppose the supplier did not bear the obligation to collect the revenue; instead the buyer is required to send the tax revenue to the government, as in the case of employers who are required to deduct income tax from their employees' pay packages (the employers here are the demanders). If this were the case we could analyze the impact of the tax by reducing the market demand curve by the \$4. This is because the demand curve reflects what buyers are willing to pay, and when suppliers are paid in the presence of the tax they will be paid the buyers' demand price minus the tax that the buyers must pay. It is not difficult to show that whether we move the supply curve upward (to reflect the responsibility of the supplier to pay the government) or move the demand curve downward, the outcome is the same – in the sense that the same price and quantity will be traded in each case. Furthermore the incidence of the tax, measured by how the price change is apportioned between the buyers and sellers is also unchanged.
Tax revenues and tax rates
It is useful to relate elasticity values to the policy question of the impact of higher or lower taxes on government tax revenue. Consider a situation in which a tax is already in place and the government considers increasing the rate of tax. Can an understanding of elasticities inform us on the likely outcome? The answer is yes. Suppose that at the initial tax-inclusive price demand is inelastic. We know immediately that a tax rate increase that increases the price must increase total expenditure. Hence the outcome is that the government will get a higher share of an increased total expenditure. In contrast, if demand is elastic at the initial tax-inclusive price a tax rate increase that leads to a higher price will decrease total expenditure. In this case the government will get a larger share of a smaller pie – not as valuable from a tax-revenue standpoint as a larger share of a larger pie. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/04%3A_Measures_of_response-_Elasticities/4.07%3A_Elasticities_and_tax_incidence.txt |
We can easily compute elasticities at any point on a demand curve, rather than over a range or arc, by using the explicit formula for the demand curve. To see this note that we can rewrite Equation 4.1 as:
The first term in the final form of this expression is obtained from the slope of the demand curve, and the second term (P/Q) is defined by the point on the curve that interests us. For example if our demand curve is , then . Inverting this to get yields –1 also. So, the point elasticity value at is . This formula provides the elasticity value at a particular point on the demand curve, rather than over a range of values or an arc. Consequently it is called the point elasticity of demand. And obviously we could apply it to a demand curve that is not linear provided we know the mathematical form and are able to establish the slope.
4.09: Key Terms
Price elasticity of demand is measured as the percentage change in quantity demanded, divided by the percentage change in price.
Demand is elastic if the price elasticity is greater than unity. It is inelastic if the value lies between unity and 0. It is unit elastic if the value is exactly one.
Cross-price elasticity of demand is the percentage change in the quantity demanded of a product divided by the percentage change in the price of another.
Income elasticity of demand is the percentage change in quantity demanded divided by a percentage change in income.
Luxury good or service is one whose income elasticity equals or exceeds unity.
Necessity is one whose income elasticity is greater than zero and is less than unity.
Inferior goods have a negative income elasticity.
Elasticity of supply is defined as the percentage change in quantity supplied divided by the percentage change in price.
Tax Incidence describes how the burden of a tax is shared between buyer and seller.
4.10: Exercises for Chapter 4
EXERCISE 4.1
Consider the information in the table below that describes the demand for movie rentals from your on-line supplier Instant Flicks.
Price per movie (\$) Quantity demanded Total revenue Elasticity of demand
2 1200
3 1100
4 1000
5 900
6 800
7 700
8 600
1. Either on graph paper or a spreadsheet, map out the demand curve.
2. In column 3, insert the total revenue generated at each price.
3. At what price is total revenue maximized?
4. In column 4, compute the elasticity of demand corresponding to each \$1 price reduction, using the average price and quantity at each state.
5. Do you see a connection between your answers in parts (c) and (d)?
EXERCISE 4.2
Your fruit stall has 100 ripe bananas that must be sold today. Your supply curve is therefore vertical. From past experience, you know that these 100 bananas will all be sold if the price is set at 40 cents per unit.
1. Draw a supply and demand diagram illustrating the market equilibrium price and quantity.
2. The demand elasticity is -0.5 at the equilibrium price. But you now discover that 10 of your bananas are rotten and cannot be sold. Draw the new supply curve and calculate the percentage price increase that will be associate with the new equilibrium, on the basis of your knowledge of the demand elasticity.
EXERCISE 4.3
University fees in the State of Nirvana have been frozen in real terms for 10 years. During this period enrolments increased by 20 percent, reflecting an increase in demand. This means the supply curve is horizontal at a given price.
1. Draw a supply curve and two demand curves to represent the two equilibria described.
2. Can you estimate a price elasticity of demand for university education in this market?
3. In contrast, during the same time period fees in a neighbouring state (where supply is also horizontal) increased by 60 percent and enrolments increased by 15 percent. Illustrate this situation in a diagram, where supply is again horizontal.
EXERCISE 4.4
Consider the demand curve defined by the information in the table below.
Price of movies Quantity demanded Total revenue Elasticity of demand
2 200
3 150
4 120
5 100
1. Plot the demand curve to scale and note that it is non-linear.
2. Compute the total revenue at each price.
3. Compute the arc elasticity of demand for each of the three price segments.
EXERCISE 4.5
Waterson Power Corporation's regulator has just allowed a rate increase from 9 to 11 cents per kilowatt hour of electricity. The short-run demand elasticity is -0.6 and the long-run demand elasticity is -1.2 at the current price..
1. What will be the percentage reduction in power demanded in the short run (use the midpoint 'arc' elasticity formula)?
2. What will be the percentage reduction in power demanded in the long run?
3. Will revenues increase or decrease in the short and long runs?
EXERCISE 4.6
Consider the own- and cross-price elasticity data in the table below.
% change in price
CDs Magazines Cappuccinos
% change in quantity CDs -0.25 0.06 0.01
Magazines -0.13 -1.20 0.27
Cappuccinos 0.07 0.41 -0.85
1. For which of the goods is demand elastic and for which is it inelastic?
2. What is the effect of an increase in the price of CDs on the purchase of magazines and cappuccinos? What does this suggest about the relationship between CDs and these other commodities; are they substitutes or complements?
3. In graphical terms, if the price of CDs or the price of cappuccinos increases, illustrate how the demand curve for magazines shifts.
EXERCISE 4.7
You are responsible for running the Speedy Bus Company and have information about the elasticity of demand for bus travel: The own-price elasticity is -1.4 at the current price. A friend who works in the competing railway company also tells you that she has estimated the cross-price elasticity of train-travel demand with respect to the price of bus travel to be 1.7.
1. As an economic analyst, would you advocate an increase or decrease in the price of bus tickets if you wished to increase revenue for Speedy?
2. Would your price decision have any impact on train ridership?
EXERCISE 4.8
A household's income and restaurant visits are observed at different points in time. The table below describes the pattern.
Income (\$) Restaurant visits Income elasticity of demand
16,000 10
24,000 15
32,000 18
40,000 20
48,000 22
56,000 23
64,000 24
1. Construct a scatter diagram showing quantity on the vertical axis and income on the horizontal axis.
2. Is there a positive or negative relationship between these variables?
3. Compute the income elasticity for each income increase, using midpoint values.
4. Are restaurant meals a normal or inferior good?
EXERCISE 4.9
The demand for bags of candy is given by P=48–0.2Q, and the supply by P=Q. The demand intercepts here are and Q=240; the supply curve is a 45 degree straight line through the origin.
1. Illustrate the resulting market equilibrium in a diagram knowing that the demand intercepts are , and that the supply curve is a 45 degree line through the origin.
2. If the government now puts a \$12 tax on all such candy bags, illustrate on a diagram how the supply curve will change.
3. Instead of the specific tax imposed in part (b), a percentage tax (ad valorem) equal to 30 percent is imposed. Illustrate how the supply curve would change.
EXERCISE 4.10
Optional: Consider the demand curve P=100–2Q. The supply curve is given by P=30.
1. Draw the supply and demand curves to scale, knowing that the demand curve intercepts are \$100 and 50, and compute the equilibrium price and quantity in this market.
2. If the government imposes a tax of \$10 per unit, draw the new equilibrium and compute the new quantity traded and the amount of tax revenue generated.
3. Is demand elastic or inelastic in this price range? [Hint: you should be able to answer this without calculations, by observing the figure you have constructed.]
EXERCISE 4.11
Optional: The supply of Henry's hamburgers is given by P=2+0.5Q; demand is given by Q=20.
1. Illustrate and compute the market equilibrium, knowing that the supply curve has an intercept of \$2 and a slope of 0.5.
2. A specific tax of \$3 per unit is subsequently imposed and that shifts the supply curve upwards and parallel by \$3, to become P=5+0.5Q. Solve for the equilibrium price and quantity after the tax.
3. Insert the post-tax supply curve along with the pre-tax supply curve, and determine who bears the burden of the tax. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/04%3A_Measures_of_response-_Elasticities/4.08%3A_Technical_tricks_with_elasticities.txt |
Chapter 5: Welfare economics and externalities
In this chapter we will explore:
5.1
Equity and efficiency
5.2
Consumer and producer surplus
5.3
Efficient market outcomes
5.4
Taxation, surplus and efficiency
5.5
Market failures – externalities
5.6
Other market failures
5.7
Environment and climate change
5.1 Equity and efficiency
In modern mixed economies, markets and governments together determine the output produced and also who benefits from that output. In this chapter we explore a very broad question that forms the core of welfare economics: Even if market forces drive efficiency, are they a good way to allocate scarce resources in view of the fact that they not only give rise to inequality and poverty, but also fail to capture the impacts of productive activity on non-market participants? Mining impacts the environment, traffic results in road fatalities, alcohol, tobacco and opioids cause premature deaths. These products all generate secondary impacts beyond their stated objective. We frequently call these external effects.
The analysis of markets in this larger sense involves not just economic efficiency; public policy additionally has a normative content because policies can impact the various participants in different ways and to different degrees. Welfare economics, therefore, deals with both normative and positive issues.
Welfare economics assesses how well the economy allocates its scarce resources in accordance with the goals of efficiency and equity.
Political parties on the left and right disagree on how well a market economy works. Canada's New Democratic Party emphasizes the market's failings and the need for government intervention, while the Progressive Conservative Party believes, broadly, that the market fosters choice, incentives, and efficiency. What lies behind this disagreement? The two principal factors are efficiency and equity. Efficiency addresses the question of how well the economy's resources are used and allocated. In contrast, equity deals with how society's goods and rewards are, and should be, distributed among its different members, and how the associated costs should be apportioned.
Equity deals with how society's goods and rewards are, and should be, distributed among its different members, and how the associated costs should be apportioned.
Efficiency addresses the question of how well the economy's resources are used and allocated.
Equity is also concerned with how different generations share an economy's productive capabilities: More investment today makes for a more productive economy tomorrow, but more greenhouse gases today will reduce environmental quality tomorrow. These are inter-generational questions.
Climate change caused by global warming forms one of the biggest challenges for humankind at the present time. As we shall see in this chapter, economics has much to say about appropriate policies to combat warming. Whether pollution-abatement policies should be implemented today or down the road involves considerations of equity between generations. Our first task is to develop an analytical tool which will prove vital in assessing and computing welfare benefits and costs – economic surplus.
5.2 Consumer and producer surplus
An understanding of economic efficiency is greatly facilitated as a result of understanding two related measures: Consumer surplus and producer surplus. Consumer surplus relates to the demand side of the market, producer surplus to the supply side. Producer surplus is also termed supplier surplus. These measures can be understood with the help of a standard example, the market for city apartments.
The market for apartments
Table 5.1 and Figure 5.1 describe the hypothetical data. We imagine first a series of city-based students who are in the market for a standardized downtown apartment. These individuals are not identical; they value the apartment differently. For example, Alex enjoys comfort and therefore places a higher value on a unit than Brian. Brian, in turn, values it more highly than Cathy or Don. Evan and Frank would prefer to spend their money on entertainment, and so on. These valuations are represented in the middle column of the demand panel in Table 5.1, and also in Figure 5.1 with the highest valuations closest to the origin. The valuations reflect the willingness to pay of each consumer.
Table 5.1 Consumer and supplier surpluses
Demand
Individual Demand valuation Surplus
Alex 900 400
Brian 800 300
Cathy 700 200
Don 600 100
Evan 500 0
Frank 400 0
Supply
Individual Reservation value Surplus
Gladys 300 200
Heward 350 150
Ian 400 100
Jeff 450 50
Kirin 500 0
Lynn 550 0
On the supply side we imagine the market as being made up of different individuals or owners, who are willing to put their apartments on the market for different prices. Gladys will accept less rent than Heward, who in turn will accept less than Ian. The minimum prices that the suppliers are willing to accept are called reservation prices or values, and these are given in the lower part of Table 5.1. Unless the market price is greater than their reservation price, suppliers will hold back.
By definition, as stated in Chapter 3, the demand curve is made up of the valuations placed on the good by the various demanders. Likewise, the reservation values of the suppliers form the supply curve. If Alex is willing to pay \$900, then that is his demand price; if Heward is willing to put his apartment on the market for \$350, he is by definition willing to supply it for that price. Figure 5.1 therefore describes the demand and supply curves in this market. The steps reflect the willingness to pay of the buyers and the reservation valuations or prices of the suppliers.
Figure 5.1 The apartment market
Demanders and suppliers are ranked in order of the value they place on an apartment. The market equilibrium is where the marginal demand value of Evan equals the marginal supply value of Kirin at \$500. Five apartments are rented in equilibrium.
In this example, the equilibrium price for apartments will be \$500. Let us see why. At that price the value placed on the marginal unit supplied by Kirin equals Evan's willingness to pay. Five apartments will be rented. A sixth apartment will not be rented because Lynn will let her apartment only if the price reaches \$550. But the sixth potential demander is willing to pay only \$400. Note that, as usual, there is just a single price in the market. Each renter pays \$500, and therefore each supplier also receives \$500.
The consumer and supplier surpluses can now be computed. Note that, while Don is willing to pay \$600, he actually pays \$500. His consumer surplus is therefore \$100. In Figure 5.1, we can see that each consumer's surplus is the distance between the market price and the individual's valuation. These values are given in the final column of the top half of Table 5.1.
Consumer surplus is the excess of consumer willingness to pay over the market price.
Using the same reasoning, we can compute each supplier's surplus, which is the excess of the amount obtained for the rented apartment over the reservation price. For example, Heward obtains a surplus on the supply side of \$150, while Jeff gets \$50. Heward is willing to put his apartment on the market for \$350, but gets the equilibrium price/rent of \$500 for it. Hence his surplus is \$150.
Supplier or producer surplus is the excess of market price over the reservation price of the supplier.
It should now be clear why these measures are called surpluses. The suppliers and demanders are all willing to participate in this market because they earn this surplus. It is a measure of their gain from being involved in the trading. The sum of each participant's surplus in the final column of Table 5.1 defines the total surplus in the market. Hence, on the demand side a total surplus arises of \$1,000 and on the supply side a value of \$500.
The taxi market
We do not normally think of demand and supply functions in terms of the steps illustrated in Figure 5.1. Usually there are so many participants in the market that the differences in reservation prices on the supply side and willingness to pay on the demand side are exceedingly small, and so the demand and supply curves are drawn as continuous lines. So our second example reflects this, and comes from the market for taxi rides. We might think of this as an Uber- or Lyft-type taxi operation.
Let us suppose that the demand and supply curves for taxi rides in a given city are given by the functions in Figure 5.2.
Figure 5.2 The taxi market
Consumer surplus is the area ABE, supplier surplus is the area BCE.
The demand curve represents the willingness to pay on the part of riders. The supply curve represents the willingness to supply on the part of drivers. The price per hour of rides defines the vertical axis; hours of rides (in thousands) are measured on the horizontal axis. The demand intercept of \$90 says that the person who values the ride most highly is willing to pay \$90 per hour. The downward slope of the demand curve states that other buyers are willing to pay less. On the supply side no driver is willing to supply his time and vehicle unless he obtains at least \$30 per hour. To induce additional suppliers a higher price must be paid, and this is represented by the upward sloping supply curve.
The intersection occurs at a price of \$42 per hour and the equilibrium number of ride-hours supplied is 48 thousand1. Computing the surpluses is very straightforward. By definition the consumer surplus is the excess of the willingness to pay by each buyer above the uniform price. Buyers who value the ride most highly obtain the biggest surplus – the highest valuation rider gets a surplus of \$48 per hour – the difference between his willingness to pay of \$90 and the actual price of \$42. Each successive rider gets a slightly lower surplus until the final rider, who obtains zero. She pays \$42 and values the ride hours at \$42 also. On the supply side, the drivers who are willing to supply rides at the lowest reservation price (\$30 and above) obtain the biggest surplus. The 'marginal' supplier gets no surplus, because the price equals her reservation price.
From this discussion it follows that the consumer surplus is given by the area ABE and the supplier surplus by the area CBE. These are two triangular areas, and measured as half of the base by the perpendicular height. Therefore, in thousands of units:
The total surplus that arises in the market is the sum of producer and consumer surpluses, and since the units are in thousands of hours the total surplus here is .
5.3 Efficient market outcomes
The definition and measurement of the surplus is straightforward provided the supply and demand functions are known. An important characteristic of the marketplace is that in certain circumstances it produces what we call an efficient outcome, or an efficient market. Such an outcome yields the highest possible sum of surpluses.
An efficient market maximizes the sum of producer and consumer surpluses.
To see that this outcome achieves the goal of maximizing the total surplus, consider what would happen if the quantity Q=48 in the taxi example were not supplied. Suppose that the city's taxi czar decreed that 50 units should be supplied, and the czar forced additional drivers on the road. If 2 additional units are to be traded in the market, consider the value of this at the margin. Suppliers value the supply more highly than the buyers are willing to pay. So on these additional 2 units negative surplus would accrue, thus reducing the total.
A second characteristic of the market equilibrium is that potential buyers who would like a cheaper ride and drivers who would like a higher hourly payment do not participate in the market. On the demand side those individuals who are unwilling to pay \$42/hour can take public transit, and on the supply side the those drivers who are unwilling to supply at \$42/hour can allocate their time to alternative activities. Obviously, only those who participate in the market benefit from a surplus.
One final characteristic of surplus measurement should be emphasized. That is, the surplus number is not unique, it depends upon the economic environment. We can illustrate this easily using the taxi example. A well recognized feature of Uber taxi rides is that the price varies with road and weather conditions. Poor weather conditions mean that there is an increased demand, and poor road or weather conditions mean that drivers are less willing to supply their services – their reservation payment increases. This situation is illustrated in Figure 5.3.
Figure 5.3 The taxi market
The curves represented by and represent the curves for bad weather: Taxi rides are more highly valued on the demand side, and drivers must be paid more to supply in less favourable work conditions.
The demand curve has shifted upwards and the supply curve has also changed in such a way that any quantity will now be supplied at a higher price. The new equilibrium is given by rather than E.2 There is a new equilibrium price-quantity combination that is efficient in the new market conditions. This illustrates that there is no such thing as a unique unchanging efficient outcome. When economic factors that influence the buyers' valuations (demand) or the suppliers' reservation prices (supply) change, then the efficient market outcome must be recomputed.
5.4 Taxation, surplus and efficiency
Despite enormous public interest in taxation and its impact on the economy, it is one of the least understood areas of public policy. In this section we will show how an understanding of two fundamental tools of analysis – elasticities and economic surplus – provides powerful insights into the field of taxation.
We begin with the simplest of cases: The federal government's goods and services tax (GST) or the provincial governments' sales taxes (PST). These taxes combined vary by province, but we suppose that a typical rate is 13 percent. In some provinces these two taxes are harmonized. Note that this is a percentage, or ad valorem, tax, not a specific tax of so many dollars per unit traded.
Figure 5.4 The efficiency cost of taxation
The tax shifts S to St and reduces the quantity traded from Q0 to Qt. At Qt the demand value placed on an additional unit exceeds the supply valuation by EtA. Since the tax keeps output at this lower level, the economy cannot take advantage of the additional potential surplus between Qt and Q0. Excess burden = deadweight loss = AEtE0.
Figure 5.4 illustrates the supply and demand curves for some commodity. In the absence of taxes, the equilibrium E0 is defined by the combination (P0, Q0).
A 13-percent tax is now imposed, and the new supply curve St lies 13 percent above the no-tax supply S. A tax wedge is therefore imposed between the price the consumer must pay and the price that the supplier receives. The new equilibrium is Et, and the new market price is at Pt. The price received by the supplier is lower than that paid by the buyer by the amount of the tax wedge. The post-tax supply price is denoted by .
There are two burdens associated with this tax. The first is the revenue burden, the amount of tax revenue paid by the market participants and received by the government. On each of the Qt units sold, the government receives the amount . Therefore, tax revenue is the amount A. As illustrated in Chapter 4, the degree to which the market price Pt rises above the no-tax price P0 depends on the supply and demand elasticities.
A tax wedge is the difference between the consumer and producer prices.
The revenue burden is the amount of tax revenue raised by a tax.
The second burden of the tax is called the excess burden. The concepts of consumer and producer surpluses help us comprehend this. The effect of the tax has been to reduce consumer surplus by . This is the reduction in the pre-tax surplus given by the triangle B. By the same reasoning, supplier surplus is reduced by the amount A; prior to the tax it was . Consumers and suppliers have therefore seen a reduction in their well-being that is measured by these dollar amounts. Nonetheless, the government has additional revenues amounting to A, and this tax imposition therefore represents a transfer from the consumers and suppliers in the marketplace to the government. Ultimately, the citizens should benefit from this revenue when it is used by the government, and it is therefore not considered to be a net loss of surplus.
However, there remains a part of the surplus loss that is not transferred, the triangular area A. This component is called the excess burden, for the reason that it represents the component of the economic surplus that is not transferred to the government in the form of tax revenue. It is also called the deadweight loss, DWL.
The excess burden, or deadweight loss, of a tax is the component of consumer and producer surpluses forming a net loss to the whole economy.
The intuition behind this concept is not difficult. At the output , the value placed by consumers on the last unit supplied is (), while the production cost of that last unit is (=A). But the potential surplus () associated with producing an additional unit cannot be realized, because the tax dictates that the production equilibrium is at rather than any higher output. Thus, if output could be increased from to , a surplus of value over cost would be realized on every additional unit equal to the vertical distance between the demand and supply functions D and S. Therefore, the loss associated with the tax is the area A.
In public policy debates, this excess burden is rarely discussed. The reason is that notions of consumer and producer surpluses are not well understood by non-economists, despite the fact that the value of lost surpluses is frequently large. Numerous studies have estimated the excess burden associated with raising an additional dollar from the tax system. They rarely find that the excess burden is less than 25 percent of total expenditure. This is a sobering finding. It tells us that if the government wished to implement a new program by raising additional tax revenue, the benefits of the new program should be 25 percent greater than the amount expended on it!
The impact of taxes and other influences that result in an inefficient use of the economy's resources are frequently called distortions because they necessarily lead the economy away from the efficient output. The magnitude of the excess burden is determined by the elasticities of supply and demand in the markets where taxes are levied. To see this, return to Figure 5.4, and suppose that the demand curve through E0 were more elastic (with the same supply curve, for simplicity). The post-tax equilibrium Et would now yield a lower Qt value and a price between Pt and P0. The resulting tax revenue raised and the magnitude of the excess burden would differ because of the new elasticity.
A distortion in resource allocation means that production is not at an efficient output.
5.5 Market failures – externalities
The consumer and producer surplus concepts we have developed are extremely powerful tools of analysis, but the world is not always quite as straightforward as simple models indicate. For example, many suppliers generate pollutants that adversely affect the health of the population, or damage the environment, or both. The term externality is used to denote such impacts. Externalities impact individuals who are not participants in the market in question, and the effects of the externalities may not be captured in the market price. For example, electricity-generating plants that use coal reduce air quality, which, in turn, adversely impacts individuals who suffer from asthma or other lung ailments. While this is an example of a negative externality, externalities can also be positive.
An externality is a benefit or cost falling on people other than those involved in the activity's market. It can create a difference between private costs or values and social costs or values.
We will now show why markets characterized by externalities are not efficient, and also show how these externalities might be corrected or reduced. The essence of an externality is that it creates a divergence between private costs/benefits and social costs/benefits. If a steel producer pollutes the air, and the steel buyer pays only the costs incurred by the producer, then the buyer is not paying the full "social" cost of the product. The problem is illustrated in Figure 5.5.
Figure 5.5 Negative externalities and inefficiency
A negative externality is associated with this good. S reflects private costs, whereas Sf reflects the full social cost. The socially optimal output is Q×, not the market outcome Q0. Beyond Q× the real cost exceeds the demand value; therefore Q0 is not an efficient output. A tax that increases P to P× and reduces output is one solution to the externality.
Negative externalities
In Figure 5.5, the supply curve S represents the cost to the supplier, whereas Sf (the full cost) reflects, in addition, the cost of bad air to the population. Of course, we are assuming that this external cost is ascertainable, in order to be able to characterize Sf accurately. Note also that this illustration assumes that, as power output increases, the external cost per unit rises, because the difference between the two supply curves increases with output. This implies that low levels of pollution do less damage per unit: Perhaps the population has a natural tolerance for low levels, but higher levels cannot be tolerated easily and so the cost per unit is greater.
Despite the externality, an efficient level of production can still be defined. It is given by Q×, not Q0. To see why, consider the impact of reducing output by one unit from Q0. At Q0 the willingness of buyers to pay for the marginal unit supplied is E0. The (private) supply cost is also E0. But from a societal standpoint there is a pollution/health cost of AE0 associated with that unit of production. The full cost, as represented by Sf, exceeds the buyer's valuation. Accordingly, if the last unit of output produced is cut, society gains by the amount AE0, because the cut in output reduces the excess of true cost over value.
Applying this logic to each unit of output between Q0 and Q×, it is evident that society can increase its well-being by the dollar amount equal to the area E×AE0, as a result of reducing production.
Next, consider the consequences of reducing output further from Q×. Note that some pollution is being created here, and environmentalists frequently advocate that pollution should be reduced to zero. However, an efficient outcome may not involve a zero level of pollution! If the production of power were reduced below Q×, the loss in value to buyers, as a result of not being able to purchase the good, would exceed the full cost of its production.
If the government decreed that, instead of producing Q×, no pollution would be tolerated, then society would forgo the possibility of earning the total real surplus equal to the area UE×K. Economists do not advocate such a zero-pollution policy; rather, we advocate a policy that permits a "tolerable" pollution level – one that still results in net benefits to society. In this particular example, the total cost of the tolerated pollution equals the area between the private and full supply functions, KE×VR.
As a matter of policy, how is this market influenced to produce the amount Q× rather than Q0? One option would be for the government to intervene directly with production quotas for each firm. An alternative would be to impose a corrective tax on the good whose production causes the externality: With an appropriate increase in the price, consumers will demand a reduced quantity. In Figure 5.5 a tax equal to the dollar value VE× would shift the supply curve upward by that amount and result in the quantity Q× being traded.
A corrective tax seeks to direct the market towards a more efficient output.
We are now venturing into the field of environmental policy, where a corrective tax is usually called a carbon tax, and this is explored in the following section. The key conclusion of the foregoing analysis is that an efficient working of the market continues to have meaning in the presence of externalities. An efficient output level still maximizes economic surplus where surplus is correctly defined.
Positive externalities
Externalities of the positive kind enable individuals or producers to get a type of 'free ride' on the efforts of others. Real world examples abound: When a large segment of the population is immunized against disease, the remaining individuals benefit on account of the reduced probability of transmission.
A less well recognized example is the benefit derived by many producers world-wide from research and development (R&D) undertaken in advanced economies and in universities and research institutes. The result is that society at large, including the corporate sector, gain from this enhanced understanding of science, the environment, or social behaviours.
The free market may not cope any better with these positive externalities than it does with negative externalities, and government intervention may be beneficial. Furthermore, firms that invest heavily in research and development would not undertake such investment if competitors could have a complete free ride and appropriate the fruits. This is why patent laws exist, as we shall see later in discussing Canada's competition policy. These laws prevent competitors from copying the product development of firms that invest in R&D. If such protection were not in place, firms would not allocate sufficient resources to R&D, which is a real engine of economic growth. In essence, the economy's research-directed resources would not be appropriately rewarded, and thus too little research would take place.
While patent protection is one form of corrective action, subsidies are another. We illustrated above that an appropriately formulated tax on a good that creates negative externalities can reduce demand for that good, and thereby reduce pollution. A subsidy can be thought of as a negative tax, and can stimulate the supply of goods and services that have positive externalities. Consider the example in Figure 5.6.
Figure 5.6 Positive externalities – the market for flu shots
The value to society of vaccinations exceeds the value to individuals: The greater the number of individuals vaccinated, the lower is the probability of others contracting the virus. Df reflects this additional value. Consequently, the social optimum is Q× which exceeds Q0.
Individuals have a demand for flu shots given by D. This reflects their private valuation – their personal willingness to pay. But the social value of flu shots is greater. When more individuals are vaccinated, the probability that others will be infected falls. Additionally, with higher rates of immunization, the health system will incur fewer costs in treating the infected. Therefore, the value to society of any quantity of flu shots is greater than the sum of the values that individuals place on them.
Df reflects the full social value of any quantity of flu shots. In this instance the quantity axis measures the percentage of the population vaccinated, which has a maximum of 100%. If S is the supply curve, the socially optimal, efficient, market outcome is Q×. The steeply upward-sloping section of S denotes that it may be very costly to vaccinate every last person – particularly those living in outlying communities. How can we influence the market to move from Q0 towards Q×? One solution is a subsidy that would reduce the price to zero. In this case that gets us almost to the optimum, because the percentage of the population now choosing to be vaccinated is given by . The zero price essentially makes the supply curve, as perceived by the population, to be running along the horizontal axis.
Note the social value of the improvement in moving from Q0 to ; the social value exceeds the social cost. But even at further gains are available because at the social value of additional vaccinations is greater than the social cost. Overall, at the point Q× the social value is given by the area under the demand curve, and the social cost by the area under the supply curve.
5.6 Other market failures
There are other ways in which markets can fail to reflect accurately the social value or social cost of economic activity. Profit-seeking monopolies, which restrict output in order to increase profits, represent inefficient markets, and we will see why in the chapter on monopoly. Or the market may not deal very well with what are called public goods. These are goods, like radio and television service, national defence, or health information: With such goods and services many individuals can be supplied with the same good at the same total cost as one individual. We will address this problem in our chapter on government. And, of course, there are international externalities that cannot be corrected by national governments because the interests of adjoining states may differ: One economy may wish to see cheap coal-based electricity being supplied to its consumers, even if this means acid rain or reduced air quality in a neighbouring state. Markets may fail to supply an "efficient" amount of a good or service in all of these situations. Global warming is perhaps the best, and most extreme, example of international externalities and market failure.
5.7 Environmental policy and climate change
Greenhouse gases
The greatest externality challenge in the modern world is to control our emissions of greenhouse gases.The emission of greenhouse gases (GHGs) is associated with a wide variety of economic activities such as coal-based power generation, oil-burning motors, wood-burning stoves, ruminant animals, etc. The most common GHG is carbon dioxide, methane is another. The gases, upon emission, circulate in the earth's atmosphere and, following an excessive build-up, prevent sufficient radiant heat from escaping. The result is a slow warming of the earth's surface and air temperatures. It is envisaged that such temperature increases will, in the long term, increase water temperatures and cause glacial melting, with the result that water levels worldwide will rise. In addition to the higher water levels, which the Intergovernmental Panel on Climate Change (IPCC) estimates will be between one foot and one metre by the end of the 21st century, oceans will become more acidic, weather patterns will change and weather events become more variable and severe. The changes will be latitude-specific and vary by economy and continent, and ultimately will impact the agricultural production abilities of certain economies.
Greenhouse gases that accumulate excessively in the earth's atmosphere prevent heat from escaping and lead to global warming.
While most scientific findings and predictions are subject to a degree of uncertainty, there is little disagreement in the scientific community on the long-term impact of increasing GHGs in the atmosphere. There is some skepticism as to whether the generally higher temperatures experienced in recent decades are completely attributable to anthropogenic activity since the industrial revolution, or whether they also reflect a natural cycle in the earth's temperature. But scientists agree that a continuance of the recent rate of GHG emissions is leading to serious climatic problems.
The major economic environmental challenge facing the world economy is this: Historically, GHG emissions have been strongly correlated with economic growth. The very high rate of economic growth in many large-population economies such as China and India that will be necessary to raise hundreds of millions out of poverty means that that historical pattern needs to be broken – GHG accumulation must be "decoupled" from economic growth.
GHGs as a common property
A critical characteristic of GHGs is that they are what we call in economics a 'common property': Every citizen in the world 'owns' them, every citizen has equal access to them, and it matters little where these GHGs originate. Consequently, if economy A reduces its GHG emissions, economy B may simply increase its emissions rather than incur the cost of reducing them. Hence, economy A's behaviour goes unrewarded. This is the crux of international agreements – or disagreements. Since GHGs are a common property, in order for A to have the incentive to reduce emissions, it needs to know that B will act correspondingly.
From the Kyoto Protocol to the Paris Accord
The world's first major response to climate concerns came in the form of the United Nations–sponsored Earth Summit in Rio de Janeiro in 1992. This was followed by the signing of the Kyoto Protocol in 1997, in which a group of countries committed themselves to reducing their GHG emissions relative to their 1990 emissions levels by the year 2012. Canada's Parliament subsequently ratified the Kyoto Protocol, and thereby agreed to meet Canada's target of a 6 percent reduction in GHGs relative to the amount emitted in 1990.
On a per-capita basis, Canada is one of the world's largest contributors to global warming, even though Canada's percentage of the total is just 2 percent. Many of the world's major economies refrained from signing the Protocol—most notably China, the United States, and India. Canada's emissions in 1990 amounted to approximately 600 giga tonnes (Gt) of carbon dioxide; but by the time we ratified the treaty in 2002, emissions were 25% above that level. Hence the signing was somewhat meaningless, in that Canada had virtually a zero possibility of attaining its target.
The target date of 2012 has come and gone and subsequent conferences in Copenhagen and Rio failed to yield an international agreement. But in Paris, December 2015, 195 economies committed to reduce their GHG emissions by specific amounts. Canada was a party to that agreement. Target reductions varied by country. Canada committed itself to reduce GHG emissions by 30% by the year 2030 relative to 2005 emissions levels. To this end the Liberal government of Prime Minister Justin Trudeau announced in late 2016 that if individual Canadian provinces failed to implement a carbon tax, or equivalent, the federal government would impose one unilaterally. The program involves a carbon tax of \$10 per tonne in 2018, that increases by \$10 per annum until it attains a value of \$50 in 2022. Some provinces already have GHG limitation systems in place (cap and trade systems - developed below), and these provinces would not be subject to the federal carbon tax provided the province-level limitation is equivalent to the federal carbon tax.
Canada's GHG emissions
An excellent summary source of data on Canada's emissions and performance during the period 1990-2018 is available on Environment Canada's web site. See:
www.canada.ca/en/environment-climate-change/services/climate-change/greenhouse-gas-emissions/sources-sinks-executive-summary-2020.html#toc3
Canada, like many economies, has become more efficient in its use of energy (the main source of GHGs) in recent decades—its use of energy per unit of total output has declined steadily. Canada emitted 0.44 mega tonnes of equivalent per billion dollars of GDP in 2005, and 0.36 mega tonnes in 2017. On a per capita basis Canada's emissions amounted to 22.9 tonnes in 2005, and dropped to 19.5 by 2017. This modest improvement in efficiency means that Canada's GDP is now less energy intensive. The critical challenge is to produce more output while using not just less energy per unit of output, but to use less energy in total.
While Canada's energy intensity (GHGs per unit of output) has dropped, overall emissions have increased by almost 20% since 1990. Furthermore, while developed economies have increased their efficiency, it is the world's efficiency that is ultimately critical. By outsourcing much of its manufacturing sector to China, Canada and the West have offloaded some of their most GHG-intensive activities. But GHGs are a common property resource.
Canada's GHG emissions also have a regional aspect: The production of oil and gas, which has created considerable wealth for all Canadians, is both energy intensive and concentrated in a limited number of provinces (Alberta, Saskatchewan and more recently Newfoundland and Labrador).
GHG measurement
GHG atmospheric concentrations are measured in parts per million (ppm). Current levels in the atmosphere are slightly above 400 ppm, and continued growth in concentration will lead to serious economic and social disruption. In the immediate pre-industrial revolution era concentrations were in the 280 ppm range. Hence, our world seems to be headed towards a doubling of GHG concentrations in the coming decades.
GHGs are augmented by the annual additions to the stock already in the atmosphere, and at the same time they decay—though very slowly. GHG-reduction strategies that propose an immediate reduction in emissions are more costly than those aimed at a more gradual reduction. For example, a slower investment strategy would permit in-place production and transportation equipment to reach the end of its economic life rather than be scrapped and replaced 'prematurely'. Policies that focus upon longer-term replacement are therefore less costly in this specific sense.
While not all economists and policy makers agree on the time scale for attacking the problem, the longer that GHG reduction is postponed, the greater the efforts will have to be in the long term—because GHGs will build up more rapidly in the near term.
A critical question in controlling GHG emissions relates to the cost of their control: How much of annual growth might need to be sacrificed in order to get emissions onto a sustainable path? Again estimates vary. The Stern Review (2006) proposed that, with an increase in technological capabilities, a strategy that focuses on the relative near-term implementation of GHG reduction measures might cost "only" a few percentage points of the value of world output. If correct, this is a low price to pay for risk avoidance in the longer term.
Nonetheless, such a reduction will require particular economic policies, and specific sectors will be impacted more than others.
Economic policies for climate change
There are three main ways in which polluters can be controlled. One involves issuing direct controls; the other two involve incentives—in the form of pollution taxes, or on tradable "permits" to pollute.
To see how these different policies operate, consider first Figure 5.7. It is a standard diagram in environmental economics, and is somewhat similar to our supply and demand curves. On the horizontal axis is measured the quantity of environmental damage or pollution, and on the vertical axis its dollar value or cost. The upward-sloping damage curve represents the cost to society of each additional unit of pollution or gas, and it is therefore called a marginal damage curve. It is positively sloped to reflect the reality that, at low levels of emissions, the damage of one more unit is less than at higher levels. In terms of our earlier discussion, this means that an increase in GHGs of 10 ppm when concentrations are at 300 ppm may be less damaging than a corresponding increase when concentrations are at 500 ppm.
The marginal damage curve reflects the cost to society of an additional unit of pollution.
Figure 5.7 The optimal quantity of pollution
Q× represents the optimal amount of pollution. More than this would involve additional social costs because damages exceed abatement costs. Coversely, less than Q× would require an abatement cost that exceeds the reduction in damage.
The second curve is the abatement curve. It reflects the cost of reducing emissions by one unit, and is therefore called a marginal abatement curve. This curve has a negative slope indicating that, as we reduce the total quantity of pollution produced (moving towards the origin on the horizontal axis), the cost of further unit reductions rises. This shape corresponds to reality. For example, halving the emissions of pollutants and gases from automobiles may be achieved by adding a catalytic converter and reducing the amount of lead in gasoline. But reducing those emissions all the way to zero requires the development of major new technologies such as electric cars—an enormously more costly undertaking.
The marginal abatement curve reflects the cost to society of reducing the quantity of pollution by one unit.
If producers are unconstrained in the amount of pollution they produce, they will produce more than what we will show is the optimal amount – corresponding to Q×. This amount is optimal in the sense that at levels greater than Q× the damage exceeds the cost of reducing the emissions. However, reducing emissions below Q× would mean incurring a cost per unit reduction that exceeds the benefit of that reduction. Another way of illustrating this is to observe that at a level of pollution above Q× the cost of reducing it is less than the damage it inflicts, and therefore a net gain accrues to society as a result of the reduction. But to reduce pollution below Q× would involve an abatement cost greater than the reduction in pollution damage and therefore no net gain to society. This constitutes a first rule in optimal pollution policy.
An optimal quantity of pollution occurs when the marginal cost of abatement equals the marginal damage.
A second guiding principle emerges by considering a situation in which some firms are relatively 'clean' and others are 'dirty'. More specifically, a clean firm A may have already invested in new equipment that uses less energy per unit of output produced, or emits fewer pollutants per unit of output. In contrast, the dirty firm B uses older dirtier technology. Suppose furthermore that these two firms form a particular sector of the economy and that the government sets a limit on total pollution from this sector, and that this limit is less than what the two firms are currently producing. What is the least costly method to meet the target?
The intuitive answer to this question goes as follows: In order to reduce pollution at least cost to the sector, calculate what it would cost each firm to reduce pollution from its present level. Then implement a system so that the firm with the least cost of reduction is the first to act. In this case the 'dirty' firm will likely have a lower cost of abatement since it has not yet upgraded its physical plant. This leads to a second rule in pollution policy:
With many polluters, the least cost policy to society requires producers with the lowest abatement costs to act first.
This principle implies that policies which impose the same emission limits on firms may not be the least costly manner of achieving a target level of pollution. Let us now consider the use of tradable permits and corrective/carbon taxes as policy instruments. These are market-based systems aimed at reducing GHGs.
Tradable permits and corrective/carbon taxes are market-based systems aimed at reducing GHGs.
Incentive mechanism I: Tradable permits
A system of tradable permits is frequently called a 'cap and trade' system, because it limits or caps the total permissible emissions, while at the same time allows a market to develop in permits. For illustrative purposes, consider the hypothetical two-firm sector we developed above, composed of firms A and B. Firm A has invested in clean technology, firm B has not. Thus it is less costly for B to reduce emissions than A if further reductions are required. Next suppose that each firm is allocated by the government a specific number of 'GHG emission permits'; and that the total of such permits is less than the amount of emissions at present, and that each firm is emitting more than its permits allow. How can these firms achieve the target set for this sector of the economy?
The answer is that they should be able to engage in mutually beneficial trade: If firm B has a lower cost of reducing emissions than A, then it may be in A's interest to pay B to reduce B's emissions heavily. Imagine that each firm is emitting 60 units of GHG, but they have permits to emit only 50 units each. And furthermore suppose it costs B \$20 to reduce GHGs by one unit, whereas it costs A \$30 to do this. In this situation A could pay B \$25 for several permits and this would benefit both firms. B can reduce GHGs at a cost of \$20 and is being paid \$25 to do this. In turn A would incur a cost of \$30 per unit to reduce his GHGs but he can buy permits from B for just \$25 and avoid the \$30 cost. Both firms gain, and the total cost to the economy is lower than if each firm had to reduce by the same amount.
The benefit of the cap 'n trade system is that it enables the marketplace to reduce GHGs at least cost.
The largest system of tradable permits currently operates in the European Union: The EU Emissions Trading System. It covers more than 10,000 large energy-using installations. Trading began in 2005. In North America a number of Western states and several Canadian provinces are joined, either as participants or observers, in the Western Climate Initiative, which is committed to reduce GHGs by means of tradable emissions permits. The longer-term goal of these systems is for the government to issue progressively fewer permits each year, and to include an ever larger share of GHG-emitting enterprises with the passage of time.
Policy in practice – international
In an ideal world, permits would be traded internationally, and such a system might be of benefit to developing economies: If the cost of reducing pollution is relatively low in developing economies because they have few controls in place, then developed economies, for whom the cost of GA reduction is high, could induce firms in the developing world to undertake cost reductions. Such a trade would be mutually beneficial. For example, imagine in the above example that B is located in the developing world and A in the developed world. Both would obviously gain from such an arrangement, and because GHGs are a common property, the source of GHGs from a damage standpoint is immaterial.
Incentive mechanism II: Taxes
Corrective taxes are frequently called Pigovian taxes, after the economist Arthur Pigou. He advocated taxing activities that cause negative externalities. These taxes have been examined above in Section 5.4. Corrective taxes of this type can be implemented as part of a tax package reform. For example, taxpayers are frequently reluctant to see governments take 'yet more' of their money, in the form of new taxes. Such concerns can be addressed by reducing taxes in other sectors of the economy, in such a way that the package of tax changes maintains a 'revenue neutral' impact.
Revenues from taxes and permits
Taxes and tradable permits differ in that taxes generate revenue for the government from polluting producers, whereas permits may not generate revenue, or may generate less revenue. If the government simply allocates permits initially to all polluters, free of charge, and allows a market to develop, such a process generates no revenue to the government. While economists may advocate an auction of permits in the start-up phase of a tradable permits market, such a mechanism may run into political objections.
Setting taxes at the appropriate level requires knowledge of the cost and damage functions associated with GHGs. At the present time, economists and environmental scientists think that an appropriate price or tax on one tonne of GHG is in the range. Such a tax would reduce emissions to a point where the longer-term impact of GHGs would not be so severe as otherwise.
British Columbia introduced a carbon tax of per tonne of GHG on fuels in 2008, and has increased that price regularly. This tax was designed to be revenue neutral in order to make it more acceptable. This means that British Columbia reduced its income tax rates by an amount such that income tax payments would fall by an amount equal to the revenue captured by the carbon tax.
GHG policy at the federal level in Canada is embodied in the Greenhouse Gas Pollution Pricing Act of 2018. As detailed earlier, the Act imposes a yearly increasing levy on emissions. The system is intended to be revenue neutral, in that the revenues will be returned to households in the form of a 'paycheck' by the federal government. Large emitters of GHGs are permitted a specific threshold number of tonnes of emission each year without being penalized. Beyond that threshold the above rates apply.
Will this amount of carbon taxation hurt consumers, and will it enable Canada to reach its 2030 GHG goal? As a specific example: the gasoline-pricing rule of thumb is that each in carbon taxation or pricing leads to an increase in the price of gasoline at the pump of about 2.5 cents. So a levy per tonne means gas at the pump should rise by 12.5 cents per litre. The proceeds are returned to households.
As for the goal of reaching the 2030 target announced at Paris: Environment Canada estimates that the pricing scheme will reduce GHG emissions by about 60 tonnes per annum. But Canada's goal stated in Paris is to reduce emissions in 2030 by approximately four times this amount. Under the Paris Accoord, Canada stated that its 2030 goal would be to reduce emissions by 30% from their 2005 level of 725 MT, that is by an amount equal to approximately 220 tonnes.
Policy in practice – domestic large final emitters
Governments frequently focus upon quantities emitted by individual large firms, or large final emitters (LFEs). In some economies, a relatively small number of producers are responsible for a disproportionate amount of an economy's total pollution, and limits are placed on those firms in the belief that significant economy-wide reductions can be achieved in this manner. One reason for concentrating on these LFEs is that the monitoring costs are relatively small compared to the costs associated with monitoring all firms in the economy. It must be kept in mind that pollution permits may be a legal requirement in some jurisdictions, but monitoring is still required, because firms could choose to risk polluting without owning a permit.
Conclusion
Welfare economics lies at the heart of public policy. Demand and supply curves can be interpreted as value curves and cost curves when there are no externalities involved. This is what enables us to define an efficient output of a product, and consequently an efficient use of the economy's resources. While efficiency is a central concept in economics, we must keep in mind that when the economic environment changes so too will the efficient use of resources, as we illustrated in Section 5.7.
In this chapter we have focused on equity issues through the lens of GHG emissions. The build-up of GHGs in our atmosphere invokes the concept of intergenerational equity: The current generation is damaging the environment and the costs of that damage will be borne by subsequent generations. Hence it is inequitable in the intergenerational sense for us to leave a negative legacy to succeeding generations. Equity arises within generations also. For example, how much more in taxes should the rich pay relative to the non-rich? We will explore this type of equity in our chapter on government.
Key Terms
Welfare economics assesses how well the economy allocates its scarce resources in accordance with the goals of efficiency and equity.
Efficiency addresses the question of how well the economy's resources are used and allocated.
Equity deals with how society's goods and rewards are, and should be, distributed among its different members, and how the associated costs should be apportioned.
Consumer surplus is the excess of consumer willingness to pay over the market price.
Supplier or producer surplus is the excess of market price over the reservation price of the supplier.
Efficient market: maximizes the sum of producer and consumer surpluses.
Tax wedge is the difference between the consumer and producer prices.
Revenue burden is the amount of tax revenue raised by a tax.
Excess burden of a tax is the component of consumer and producer surpluses forming a net loss to the whole economy.
Deadweight loss of a tax is the component of consumer and producer surpluses forming a net loss to the whole economy.
Distortion in resource allocation means that production is not at an efficient output.
Externality is a benefit or cost falling on people other than those involved in the activity's market. It can create a difference between private costs or values and social costs or values.
Corrective tax seeks to direct the market towards a more efficient output.
Greenhouse gases that accumulate excessively in the earth's atmosphere prevent heat from escaping and lead to global warming.
Marginal damage curve reflects the cost to society of an additional unit of pollution.
Marginal abatement curve reflects the cost to society of reducing the quantity of pollution by one unit.
Tradable permits are a market-based system aimed at reducing GHGs.
Carbon taxes are a market-based system aimed at reducing GHGs.
Exercises for Chapter 5
EXERCISE 5.1
Four teenagers live on your street. Each is willing to shovel snow from one driveway each day. Their "willingness to shovel" valuations (supply) are: Jean, \$10; Kevin, \$9; Liam, \$7; Margaret, \$5. Several households are interested in having their driveways shoveled, and their willingness to pay values (demand) are: Jones, \$8; Kirpinsky, \$4; Lafleur, \$7.50; Murray, \$6.
1. Draw the implied supply and demand curves as step functions.
2. How many driveways will be shoveled in equilibrium?
3. Compute the maximum possible sum for the consumer and supplier surpluses.
4. If a new (wealthy) family arrives on the block, that is willing to pay \$12 to have their driveway cleared, recompute the answers to parts (a), (b), and (c).
EXERCISE 5.2
Consider a market where supply curve is horizontal at P=10 and the demand curve has intercepts , and is defined by the relation P=34–Q.
1. Illustrate the market geometrically.
2. Impose a tax of \$2 per unit on the good so that the supply curve is now P=12. Illustrate the new equilibrium quantity.
3. Illustrate in your diagram the tax revenue generated.
4. Illustrate the deadweight loss of the tax.
EXERCISE 5.3
Next, consider an example of DWL in the labour market. Suppose the demand for labour is given by the fixed gross wage . The supply is given by W=0.8L, indicating that the supply curve goes through the origin with a slope of 0.8.
1. Illustrate the market geometrically.
2. Calculate the supplier surplus, knowing that the equilibrium is L=20.
3. Optional: Suppose a wage tax is imposed that produces a net-of-tax wage equal to . This can be seen as a downward shift in the demand curve. Illustrate the new quantity supplied and the new supplier's surplus.
EXERCISE 5.4
Governments are in the business of providing information to potential buyers. The first serious provision of information on the health consequences of tobacco use appeared in the United States Report of the Surgeon General in 1964.
1. How would you represent this intervention in a supply and demand for tobacco diagram?
2. Did this intervention "correct" the existing market demand?
EXERCISE 5.5
In deciding to drive a car in the rush hour, you think about the cost of gas and the time of the trip.
1. Do you slow down other people by driving?
2. Is this an externality, given that you yourself are suffering from slow traffic?
EXERCISE 5.6
Suppose that our local power station burns coal to generate electricity. The demand and supply functions for electricity are given by P=12–0.5Q and P=2+0.5Q, respectively. The demand curve has intercepts and the supply curve intercept is at \$2 with a slope of one half. However, for each unit of electricity generated, there is an externality. When we factor this into the supply side of the market, the real social cost is increased by \$1 per unit. That is, the supply curve shifts upwards by \$1, and now takes the form P=3+0.5Q.
1. Illustrate the free-market equilibrium.
2. Illustrate the efficient (i.e. socially optimal) level of production.
EXERCISE 5.7
Your local dry cleaner, Bleached Brite, is willing to launder shirts at its cost of \$1.00 per shirt. The neighbourhood demand for this service is P=5–0.005Q, knowing that the demand intercepts are .
1. Illustrate the market equilibrium.
2. Suppose that, for each shirt, Bleached Brite emits chemicals into the local environment that cause \$0.25 damage per shirt. This means the full cost of each shirt is \$1.25. Illustrate graphically the socially optimal number of shirts to be cleaned.
3. Optional: Calculate the socially optimal number of shirts to be cleaned.
EXERCISE 5.8
The supply curve for agricultural labour is given by W=6+0.1L, where W is the wage (price per unit) and L the quantity traded. Employers are willing to pay a wage of \$12 to all workers who are willing to work at that wage; hence the demand curve is W=12.
1. Illustrate the market equilibrium, if you are told that the equilibrium occurs where L=60.
2. Compute the supplier surplus at this equilibrium.
EXERCISE 5.9
Optional: The market demand for vaccine XYZ is given by P=36–Q and the supply conditions are P=20; so \$20 represents the true cost of supplying a unit of vaccine. There is a positive externality associated with being vaccinated, and the real societal value is known and given by P=36–(1/2)Q. This new demand curve represents the true value to society of each vaccination. This is reflected in the private value demand curve rotating upward around the price intercept of \$36.
1. Illustrate the private and social demand curves on a diagram, with intercept values calculated.
2. What is the market solution to this supply and demand problem?
3. What is the socially optimal number of vaccinations?
05: Welfare economics and externalities
In modern mixed economies, markets and governments together determine the output produced and also who benefits from that output. In this chapter we explore a very broad question that forms the core of welfare economics: Even if market forces drive efficiency, are they a good way to allocate scarce resources in view of the fact that they not only give rise to inequality and poverty, but also fail to capture the impacts of productive activity on non-market participants? Mining impacts the environment, traffic results in road fatalities, alcohol, tobacco and opioids cause premature deaths. These products all generate secondary impacts beyond their stated objective. We frequently call these external effects.
The analysis of markets in this larger sense involves not just economic efficiency; public policy additionally has a normative content because policies can impact the various participants in different ways and to different degrees. Welfare economics, therefore, deals with both normative and positive issues.
Welfare economics assesses how well the economy allocates its scarce resources in accordance with the goals of efficiency and equity.
Political parties on the left and right disagree on how well a market economy works. Canada's New Democratic Party emphasizes the market's failings and the need for government intervention, while the Progressive Conservative Party believes, broadly, that the market fosters choice, incentives, and efficiency. What lies behind this disagreement? The two principal factors are efficiency and equity. Efficiency addresses the question of how well the economy's resources are used and allocated. In contrast, equity deals with how society's goods and rewards are, and should be, distributed among its different members, and how the associated costs should be apportioned.
Equity deals with how society's goods and rewards are, and should be, distributed among its different members, and how the associated costs should be apportioned.
Efficiency addresses the question of how well the economy's resources are used and allocated.
Equity is also concerned with how different generations share an economy's productive capabilities: More investment today makes for a more productive economy tomorrow, but more greenhouse gases today will reduce environmental quality tomorrow. These are inter-generational questions.
Climate change caused by global warming forms one of the biggest challenges for humankind at the present time. As we shall see in this chapter, economics has much to say about appropriate policies to combat warming. Whether pollution-abatement policies should be implemented today or down the road involves considerations of equity between generations. Our first task is to develop an analytical tool which will prove vital in assessing and computing welfare benefits and costs – economic surplus. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/05%3A_Welfare_economics_and_externalities/5.01%3A_Equity_and_efficiency.txt |
An understanding of economic efficiency is greatly facilitated as a result of understanding two related measures: Consumer surplus and producer surplus. Consumer surplus relates to the demand side of the market, producer surplus to the supply side. Producer surplus is also termed supplier surplus. These measures can be understood with the help of a standard example, the market for city apartments.
The market for apartments
Table 5.1 and Figure 5.1 describe the hypothetical data. We imagine first a series of city-based students who are in the market for a standardized downtown apartment. These individuals are not identical; they value the apartment differently. For example, Alex enjoys comfort and therefore places a higher value on a unit than Brian. Brian, in turn, values it more highly than Cathy or Don. Evan and Frank would prefer to spend their money on entertainment, and so on. These valuations are represented in the middle column of the demand panel in Table 5.1, and also in Figure 5.1 with the highest valuations closest to the origin. The valuations reflect the willingness to pay of each consumer.
Table 5.1 Consumer and supplier surpluses
Demand
Individual Demand valuation Surplus
Alex 900 400
Brian 800 300
Cathy 700 200
Don 600 100
Evan 500 0
Frank 400 0
Supply
Individual Reservation value Surplus
Gladys 300 200
Heward 350 150
Ian 400 100
Jeff 450 50
Kirin 500 0
Lynn 550 0
On the supply side we imagine the market as being made up of different individuals or owners, who are willing to put their apartments on the market for different prices. Gladys will accept less rent than Heward, who in turn will accept less than Ian. The minimum prices that the suppliers are willing to accept are called reservation prices or values, and these are given in the lower part of Table 5.1. Unless the market price is greater than their reservation price, suppliers will hold back.
By definition, as stated in Chapter 3, the demand curve is made up of the valuations placed on the good by the various demanders. Likewise, the reservation values of the suppliers form the supply curve. If Alex is willing to pay \$900, then that is his demand price; if Heward is willing to put his apartment on the market for \$350, he is by definition willing to supply it for that price. Figure 5.1 therefore describes the demand and supply curves in this market. The steps reflect the willingness to pay of the buyers and the reservation valuations or prices of the suppliers.
Figure 5.1 The apartment market
Demanders and suppliers are ranked in order of the value they place on an apartment. The market equilibrium is where the marginal demand value of Evan equals the marginal supply value of Kirin at \$500. Five apartments are rented in equilibrium.
In this example, the equilibrium price for apartments will be \$500. Let us see why. At that price the value placed on the marginal unit supplied by Kirin equals Evan's willingness to pay. Five apartments will be rented. A sixth apartment will not be rented because Lynn will let her apartment only if the price reaches \$550. But the sixth potential demander is willing to pay only \$400. Note that, as usual, there is just a single price in the market. Each renter pays \$500, and therefore each supplier also receives \$500.
The consumer and supplier surpluses can now be computed. Note that, while Don is willing to pay \$600, he actually pays \$500. His consumer surplus is therefore \$100. In Figure 5.1, we can see that each consumer's surplus is the distance between the market price and the individual's valuation. These values are given in the final column of the top half of Table 5.1.
Consumer surplus is the excess of consumer willingness to pay over the market price.
Using the same reasoning, we can compute each supplier's surplus, which is the excess of the amount obtained for the rented apartment over the reservation price. For example, Heward obtains a surplus on the supply side of \$150, while Jeff gets \$50. Heward is willing to put his apartment on the market for \$350, but gets the equilibrium price/rent of \$500 for it. Hence his surplus is \$150.
Supplier or producer surplus is the excess of market price over the reservation price of the supplier.
It should now be clear why these measures are called surpluses. The suppliers and demanders are all willing to participate in this market because they earn this surplus. It is a measure of their gain from being involved in the trading. The sum of each participant's surplus in the final column of Table 5.1 defines the total surplus in the market. Hence, on the demand side a total surplus arises of \$1,000 and on the supply side a value of \$500.
The taxi market
We do not normally think of demand and supply functions in terms of the steps illustrated in Figure 5.1. Usually there are so many participants in the market that the differences in reservation prices on the supply side and willingness to pay on the demand side are exceedingly small, and so the demand and supply curves are drawn as continuous lines. So our second example reflects this, and comes from the market for taxi rides. We might think of this as an Uber- or Lyft-type taxi operation.
Let us suppose that the demand and supply curves for taxi rides in a given city are given by the functions in Figure 5.2.
Figure 5.2 The taxi market
Consumer surplus is the area ABE, supplier surplus is the area BCE.
The demand curve represents the willingness to pay on the part of riders. The supply curve represents the willingness to supply on the part of drivers. The price per hour of rides defines the vertical axis; hours of rides (in thousands) are measured on the horizontal axis. The demand intercept of \$90 says that the person who values the ride most highly is willing to pay \$90 per hour. The downward slope of the demand curve states that other buyers are willing to pay less. On the supply side no driver is willing to supply his time and vehicle unless he obtains at least \$30 per hour. To induce additional suppliers a higher price must be paid, and this is represented by the upward sloping supply curve.
The intersection occurs at a price of \$42 per hour and the equilibrium number of ride-hours supplied is 48 thousand1. Computing the surpluses is very straightforward. By definition the consumer surplus is the excess of the willingness to pay by each buyer above the uniform price. Buyers who value the ride most highly obtain the biggest surplus – the highest valuation rider gets a surplus of \$48 per hour – the difference between his willingness to pay of \$90 and the actual price of \$42. Each successive rider gets a slightly lower surplus until the final rider, who obtains zero. She pays \$42 and values the ride hours at \$42 also. On the supply side, the drivers who are willing to supply rides at the lowest reservation price (\$30 and above) obtain the biggest surplus. The 'marginal' supplier gets no surplus, because the price equals her reservation price.
From this discussion it follows that the consumer surplus is given by the area ABE and the supplier surplus by the area CBE. These are two triangular areas, and measured as half of the base by the perpendicular height. Therefore, in thousands of units:
The total surplus that arises in the market is the sum of producer and consumer surpluses, and since the units are in thousands of hours the total surplus here is . | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/05%3A_Welfare_economics_and_externalities/5.02%3A_Consumer_and_producer_surplus.txt |
The definition and measurement of the surplus is straightforward provided the supply and demand functions are known. An important characteristic of the marketplace is that in certain circumstances it produces what we call an efficient outcome, or an efficient market. Such an outcome yields the highest possible sum of surpluses.
An efficient market maximizes the sum of producer and consumer surpluses.
To see that this outcome achieves the goal of maximizing the total surplus, consider what would happen if the quantity Q=48 in the taxi example were not supplied. Suppose that the city's taxi czar decreed that 50 units should be supplied, and the czar forced additional drivers on the road. If 2 additional units are to be traded in the market, consider the value of this at the margin. Suppliers value the supply more highly than the buyers are willing to pay. So on these additional 2 units negative surplus would accrue, thus reducing the total.
A second characteristic of the market equilibrium is that potential buyers who would like a cheaper ride and drivers who would like a higher hourly payment do not participate in the market. On the demand side those individuals who are unwilling to pay \$42/hour can take public transit, and on the supply side the those drivers who are unwilling to supply at \$42/hour can allocate their time to alternative activities. Obviously, only those who participate in the market benefit from a surplus.
One final characteristic of surplus measurement should be emphasized. That is, the surplus number is not unique, it depends upon the economic environment. We can illustrate this easily using the taxi example. A well recognized feature of Uber taxi rides is that the price varies with road and weather conditions. Poor weather conditions mean that there is an increased demand, and poor road or weather conditions mean that drivers are less willing to supply their services – their reservation payment increases. This situation is illustrated in Figure 5.3.
Figure 5.3 The taxi market
The curves represented by and represent the curves for bad weather: Taxi rides are more highly valued on the demand side, and drivers must be paid more to supply in less favourable work conditions.
The demand curve has shifted upwards and the supply curve has also changed in such a way that any quantity will now be supplied at a higher price. The new equilibrium is given by rather than E.2 There is a new equilibrium price-quantity combination that is efficient in the new market conditions. This illustrates that there is no such thing as a unique unchanging efficient outcome. When economic factors that influence the buyers' valuations (demand) or the suppliers' reservation prices (supply) change, then the efficient market outcome must be recomputed.
5.04: Taxation surplus and efficiency
Despite enormous public interest in taxation and its impact on the economy, it is one of the least understood areas of public policy. In this section we will show how an understanding of two fundamental tools of analysis – elasticities and economic surplus – provides powerful insights into the field of taxation.
We begin with the simplest of cases: The federal government's goods and services tax (GST) or the provincial governments' sales taxes (PST). These taxes combined vary by province, but we suppose that a typical rate is 13 percent. In some provinces these two taxes are harmonized. Note that this is a percentage, or ad valorem, tax, not a specific tax of so many dollars per unit traded.
Figure 5.4 The efficiency cost of taxation
The tax shifts S to St and reduces the quantity traded from Q0 to Qt. At Qt the demand value placed on an additional unit exceeds the supply valuation by EtA. Since the tax keeps output at this lower level, the economy cannot take advantage of the additional potential surplus between Qt and Q0. Excess burden = deadweight loss = AEtE0.
Figure 5.4 illustrates the supply and demand curves for some commodity. In the absence of taxes, the equilibrium E0 is defined by the combination (P0, Q0).
A 13-percent tax is now imposed, and the new supply curve St lies 13 percent above the no-tax supply S. A tax wedge is therefore imposed between the price the consumer must pay and the price that the supplier receives. The new equilibrium is Et, and the new market price is at Pt. The price received by the supplier is lower than that paid by the buyer by the amount of the tax wedge. The post-tax supply price is denoted by .
There are two burdens associated with this tax. The first is the revenue burden, the amount of tax revenue paid by the market participants and received by the government. On each of the Qt units sold, the government receives the amount . Therefore, tax revenue is the amount A. As illustrated in Chapter 4, the degree to which the market price Pt rises above the no-tax price P0 depends on the supply and demand elasticities.
A tax wedge is the difference between the consumer and producer prices.
The revenue burden is the amount of tax revenue raised by a tax.
The second burden of the tax is called the excess burden. The concepts of consumer and producer surpluses help us comprehend this. The effect of the tax has been to reduce consumer surplus by . This is the reduction in the pre-tax surplus given by the triangle B. By the same reasoning, supplier surplus is reduced by the amount A; prior to the tax it was . Consumers and suppliers have therefore seen a reduction in their well-being that is measured by these dollar amounts. Nonetheless, the government has additional revenues amounting to A, and this tax imposition therefore represents a transfer from the consumers and suppliers in the marketplace to the government. Ultimately, the citizens should benefit from this revenue when it is used by the government, and it is therefore not considered to be a net loss of surplus.
However, there remains a part of the surplus loss that is not transferred, the triangular area A. This component is called the excess burden, for the reason that it represents the component of the economic surplus that is not transferred to the government in the form of tax revenue. It is also called the deadweight loss, DWL.
The excess burden, or deadweight loss, of a tax is the component of consumer and producer surpluses forming a net loss to the whole economy.
The intuition behind this concept is not difficult. At the output , the value placed by consumers on the last unit supplied is (), while the production cost of that last unit is (=A). But the potential surplus () associated with producing an additional unit cannot be realized, because the tax dictates that the production equilibrium is at rather than any higher output. Thus, if output could be increased from to , a surplus of value over cost would be realized on every additional unit equal to the vertical distance between the demand and supply functions D and S. Therefore, the loss associated with the tax is the area A.
In public policy debates, this excess burden is rarely discussed. The reason is that notions of consumer and producer surpluses are not well understood by non-economists, despite the fact that the value of lost surpluses is frequently large. Numerous studies have estimated the excess burden associated with raising an additional dollar from the tax system. They rarely find that the excess burden is less than 25 percent of total expenditure. This is a sobering finding. It tells us that if the government wished to implement a new program by raising additional tax revenue, the benefits of the new program should be 25 percent greater than the amount expended on it!
The impact of taxes and other influences that result in an inefficient use of the economy's resources are frequently called distortions because they necessarily lead the economy away from the efficient output. The magnitude of the excess burden is determined by the elasticities of supply and demand in the markets where taxes are levied. To see this, return to Figure 5.4, and suppose that the demand curve through E0 were more elastic (with the same supply curve, for simplicity). The post-tax equilibrium Et would now yield a lower Qt value and a price between Pt and P0. The resulting tax revenue raised and the magnitude of the excess burden would differ because of the new elasticity.
A distortion in resource allocation means that production is not at an efficient output. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/05%3A_Welfare_economics_and_externalities/5.03%3A_Efficient_market_outcomes.txt |
The consumer and producer surplus concepts we have developed are extremely powerful tools of analysis, but the world is not always quite as straightforward as simple models indicate. For example, many suppliers generate pollutants that adversely affect the health of the population, or damage the environment, or both. The term externality is used to denote such impacts. Externalities impact individuals who are not participants in the market in question, and the effects of the externalities may not be captured in the market price. For example, electricity-generating plants that use coal reduce air quality, which, in turn, adversely impacts individuals who suffer from asthma or other lung ailments. While this is an example of a negative externality, externalities can also be positive.
An externality is a benefit or cost falling on people other than those involved in the activity's market. It can create a difference between private costs or values and social costs or values.
We will now show why markets characterized by externalities are not efficient, and also show how these externalities might be corrected or reduced. The essence of an externality is that it creates a divergence between private costs/benefits and social costs/benefits. If a steel producer pollutes the air, and the steel buyer pays only the costs incurred by the producer, then the buyer is not paying the full "social" cost of the product. The problem is illustrated in Figure 5.5.
Figure 5.5 Negative externalities and inefficiency
A negative externality is associated with this good. S reflects private costs, whereas Sf reflects the full social cost. The socially optimal output is Q×, not the market outcome Q0. Beyond Q× the real cost exceeds the demand value; therefore Q0 is not an efficient output. A tax that increases P to P× and reduces output is one solution to the externality.
Negative externalities
In Figure 5.5, the supply curve S represents the cost to the supplier, whereas Sf (the full cost) reflects, in addition, the cost of bad air to the population. Of course, we are assuming that this external cost is ascertainable, in order to be able to characterize Sf accurately. Note also that this illustration assumes that, as power output increases, the external cost per unit rises, because the difference between the two supply curves increases with output. This implies that low levels of pollution do less damage per unit: Perhaps the population has a natural tolerance for low levels, but higher levels cannot be tolerated easily and so the cost per unit is greater.
Despite the externality, an efficient level of production can still be defined. It is given by Q×, not Q0. To see why, consider the impact of reducing output by one unit from Q0. At Q0 the willingness of buyers to pay for the marginal unit supplied is E0. The (private) supply cost is also E0. But from a societal standpoint there is a pollution/health cost of AE0 associated with that unit of production. The full cost, as represented by Sf, exceeds the buyer's valuation. Accordingly, if the last unit of output produced is cut, society gains by the amount AE0, because the cut in output reduces the excess of true cost over value.
Applying this logic to each unit of output between Q0 and Q×, it is evident that society can increase its well-being by the dollar amount equal to the area E×AE0, as a result of reducing production.
Next, consider the consequences of reducing output further from Q×. Note that some pollution is being created here, and environmentalists frequently advocate that pollution should be reduced to zero. However, an efficient outcome may not involve a zero level of pollution! If the production of power were reduced below Q×, the loss in value to buyers, as a result of not being able to purchase the good, would exceed the full cost of its production.
If the government decreed that, instead of producing Q×, no pollution would be tolerated, then society would forgo the possibility of earning the total real surplus equal to the area UE×K. Economists do not advocate such a zero-pollution policy; rather, we advocate a policy that permits a "tolerable" pollution level – one that still results in net benefits to society. In this particular example, the total cost of the tolerated pollution equals the area between the private and full supply functions, KE×VR.
As a matter of policy, how is this market influenced to produce the amount Q× rather than Q0? One option would be for the government to intervene directly with production quotas for each firm. An alternative would be to impose a corrective tax on the good whose production causes the externality: With an appropriate increase in the price, consumers will demand a reduced quantity. In Figure 5.5 a tax equal to the dollar value VE× would shift the supply curve upward by that amount and result in the quantity Q× being traded.
A corrective tax seeks to direct the market towards a more efficient output.
We are now venturing into the field of environmental policy, where a corrective tax is usually called a carbon tax, and this is explored in the following section. The key conclusion of the foregoing analysis is that an efficient working of the market continues to have meaning in the presence of externalities. An efficient output level still maximizes economic surplus where surplus is correctly defined.
Positive externalities
Externalities of the positive kind enable individuals or producers to get a type of 'free ride' on the efforts of others. Real world examples abound: When a large segment of the population is immunized against disease, the remaining individuals benefit on account of the reduced probability of transmission.
A less well recognized example is the benefit derived by many producers world-wide from research and development (R&D) undertaken in advanced economies and in universities and research institutes. The result is that society at large, including the corporate sector, gain from this enhanced understanding of science, the environment, or social behaviours.
The free market may not cope any better with these positive externalities than it does with negative externalities, and government intervention may be beneficial. Furthermore, firms that invest heavily in research and development would not undertake such investment if competitors could have a complete free ride and appropriate the fruits. This is why patent laws exist, as we shall see later in discussing Canada's competition policy. These laws prevent competitors from copying the product development of firms that invest in R&D. If such protection were not in place, firms would not allocate sufficient resources to R&D, which is a real engine of economic growth. In essence, the economy's research-directed resources would not be appropriately rewarded, and thus too little research would take place.
While patent protection is one form of corrective action, subsidies are another. We illustrated above that an appropriately formulated tax on a good that creates negative externalities can reduce demand for that good, and thereby reduce pollution. A subsidy can be thought of as a negative tax, and can stimulate the supply of goods and services that have positive externalities. Consider the example in Figure 5.6.
Figure 5.6 Positive externalities – the market for flu shots
The value to society of vaccinations exceeds the value to individuals: The greater the number of individuals vaccinated, the lower is the probability of others contracting the virus. Df reflects this additional value. Consequently, the social optimum is Q× which exceeds Q0.
Individuals have a demand for flu shots given by D. This reflects their private valuation – their personal willingness to pay. But the social value of flu shots is greater. When more individuals are vaccinated, the probability that others will be infected falls. Additionally, with higher rates of immunization, the health system will incur fewer costs in treating the infected. Therefore, the value to society of any quantity of flu shots is greater than the sum of the values that individuals place on them.
Df reflects the full social value of any quantity of flu shots. In this instance the quantity axis measures the percentage of the population vaccinated, which has a maximum of 100%. If S is the supply curve, the socially optimal, efficient, market outcome is Q×. The steeply upward-sloping section of S denotes that it may be very costly to vaccinate every last person – particularly those living in outlying communities. How can we influence the market to move from Q0 towards Q×? One solution is a subsidy that would reduce the price to zero. In this case that gets us almost to the optimum, because the percentage of the population now choosing to be vaccinated is given by . The zero price essentially makes the supply curve, as perceived by the population, to be running along the horizontal axis.
Note the social value of the improvement in moving from Q0 to ; the social value exceeds the social cost. But even at further gains are available because at the social value of additional vaccinations is greater than the social cost. Overall, at the point Q× the social value is given by the area under the demand curve, and the social cost by the area under the supply curve.
5.06: Other market failures
There are other ways in which markets can fail to reflect accurately the social value or social cost of economic activity. Profit-seeking monopolies, which restrict output in order to increase profits, represent inefficient markets, and we will see why in the chapter on monopoly. Or the market may not deal very well with what are called public goods. These are goods, like radio and television service, national defence, or health information: With such goods and services many individuals can be supplied with the same good at the same total cost as one individual. We will address this problem in our chapter on government. And, of course, there are international externalities that cannot be corrected by national governments because the interests of adjoining states may differ: One economy may wish to see cheap coal-based electricity being supplied to its consumers, even if this means acid rain or reduced air quality in a neighbouring state. Markets may fail to supply an "efficient" amount of a good or service in all of these situations. Global warming is perhaps the best, and most extreme, example of international externalities and market failure. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/05%3A_Welfare_economics_and_externalities/5.05%3A_Market_failures_-_externalities.txt |
Greenhouse gases
The greatest externality challenge in the modern world is to control our emissions of greenhouse gases.The emission of greenhouse gases (GHGs) is associated with a wide variety of economic activities such as coal-based power generation, oil-burning motors, wood-burning stoves, ruminant animals, etc. The most common GHG is carbon dioxide, methane is another. The gases, upon emission, circulate in the earth's atmosphere and, following an excessive build-up, prevent sufficient radiant heat from escaping. The result is a slow warming of the earth's surface and air temperatures. It is envisaged that such temperature increases will, in the long term, increase water temperatures and cause glacial melting, with the result that water levels worldwide will rise. In addition to the higher water levels, which the Intergovernmental Panel on Climate Change (IPCC) estimates will be between one foot and one metre by the end of the 21st century, oceans will become more acidic, weather patterns will change and weather events become more variable and severe. The changes will be latitude-specific and vary by economy and continent, and ultimately will impact the agricultural production abilities of certain economies.
Greenhouse gases that accumulate excessively in the earth's atmosphere prevent heat from escaping and lead to global warming.
While most scientific findings and predictions are subject to a degree of uncertainty, there is little disagreement in the scientific community on the long-term impact of increasing GHGs in the atmosphere. There is some skepticism as to whether the generally higher temperatures experienced in recent decades are completely attributable to anthropogenic activity since the industrial revolution, or whether they also reflect a natural cycle in the earth's temperature. But scientists agree that a continuance of the recent rate of GHG emissions is leading to serious climatic problems.
The major economic environmental challenge facing the world economy is this: Historically, GHG emissions have been strongly correlated with economic growth. The very high rate of economic growth in many large-population economies such as China and India that will be necessary to raise hundreds of millions out of poverty means that that historical pattern needs to be broken – GHG accumulation must be "decoupled" from economic growth.
GHGs as a common property
A critical characteristic of GHGs is that they are what we call in economics a 'common property': Every citizen in the world 'owns' them, every citizen has equal access to them, and it matters little where these GHGs originate. Consequently, if economy A reduces its GHG emissions, economy B may simply increase its emissions rather than incur the cost of reducing them. Hence, economy A's behaviour goes unrewarded. This is the crux of international agreements – or disagreements. Since GHGs are a common property, in order for A to have the incentive to reduce emissions, it needs to know that B will act correspondingly.
From the Kyoto Protocol to the Paris Accord
The world's first major response to climate concerns came in the form of the United Nations–sponsored Earth Summit in Rio de Janeiro in 1992. This was followed by the signing of the Kyoto Protocol in 1997, in which a group of countries committed themselves to reducing their GHG emissions relative to their 1990 emissions levels by the year 2012. Canada's Parliament subsequently ratified the Kyoto Protocol, and thereby agreed to meet Canada's target of a 6 percent reduction in GHGs relative to the amount emitted in 1990.
On a per-capita basis, Canada is one of the world's largest contributors to global warming, even though Canada's percentage of the total is just 2 percent. Many of the world's major economies refrained from signing the Protocol—most notably China, the United States, and India. Canada's emissions in 1990 amounted to approximately 600 giga tonnes (Gt) of carbon dioxide; but by the time we ratified the treaty in 2002, emissions were 25% above that level. Hence the signing was somewhat meaningless, in that Canada had virtually a zero possibility of attaining its target.
The target date of 2012 has come and gone and subsequent conferences in Copenhagen and Rio failed to yield an international agreement. But in Paris, December 2015, 195 economies committed to reduce their GHG emissions by specific amounts. Canada was a party to that agreement. Target reductions varied by country. Canada committed itself to reduce GHG emissions by 30% by the year 2030 relative to 2005 emissions levels. To this end the Liberal government of Prime Minister Justin Trudeau announced in late 2016 that if individual Canadian provinces failed to implement a carbon tax, or equivalent, the federal government would impose one unilaterally. The program involves a carbon tax of \$10 per tonne in 2018, that increases by \$10 per annum until it attains a value of \$50 in 2022. Some provinces already have GHG limitation systems in place (cap and trade systems - developed below), and these provinces would not be subject to the federal carbon tax provided the province-level limitation is equivalent to the federal carbon tax.
Canada's GHG emissions
An excellent summary source of data on Canada's emissions and performance during the period 1990-2018 is available on Environment Canada's web site. See:
www.canada.ca/en/environment-climate-change/services/climate-change/greenhouse-gas-emissions/sources-sinks-executive-summary-2020.html#toc3
Canada, like many economies, has become more efficient in its use of energy (the main source of GHGs) in recent decades—its use of energy per unit of total output has declined steadily. Canada emitted 0.44 mega tonnes of equivalent per billion dollars of GDP in 2005, and 0.36 mega tonnes in 2017. On a per capita basis Canada's emissions amounted to 22.9 tonnes in 2005, and dropped to 19.5 by 2017. This modest improvement in efficiency means that Canada's GDP is now less energy intensive. The critical challenge is to produce more output while using not just less energy per unit of output, but to use less energy in total.
While Canada's energy intensity (GHGs per unit of output) has dropped, overall emissions have increased by almost 20% since 1990. Furthermore, while developed economies have increased their efficiency, it is the world's efficiency that is ultimately critical. By outsourcing much of its manufacturing sector to China, Canada and the West have offloaded some of their most GHG-intensive activities. But GHGs are a common property resource.
Canada's GHG emissions also have a regional aspect: The production of oil and gas, which has created considerable wealth for all Canadians, is both energy intensive and concentrated in a limited number of provinces (Alberta, Saskatchewan and more recently Newfoundland and Labrador).
GHG measurement
GHG atmospheric concentrations are measured in parts per million (ppm). Current levels in the atmosphere are slightly above 400 ppm, and continued growth in concentration will lead to serious economic and social disruption. In the immediate pre-industrial revolution era concentrations were in the 280 ppm range. Hence, our world seems to be headed towards a doubling of GHG concentrations in the coming decades.
GHGs are augmented by the annual additions to the stock already in the atmosphere, and at the same time they decay—though very slowly. GHG-reduction strategies that propose an immediate reduction in emissions are more costly than those aimed at a more gradual reduction. For example, a slower investment strategy would permit in-place production and transportation equipment to reach the end of its economic life rather than be scrapped and replaced 'prematurely'. Policies that focus upon longer-term replacement are therefore less costly in this specific sense.
While not all economists and policy makers agree on the time scale for attacking the problem, the longer that GHG reduction is postponed, the greater the efforts will have to be in the long term—because GHGs will build up more rapidly in the near term.
A critical question in controlling GHG emissions relates to the cost of their control: How much of annual growth might need to be sacrificed in order to get emissions onto a sustainable path? Again estimates vary. The Stern Review (2006) proposed that, with an increase in technological capabilities, a strategy that focuses on the relative near-term implementation of GHG reduction measures might cost "only" a few percentage points of the value of world output. If correct, this is a low price to pay for risk avoidance in the longer term.
Nonetheless, such a reduction will require particular economic policies, and specific sectors will be impacted more than others.
Economic policies for climate change
There are three main ways in which polluters can be controlled. One involves issuing direct controls; the other two involve incentives—in the form of pollution taxes, or on tradable "permits" to pollute.
To see how these different policies operate, consider first Figure 5.7. It is a standard diagram in environmental economics, and is somewhat similar to our supply and demand curves. On the horizontal axis is measured the quantity of environmental damage or pollution, and on the vertical axis its dollar value or cost. The upward-sloping damage curve represents the cost to society of each additional unit of pollution or gas, and it is therefore called a marginal damage curve. It is positively sloped to reflect the reality that, at low levels of emissions, the damage of one more unit is less than at higher levels. In terms of our earlier discussion, this means that an increase in GHGs of 10 ppm when concentrations are at 300 ppm may be less damaging than a corresponding increase when concentrations are at 500 ppm.
The marginal damage curve reflects the cost to society of an additional unit of pollution.
Figure 5.7 The optimal quantity of pollution
Q× represents the optimal amount of pollution. More than this would involve additional social costs because damages exceed abatement costs. Coversely, less than Q× would require an abatement cost that exceeds the reduction in damage.
The second curve is the abatement curve. It reflects the cost of reducing emissions by one unit, and is therefore called a marginal abatement curve. This curve has a negative slope indicating that, as we reduce the total quantity of pollution produced (moving towards the origin on the horizontal axis), the cost of further unit reductions rises. This shape corresponds to reality. For example, halving the emissions of pollutants and gases from automobiles may be achieved by adding a catalytic converter and reducing the amount of lead in gasoline. But reducing those emissions all the way to zero requires the development of major new technologies such as electric cars—an enormously more costly undertaking.
The marginal abatement curve reflects the cost to society of reducing the quantity of pollution by one unit.
If producers are unconstrained in the amount of pollution they produce, they will produce more than what we will show is the optimal amount – corresponding to Q×. This amount is optimal in the sense that at levels greater than Q× the damage exceeds the cost of reducing the emissions. However, reducing emissions below Q× would mean incurring a cost per unit reduction that exceeds the benefit of that reduction. Another way of illustrating this is to observe that at a level of pollution above Q× the cost of reducing it is less than the damage it inflicts, and therefore a net gain accrues to society as a result of the reduction. But to reduce pollution below Q× would involve an abatement cost greater than the reduction in pollution damage and therefore no net gain to society. This constitutes a first rule in optimal pollution policy.
An optimal quantity of pollution occurs when the marginal cost of abatement equals the marginal damage.
A second guiding principle emerges by considering a situation in which some firms are relatively 'clean' and others are 'dirty'. More specifically, a clean firm A may have already invested in new equipment that uses less energy per unit of output produced, or emits fewer pollutants per unit of output. In contrast, the dirty firm B uses older dirtier technology. Suppose furthermore that these two firms form a particular sector of the economy and that the government sets a limit on total pollution from this sector, and that this limit is less than what the two firms are currently producing. What is the least costly method to meet the target?
The intuitive answer to this question goes as follows: In order to reduce pollution at least cost to the sector, calculate what it would cost each firm to reduce pollution from its present level. Then implement a system so that the firm with the least cost of reduction is the first to act. In this case the 'dirty' firm will likely have a lower cost of abatement since it has not yet upgraded its physical plant. This leads to a second rule in pollution policy:
With many polluters, the least cost policy to society requires producers with the lowest abatement costs to act first.
This principle implies that policies which impose the same emission limits on firms may not be the least costly manner of achieving a target level of pollution. Let us now consider the use of tradable permits and corrective/carbon taxes as policy instruments. These are market-based systems aimed at reducing GHGs.
Tradable permits and corrective/carbon taxes are market-based systems aimed at reducing GHGs.
Incentive mechanism I: Tradable permits
A system of tradable permits is frequently called a 'cap and trade' system, because it limits or caps the total permissible emissions, while at the same time allows a market to develop in permits. For illustrative purposes, consider the hypothetical two-firm sector we developed above, composed of firms A and B. Firm A has invested in clean technology, firm B has not. Thus it is less costly for B to reduce emissions than A if further reductions are required. Next suppose that each firm is allocated by the government a specific number of 'GHG emission permits'; and that the total of such permits is less than the amount of emissions at present, and that each firm is emitting more than its permits allow. How can these firms achieve the target set for this sector of the economy?
The answer is that they should be able to engage in mutually beneficial trade: If firm B has a lower cost of reducing emissions than A, then it may be in A's interest to pay B to reduce B's emissions heavily. Imagine that each firm is emitting 60 units of GHG, but they have permits to emit only 50 units each. And furthermore suppose it costs B \$20 to reduce GHGs by one unit, whereas it costs A \$30 to do this. In this situation A could pay B \$25 for several permits and this would benefit both firms. B can reduce GHGs at a cost of \$20 and is being paid \$25 to do this. In turn A would incur a cost of \$30 per unit to reduce his GHGs but he can buy permits from B for just \$25 and avoid the \$30 cost. Both firms gain, and the total cost to the economy is lower than if each firm had to reduce by the same amount.
The benefit of the cap 'n trade system is that it enables the marketplace to reduce GHGs at least cost.
The largest system of tradable permits currently operates in the European Union: The EU Emissions Trading System. It covers more than 10,000 large energy-using installations. Trading began in 2005. In North America a number of Western states and several Canadian provinces are joined, either as participants or observers, in the Western Climate Initiative, which is committed to reduce GHGs by means of tradable emissions permits. The longer-term goal of these systems is for the government to issue progressively fewer permits each year, and to include an ever larger share of GHG-emitting enterprises with the passage of time.
Policy in practice – international
In an ideal world, permits would be traded internationally, and such a system might be of benefit to developing economies: If the cost of reducing pollution is relatively low in developing economies because they have few controls in place, then developed economies, for whom the cost of GA reduction is high, could induce firms in the developing world to undertake cost reductions. Such a trade would be mutually beneficial. For example, imagine in the above example that B is located in the developing world and A in the developed world. Both would obviously gain from such an arrangement, and because GHGs are a common property, the source of GHGs from a damage standpoint is immaterial.
Incentive mechanism II: Taxes
Corrective taxes are frequently called Pigovian taxes, after the economist Arthur Pigou. He advocated taxing activities that cause negative externalities. These taxes have been examined above in Section 5.4. Corrective taxes of this type can be implemented as part of a tax package reform. For example, taxpayers are frequently reluctant to see governments take 'yet more' of their money, in the form of new taxes. Such concerns can be addressed by reducing taxes in other sectors of the economy, in such a way that the package of tax changes maintains a 'revenue neutral' impact.
Revenues from taxes and permits
Taxes and tradable permits differ in that taxes generate revenue for the government from polluting producers, whereas permits may not generate revenue, or may generate less revenue. If the government simply allocates permits initially to all polluters, free of charge, and allows a market to develop, such a process generates no revenue to the government. While economists may advocate an auction of permits in the start-up phase of a tradable permits market, such a mechanism may run into political objections.
Setting taxes at the appropriate level requires knowledge of the cost and damage functions associated with GHGs. At the present time, economists and environmental scientists think that an appropriate price or tax on one tonne of GHG is in the range. Such a tax would reduce emissions to a point where the longer-term impact of GHGs would not be so severe as otherwise.
British Columbia introduced a carbon tax of per tonne of GHG on fuels in 2008, and has increased that price regularly. This tax was designed to be revenue neutral in order to make it more acceptable. This means that British Columbia reduced its income tax rates by an amount such that income tax payments would fall by an amount equal to the revenue captured by the carbon tax.
GHG policy at the federal level in Canada is embodied in the Greenhouse Gas Pollution Pricing Act of 2018. As detailed earlier, the Act imposes a yearly increasing levy on emissions. The system is intended to be revenue neutral, in that the revenues will be returned to households in the form of a 'paycheck' by the federal government. Large emitters of GHGs are permitted a specific threshold number of tonnes of emission each year without being penalized. Beyond that threshold the above rates apply.
Will this amount of carbon taxation hurt consumers, and will it enable Canada to reach its 2030 GHG goal? As a specific example: the gasoline-pricing rule of thumb is that each in carbon taxation or pricing leads to an increase in the price of gasoline at the pump of about 2.5 cents. So a levy per tonne means gas at the pump should rise by 12.5 cents per litre. The proceeds are returned to households.
As for the goal of reaching the 2030 target announced at Paris: Environment Canada estimates that the pricing scheme will reduce GHG emissions by about 60 tonnes per annum. But Canada's goal stated in Paris is to reduce emissions in 2030 by approximately four times this amount. Under the Paris Accoord, Canada stated that its 2030 goal would be to reduce emissions by 30% from their 2005 level of 725 MT, that is by an amount equal to approximately 220 tonnes.
Policy in practice – domestic large final emitters
Governments frequently focus upon quantities emitted by individual large firms, or large final emitters (LFEs). In some economies, a relatively small number of producers are responsible for a disproportionate amount of an economy's total pollution, and limits are placed on those firms in the belief that significant economy-wide reductions can be achieved in this manner. One reason for concentrating on these LFEs is that the monitoring costs are relatively small compared to the costs associated with monitoring all firms in the economy. It must be kept in mind that pollution permits may be a legal requirement in some jurisdictions, but monitoring is still required, because firms could choose to risk polluting without owning a permit. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/05%3A_Welfare_economics_and_externalities/5.07%3A_Environmental_policy_and_climate_change.txt |
Welfare economics lies at the heart of public policy. Demand and supply curves can be interpreted as value curves and cost curves when there are no externalities involved. This is what enables us to define an efficient output of a product, and consequently an efficient use of the economy's resources. While efficiency is a central concept in economics, we must keep in mind that when the economic environment changes so too will the efficient use of resources, as we illustrated in Section 5.7.
In this chapter we have focused on equity issues through the lens of GHG emissions. The build-up of GHGs in our atmosphere invokes the concept of intergenerational equity: The current generation is damaging the environment and the costs of that damage will be borne by subsequent generations. Hence it is inequitable in the intergenerational sense for us to leave a negative legacy to succeeding generations. Equity arises within generations also. For example, how much more in taxes should the rich pay relative to the non-rich? We will explore this type of equity in our chapter on government.
5.09: Key Terms
Welfare economics assesses how well the economy allocates its scarce resources in accordance with the goals of efficiency and equity.
Efficiency addresses the question of how well the economy's resources are used and allocated.
Equity deals with how society's goods and rewards are, and should be, distributed among its different members, and how the associated costs should be apportioned.
Consumer surplus is the excess of consumer willingness to pay over the market price.
Supplier or producer surplus is the excess of market price over the reservation price of the supplier.
Efficient market: maximizes the sum of producer and consumer surpluses.
Tax wedge is the difference between the consumer and producer prices.
Revenue burden is the amount of tax revenue raised by a tax.
Excess burden of a tax is the component of consumer and producer surpluses forming a net loss to the whole economy.
Deadweight loss of a tax is the component of consumer and producer surpluses forming a net loss to the whole economy.
Distortion in resource allocation means that production is not at an efficient output.
Externality is a benefit or cost falling on people other than those involved in the activity's market. It can create a difference between private costs or values and social costs or values.
Corrective tax seeks to direct the market towards a more efficient output.
Greenhouse gases that accumulate excessively in the earth's atmosphere prevent heat from escaping and lead to global warming.
Marginal damage curve reflects the cost to society of an additional unit of pollution.
Marginal abatement curve reflects the cost to society of reducing the quantity of pollution by one unit.
Tradable permits are a market-based system aimed at reducing GHGs.
Carbon taxes are a market-based system aimed at reducing GHGs.
5.10: Exercises for Chapter 5
EXERCISE 5.1
Four teenagers live on your street. Each is willing to shovel snow from one driveway each day. Their "willingness to shovel" valuations (supply) are: Jean, \$10; Kevin, \$9; Liam, \$7; Margaret, \$5. Several households are interested in having their driveways shoveled, and their willingness to pay values (demand) are: Jones, \$8; Kirpinsky, \$4; Lafleur, \$7.50; Murray, \$6.
1. Draw the implied supply and demand curves as step functions.
2. How many driveways will be shoveled in equilibrium?
3. Compute the maximum possible sum for the consumer and supplier surpluses.
4. If a new (wealthy) family arrives on the block, that is willing to pay \$12 to have their driveway cleared, recompute the answers to parts (a), (b), and (c).
EXERCISE 5.2
Consider a market where supply curve is horizontal at P=10 and the demand curve has intercepts , and is defined by the relation P=34–Q.
1. Illustrate the market geometrically.
2. Impose a tax of \$2 per unit on the good so that the supply curve is now P=12. Illustrate the new equilibrium quantity.
3. Illustrate in your diagram the tax revenue generated.
4. Illustrate the deadweight loss of the tax.
EXERCISE 5.3
Next, consider an example of DWL in the labour market. Suppose the demand for labour is given by the fixed gross wage . The supply is given by W=0.8L, indicating that the supply curve goes through the origin with a slope of 0.8.
1. Illustrate the market geometrically.
2. Calculate the supplier surplus, knowing that the equilibrium is L=20.
3. Optional: Suppose a wage tax is imposed that produces a net-of-tax wage equal to . This can be seen as a downward shift in the demand curve. Illustrate the new quantity supplied and the new supplier's surplus.
EXERCISE 5.4
Governments are in the business of providing information to potential buyers. The first serious provision of information on the health consequences of tobacco use appeared in the United States Report of the Surgeon General in 1964.
1. How would you represent this intervention in a supply and demand for tobacco diagram?
2. Did this intervention "correct" the existing market demand?
EXERCISE 5.5
In deciding to drive a car in the rush hour, you think about the cost of gas and the time of the trip.
1. Do you slow down other people by driving?
2. Is this an externality, given that you yourself are suffering from slow traffic?
EXERCISE 5.6
Suppose that our local power station burns coal to generate electricity. The demand and supply functions for electricity are given by P=12–0.5Q and P=2+0.5Q, respectively. The demand curve has intercepts and the supply curve intercept is at \$2 with a slope of one half. However, for each unit of electricity generated, there is an externality. When we factor this into the supply side of the market, the real social cost is increased by \$1 per unit. That is, the supply curve shifts upwards by \$1, and now takes the form P=3+0.5Q.
1. Illustrate the free-market equilibrium.
2. Illustrate the efficient (i.e. socially optimal) level of production.
EXERCISE 5.7
Your local dry cleaner, Bleached Brite, is willing to launder shirts at its cost of \$1.00 per shirt. The neighbourhood demand for this service is P=5–0.005Q, knowing that the demand intercepts are .
1. Illustrate the market equilibrium.
2. Suppose that, for each shirt, Bleached Brite emits chemicals into the local environment that cause \$0.25 damage per shirt. This means the full cost of each shirt is \$1.25. Illustrate graphically the socially optimal number of shirts to be cleaned.
3. Optional: Calculate the socially optimal number of shirts to be cleaned.
EXERCISE 5.8
The supply curve for agricultural labour is given by W=6+0.1L, where W is the wage (price per unit) and L the quantity traded. Employers are willing to pay a wage of \$12 to all workers who are willing to work at that wage; hence the demand curve is W=12.
1. Illustrate the market equilibrium, if you are told that the equilibrium occurs where L=60.
2. Compute the supplier surplus at this equilibrium.
EXERCISE 5.9
Optional: The market demand for vaccine XYZ is given by P=36–Q and the supply conditions are P=20; so \$20 represents the true cost of supplying a unit of vaccine. There is a positive externality associated with being vaccinated, and the real societal value is known and given by P=36–(1/2)Q. This new demand curve represents the true value to society of each vaccination. This is reflected in the private value demand curve rotating upward around the price intercept of \$36.
1. Illustrate the private and social demand curves on a diagram, with intercept values calculated.
2. What is the market solution to this supply and demand problem?
3. What is the socially optimal number of vaccinations? | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/02%3A_Responsiveness_and_the_Value_of_Markets/05%3A_Welfare_economics_and_externalities/5.08%3A_Conclusion.txt |
Chapter 6: Individual choice
In this chapter we will explore:
6.1
Rationality
6.2
Consumer choice with measurable utility
6.3
Consumer choice with ordinal utility
6.4
Applications of indifference analysis
6.1 Rationality
A critical behavioural assumption in economics is that agents operate in a way that is oriented towards achieving a goal. This can be interpreted to mean that individuals and firms maximize their personal well-being and/or their profits. These players may have other goals in addition: Philanthropy and the well-being of others are consistent with individual optimization.
If individuals are to achieve their goals then they must act in a manner that will get them to their objective; broadly, they must act in a rational manner. The theory of individual maximization that we will develop in this chapter is based on that premise or assumption. In assuming individuals are rational we need not assume that they have every piece of information available to them that might be relevant for a specific decision or choice. Nor need we assume that they have super computers in their brain when they evaluate alternative possible strategies.
What we do need to assume, however, is that individuals act in a manner that is consistent with obtaining a given objective. The modern theory of behavioural economics and behavioural psychology examines decision making in a wide range of circumstances and has uncovered many fascinating behaviours – some of which are developed in Application Box 6.1 below.
We indicated in Chapter 1 that as social scientists, we require a reliable model of behaviour, that is, a way of describing the essentials of choice that is consistent with everyday observations on individual behaviour patterns. In this chapter, our aim is to understand more fully the behavioural forces that drive the demand side of the economy.
Economists analyze individual decision making using two different, yet complementary, approaches – utility analysis and indifference analysis. We begin by portraying individuals as maximizing their measurable utility (sometimes called cardinal utility); then progress to indifference analysis, where a weaker assumption is made on the ability of individuals to measure their satisfaction. In this second instance we do not assume that individuals can measure their utility numerically, only that they can say if one collection of goods and services yields them greater satisfaction than another group. This ranking of choices corresponds to what is sometimes called ordinal utility – because individuals can order groups of goods and services in ascending order of satisfaction. In each case individuals are perceived as rational maximizers or optimizers: They allocate their income so as to choose the outcome that will make them as well off as possible.
The second approach to consumer behaviour is frequently omitted in introductory texts. It can be omitted here without interpreting the flow of ideas, although it does yield additional insights into consumer choice and government policy. As in preceding chapters, we begin the analysis with a motivating numerical example.
Application Box 6.1 Rationality and impulse
A number of informative and popular books on decision making have appeared recently. Their central theme is that our decision processes should not be viewed solely as a rational computer – operating in one single mode only, and unmoved by our emotions or history. Psychologists now know that our brains have at least two decision modes, and these are developed by economics Nobel Prize winner Daniel Kahneman in his book "Thinking, Fast and Slow". One part of our brain operates in a rational goal-oriented forward-looking manner (the 'slow' part), another is motivated by immediate gratification (the 'fast' part). Decisions that we observe in the world about us reflect these different mechanisms.
Richard Thaler, a Chicago economist and his law professor colleague Cass Sunstein, have developed a role for public policy in their book entitled "Nudge". They too argue that individuals do not inevitably operate in their own best long-term interests, and as a consequence individuals frequently require a nudge by government to make the long-term choice rather than the short-term choice. For example, when individuals begin a new job, they might be automatically enrolled in the company pension plan and be given the freedom to opt out, rather than not be enrolled and given the choice to opt in. Such policies are deemed to be 'soft paternalism'. They are paternalistic for the obvious reason – another organism is directing, but they are also soft in that they are not binding.
6.2 Choice with measurable utility
Neal loves to pump his way through the high-altitude powder at the Whistler ski and snowboard resort. His student-rate lift-ticket cost is \$30 per visit. He also loves to frequent the jazz bars in downtown Vancouver, and each such visit costs him \$20. With expensive passions, Neal must allocate his monthly entertainment budget carefully. He has evaluated how much satisfaction, measured in utils, he obtains from each snowboard outing and each jazz club visit. We assume that these utils are measurable, and use the term cardinal utility to denote this. These measurable utility values are listed in columns 2 and 3 of Table 6.1. They define the total utility he gets from various amounts of the two activities.
Table 6.1 Utils from snowboarding and jazz
1 2 3 4 5 6 7
Visit Total Total Marginal Marginal Marginal Marginal
# snowboard jazz snowboard jazz utils snowboard jazz utils
utils utils utils utils per \$ per \$
1 72 52 72 52 2.4 2.6
2 132 94 60 42 2.0 2.1
3 182 128 50 34 1.67 1.7
4 224 156 42 28 1.4 1.4
5 260 180 36 24 1.2 1.2
6 292 201 32 21 1.07 1.05
7 321 220 29 19 0.97 0.95
Price of snowboard visit=\$30. Price of jazz club visit=\$20.
Cardinal utility is a measurable concept of satisfaction.
Total utility is a measure of the total satisfaction derived from consuming a given amount of goods and services.
Neal's total utility from each activity in this example is independent of the amount of the other activity he engages in. These total utilities are plotted in Figures 6.1 and 6.2. Clearly, more of each activity yields more utility, so the additional or marginal utility (MU) of each activity is positive. This positive marginal utility for any amount of the good consumed, no matter how much, reflects the assumption of non-satiation—more is always better. Note, however, that the decreasing slopes of the total utility curves show that total utility is increasing at a diminishing rate. While more is certainly better, each additional visit to Whistler or a jazz club augments Neal's utility by a smaller amount. At the margin, his additional utility declines: He has diminishing marginal utility. The marginal utilities associated with snowboarding and jazz are entered in columns 4 and 5 of Table 6.1. They are the differences in total utility values when consumption increases by one unit. For example, when Neal makes a sixth visit to Whistler his total utility increases from 260 utils to 292 utils. His marginal utility for the sixth unit is therefore 32 utils, as defined in column 4. In light of this example, it should be clear that we can define marginal utility as:
(6.1)
where denotes the change in the quantity consumed of the good or service in question.
Marginal utility is the addition to total utility created when one more unit of a good or service is consumed.
Diminishing marginal utility implies that the addition to total utility from each extra unit of a good or service consumed is declining.
Figure 6.1 TU from snowboarding
Figure 6.2 TU from jazz
Figure 6.3 MU from snowboarding
Figure 6.4 MU from jazz
The marginal utilities associated with consuming different amounts of the two goods are plotted in Figures 6.3 and 6.4, using the data from columns 4 and 5 in Table 6.1. These functions are declining, as indicated by their negative slope. It should also be clear that the MU curves can be derived from the TU curves. For example, in figure 6.2, when going from 2 units to 3 units of Jazz, TU increases by 34 units. But 34/1 is the slope of the TU function in this range of consumption – the vertical distance divided by the horizontal distance. Similarly, if jazz consumption increases from 4 units to 5 units the corresponding change in TU is 24 units, again the vertical distance divided by the horizontal distance, and so the slope of the function. In short, the MU is the slope of the TU function.
Now that Neal has defined his utility schedules, he must consider the price of each activity. Ultimately, when deciding how to allocate his monthly entertainment budget, he must evaluate how much utility he gets from each dollar spent on snowboarding and jazz: What "bang for his buck" does he get? Let us see how he might go about allocating his budget. When he has fully spent his budget in the manner that will yield him greatest utility, we say that he has attained equilibrium, because he will have no incentive to change his expenditure patterns.
If he boards once, at a cost of \$30, he gets 72 utils of satisfaction, which is 2.4 utils per dollar spent (=72/30). One visit to a jazz club would yield him 2.6 utils per dollar (=52/20). Initially, therefore, his dollars give him more utility per dollar when spent on jazz. His MU per dollar spent on each activity is given in the final two columns of the table. These values are obtained by dividing the MU associated with each additional unit by the good's price.
We will assume that Neal has a budget of \$200. He realizes that his initial expenditure should be on a jazz club visit, because he gets more utility per dollar spent there. Having made one such expenditure, he sees that a second jazz outing would yield him 2.1 utils per dollar expended, while a first visit to Whistler would yield him 2.4 utils per dollar. Accordingly, his second activity is a snowboard outing.
Having made one jazz and one snowboarding visit, he then decides upon a second jazz club visit for the same reason as before—utility value for his money. He continues to allocate his budget in this way until his budget is exhausted. In our example, this occurs when he spends \$120 on four snowboarding outings and \$80 on four jazz club visits. At this consumer equilibrium, he gets the same utility value per dollar for the last unit of each activity consumed. This is a necessary condition for him to be maximizing his utility, that is, to be in equilibrium.
Consumer equilibrium occurs when marginal utility per dollar spent on the last unit of each good is equal.
To be absolutely convinced of this, imagine that Neal had chosen instead to board twice and to visit the jazz clubs seven times; this combination would also exhaust his \$200 budget exactly. With such an allocation, he would get 2.0 utils per dollar spent on his marginal (second) snowboard outing, but just 0.95 utils per dollar spent on his marginal (seventh) jazz club visit.1 If, instead, he were to reallocate his budget in favour of snowboarding, he would get 1.67 utils per dollar spent on a third visit to the hills. By reducing the number of jazz visits by one, he would lose 0.95 utils per dollar reallocated. Consequently, the utility gain from a reallocation of his budget towards snowboarding would outweigh the utility loss from allocating fewer dollars to jazz. His initial allocation, therefore, was not an optimum, or equilibrium.
Only when the utility per dollar expended on each activity is equal at the margin will Neal be optimizing. When that condition holds, a reallocation would be of no benefit to him, because the gains from one more dollar on boarding would be exactly offset by the loss from one dollar less spent on jazz. Therefore, we can write the equilibrium condition as
(6.2)
While this example has just two goods, in the more general case of many goods, this same condition must hold for all pairs of goods on which the consumer allocates his or her budget.
From utility to demand
Utility theory is a useful way of analyzing how a consumer makes choices. But in the real world we do not observe a consumer's utility, either total or marginal. Instead, his or her behaviour in the marketplace is observed through the demand curve. How are utility and demand related?
Demand functions relate the quantity of a good consumed to the price of that good, other things being equal. So let us trace out the effects of a price change on demand, with the help of this utility framework. We will introduce a simplification here: Goods are divisible, or that they come in small packages relative to income. Think, for example, of kilometres driven per year, or liters of gasoline purchased. Conceptualizing things in this way enables us to imagine more easily experiments in which small amounts of a budget are allocated one dollar at a time. In contrast, in the snowboard/jazz example, we had to reallocate the budget in lumps of \$30 or \$20 at a time because we could not "fractionalize" these goods.
The effects of a price change on a consumer's demand can be seen through the condition that describes his or her equilibrium. If income is allocated to, say, three goods , such that MUa/Pa=MUb/Pb=MUc/Pc, and the price of, say, good b falls, the consumer must reallocate the budget so that once again the MUs per dollar spent are all equated. How does he do this? Clearly, if he purchases more or less of any one good, the MU changes. If the price of good b falls, then the consumer initially gets more utility from good b for the last dollar he spends on it (the denominator in the expression MUb/Pb falls, and consequently the value of the ratio rises to a value greater than the values for goods a and c).
The consumer responds to this, in the first instance, by buying more of the cheaper good. He obtains more total utility as a consequence, and in the process will get less utility at the margin from that good. In essence, the numerator in the expression then falls, in order to realign it with the lower price. This equality also provides an underpinning for what is called the law of demand: More of a good is demanded at a lower price. If the price of any good falls, then, in order for the equilibrium condition to be re-established, the MU of that good must be driven down also. Since MU declines when more is purchased, this establishes that demand curves must slope downwards.
The law of demand states that, other things being equal, more of a good is demanded the lower is its price.
However, the effects of a price decline are normally more widespread than this, because the quantities of other goods consumed may also change. As explained in earlier chapters, the decline in the price of good b will lead the consumer to purchase more units of complementary goods and fewer units of goods that are substitutes. So the whole budget allocation process must be redetermined in response to any price change. But at the end of the day, a new equilibrium must be one where the marginal utility per dollar spent on each good is equal.
Applying the theory
The demand curves developed in Chapter 3 can be related to the foregoing utility analysis. In our example, Neal purchased four lift tickets at Whistler when the price was \$30. We can think of this combination as one point on his demand curve, where the "other things kept constant" are the price of jazz, his income, his tastes, etc.
Suppose now that the price of a lift ticket increased to \$40. How could we find another point on his demand curve corresponding to this price, using the information in Table 6.1? The marginal utility per dollar associated with each visit to Whistler could be recomputed by dividing the values in column 4 by 40 rather than 30, yielding a new column 6. We would then determine a new allocation of his budget between the two goods that would maximize utility. After such a calculation we would find that he makes three visits to Whistler and four jazz-club visits. Thus, the combination is another point on his demand curve. Note that this allocation exactly exhausts his \$200 budget.
By setting the price equal to \$20, this exercise could be performed again, and the outcome will be a quantity demanded of lift tickets equal to seven (plus three jazz club visits). Thus, the combination is another point on his demand curve. Figure 6.5 plots a demand curve going through these three points.
By repeating this exercise for many different prices, the demand curve is established. We have now linked the demand curve to utility theory.
Figure 6.5 Utility to demand
When , the consumer finds the quantity such that MU/P is equal for all purchases. The corresponding quantity purchased is 4 tickets. At prices of \$40 and \$20 the equilibrium condition implies quantities of 3 and 7 respectively.
Application Box 6.2 Individual and Collective Utility
The example developed in the text is not far removed from what economists do in practice. From a philosophical standpoint, economists are supposed to be interested in the well-being of the citizens who make up an economy or a country. To determine how 'well-off' citizens may be, social scientists frequently carry out surveys on how 'content' or 'happy' people are in their every-day lives. For example, the Earth Institute at Columbia University regularly produces a 'World Happiness Report'. The report is based upon responses to survey questions in numerous economies. One of the measures it uses to compare utility levels is the Cantril ladder. This is an 11-point scale running from 0 to 10, with the lowest value signifying the worst possible life, and 10 the highest possible quality of life. In reporting their findings, the researchers are essentially claiming that some economies have, on average, more contented or happier, people than others. Utility can be considered in exactly this way: A higher reported value on the Cantril ladder suggests higher utility.
A slightly different measure of well-being across economies is given by the United Nations Human Development Index. In this case, countries score high by having a high level of income, good health (as measured by life expectancy), and high levels of education, as measured by the number of years of education completed or envisaged.
In practice, social scientists are very comfortable using utility-based concepts to describe the economic circumstances of individuals in different economies.
6.3 Choice with ordinal utility
The budget constraint
In the preceding section, we assumed that utility is measurable in order to better understand how consumers allocate their budgets, and how this process is reflected in the market demands that are observed. The belief that utility might be measurable is not too extreme in the modern era. Neuroscientists are mapping more and more of the human brain and understanding how it responds to positive and negative stimuli. At the same time, numerous sociological surveys throughout the world ask individuals to rank their happiness on a scale of one to ten, or something similar, with a view to making comparisons between individual-level and group-level happiness – see Application Box 6.2. Nonetheless, not every scientist may be convinced that we should formulate behavioural rules on this basis. Accordingly we now examine the economics of consumer behaviour without this strong assumption. We assume instead that individuals are able to identify (a) different combinations of goods and services that yield equal satisfaction, and (b) combinations of goods and services that yield more satisfaction than other combinations. In contrast to measurable (or cardinal) utility, this concept is called ordinal utility, because it assumes only that consumers can order utility bundles rather than quantify the utility.
Ordinal utility assumes that individuals can rank commodity bundles in accordance with the level of satisfaction associated with each bundle.
The budget constraint
Neal's monthly expenditure limit, or budget constraint, is \$200. In addition, he faces a price of \$30 for lift tickets and \$20 per visit to jazz clubs. Therefore, using S to denote the number of snowboard outings and J the number of jazz club visits, if he spends his entire budget it must be true that the sum of expenditures on each activity exhausts his budget or income (I):
Since many different combinations of the two goods are affordable, it follows that the budget constraint defines all bundles of goods that the consumer can afford with a given budget.
The budget constraint defines all bundles of goods that the consumer can afford with a given budget.
The budget constraint, then, is just what it claims to be—a limit on behaviour. Neal's budget constraint is illustrated in Figure 6.6, where the amount of each good consumed is given on the axes. If he spends all of his \$200 income on jazz, he can make exactly ten jazz club visits . The calculation also applies to visits to Whistler. The intercept value is always obtained by dividing income by the price of the good or activity in question.
Figure 6.6 The budget line
FC is the budget constraint and defines the affordable combinations of snowboarding and jazz. F represents all income spent on snowboarding. Thus F=I/Ps. Similarly C=I/Pj. Points above FC are not attainable. The slope = OF/OC =(I/Ps)/(I/Pj)=Pj/Ps=20/30=2/3. The affordable set is 0FC.
In addition to these affordable extremes, Neal can also afford many other bundles, e.g., (S=2,J=7), or (S=4,J=4), or (S=6,J=1). The set of feasible, or affordable, combinations is bounded by the budget line, and this is illustrated in Figure 6.6.
The affordable set of goods and services for the consumer is bounded by the budget line from above; the non-affordable set lies strictly above the budget line.
The slope of the budget line is informative. As illustrated in Chapter 1, it indicates how many snowboard visits must be sacrificed for one additional jazz visit; it defines the consumer's trade-offs. To illustrate: Suppose Neal is initially at point A (J=4,S=4), and moves to point K (J=7,S=2). Clearly, both points are affordable. In making the move, he trades two snowboard outings in order to get three additional jazz club visits, a trade-off of 2/3. This trade-off is the slope of the budget line, which, in Figure 6.6, is AB/BK=–2/3, where the negative sign reflects the downward slope.
Could it be that this ratio reflects the two prices (\$20/\$30)? The answer is yes: The slope of the budget line is given by the vertical distance divided by the horizontal distance, OF/OC. The points F and C were obtained by dividing income by the respective price—remember that the jazz intercept is . Formally, that is I/PJ. The intercept on the snowboard axis is likewise I/PS. Accordingly, the slope of the budget constraint is:
Since the budget line has a negative slope, it is technically correct to define it with a negative sign. But, as with elasticities, the sign is frequently omitted.
Tastes and indifference
We now consider how to represent a consumer's tastes in two dimensions, given that he can order, or rank, different consumption bundles, and that he can define a series of different bundles that all yield the same satisfaction. We limit ourselves initially to considering just "goods," and not "bads" such as pollution.
Figure 6.7 Ranking consumption bundles
L is preferred to R since more of each good is consumed at L, while points such as V are less preferred than R. Points W and T contain more of one good and less of the other than R. Consequently, we cannot say if they are preferred to R without knowing how the consumer trades the goods off – that is, his preferences.
Figure 6.7 examines the implications of these assumptions about tastes. Each point shows a consumption bundle of snowboarding and jazz. Let us begin at bundle R. Since more of a good is preferred to less, any point such as L, which lies to the northeast of R, is preferred to R, since L offers more of both goods than R. Conversely, points to the southwest of R offer less of each good than R, and therefore R is preferred to a point such as V.
Without knowing the consumer's tastes, we cannot be sure at this stage how points in the northwest and southeast regions compare with R. At W or T, the consumer has more of one good and less of the other than at R. Someone who really likes snowboarding might prefer W to R, but a jazz buff might prefer T to R.
Let us now ask Neal to disclose his tastes, by asking him to define several combinations of snowboarding and jazz that yield him exactly the same degree of satisfaction as the combination at R. Suppose further, for reasons we shall understand shortly, that his answers define a series of points that lie on the beautifully smooth contour UR in Figure 6.8. Since he is indifferent between all points on UR by construction, this contour is an indifference curve.
Figure 6.8 Indifference curves
An indifference curve defines a series of consumption bundles, all of which yield the same satisfaction. The slope of an indifference curve is the marginal rate of substitution (MRS) and defines the number of units of the good on the vertical axis that the individual will trade for one unit of the good on the horizontal axis. The MRS declines as we move south-easterly, because the consumer values the good more highly when he has less of it.
An indifference curve defines combinations of goods and services that yield the same level of satisfaction to the consumer.
Pursuing this experiment, we could take other points in Figure 6.8, such as L and V, and ask the consumer to define bundles that would yield the same level of satisfaction, or indifference. These combinations would yield additional contours, such as UL and UV in Figure 6.8. This process yields a series of indifference curves that together form an indifference map.
An indifference map is a set of indifference curves, where curves further from the origin denote a higher level of satisfaction.
Let us now explore the properties of this map, and thereby understand why the contours have their smooth convex shape. They have four properties. The first three follow from our preceding discussion, and the fourth requires investigation.
1. Indifference curves further from the origin reflect higher levels of satisfaction.
2. Indifference curves are negatively sloped. This reflects the fact that if a consumer gets more of one good she should have less of the other in order to remain indifferent between the two combinations.
3. Indifference curves cannot intersect. If two curves were to intersect at a given point, then we would have two different levels of satisfaction being associated with the same commodity bundle—an impossibility.
4. Indifference curves are convex when viewed from the origin, reflecting a diminishing marginal rate of substitution.
The convex shape reflects an important characteristic of preferences: When consumers have a lot of some good, they value a marginal unit of it less than when they have a small amount of that good. More formally, they have a higher marginal valuation at low consumption levels—that first cup of coffee in the morning provides greater satisfaction than the second or third cup.
Consider the various points on UR, starting at M in Figure 6.8. At M Neal snowboards a lot; at N he boards much less. The convex shape of his indifference map shows that he values a marginal snowboard trip more at N than at M. To see this, consider what happens as he moves along his indifference curve, starting at M. We have chosen the coordinates on UR so that, in moving from M to R, and again from N to H, the additional amount of jazz is the same: CR=FH. From M, if Neal moves to R, he consumes an additional amount of jazz, CR. By definition of the indifference curve, he is willing to give up MC snowboard outings. The ratio MC/CR defines his willingness to substitute one good for the other. This ratio, being a vertical distance divided by a horizontal distance, is the slope of the indifference curve and is called the marginal rate of substitution, MRS.
The marginal rate of substitution is the slope of the indifference curve. It defines the amount of one good the consumer is willing to sacrifice in order to obtain a given increment of the other, while maintaining utility unchanged.
At N, the consumer is willing to sacrifice the amount NF of boarding to get the same additional amount of jazz. Note that, when he boards less, as at N, he is willing to give up less boarding than when he has a lot of it, as at M, in order to get the same additional amount of jazz. His willingness to substitute diminishes as he moves from M to N: The quantity NF is less than the quantity MC. In order to reflect this taste characteristic, the indifference curve has a diminishing marginal rate of substitution: A flatter slope as we move down along its surface.
A diminishing marginal rate of substitution reflects a higher marginal value being associated with smaller quantities of any good consumed.
Optimization
We are now in a position to examine how the consumer optimizes—how he gets to the highest level of satisfaction possible. The constraint on his behaviour is the affordable set defined in Figure 6.6, the budget line.
Figure 6.9 displays several of Neal's indifference curves in conjunction with his budget constraint. We propose that he maximizes his utility, or satisfaction, at the point E, on the indifference curve denoted by U3. While points such as F and G are also on the boundary of the affordable set, they do not yield as much satisfaction as E, because E lies on a higher indifference curve. The highest possible level of satisfaction is attained, therefore, when the budget line touches an indifference curve at just a single point—that is, where the constraint is tangent to the indifference curve. E is such a point.
Figure 6.9 The consumer optimum
The budget constraint constrains the individual to points on or below HK. The highest level of satisfaction attainable is U3, where the budget constraint just touches, or is just tangent to, it. At this optimum the slope of the budget constraint (–Pj/Ps) equals the MRS.
This tangency between the budget constraint and an indifference curve requires that the slopes of each be the same at the point of tangency. We have already established that the slope of the budget constraint is the negative of the price ratio (). The slope of the indifference curve is the marginal rate of substitution MRS. It follows, therefore, that the consumer optimizes where the marginal rate of substitution equals the slope of the price line.
Optimization requires:
(6.3)
A consumer optimum occurs where the chosen consumption bundle is a point such that the price ratio equals the marginal rate of substitution.
Notice the resemblance between this condition and the one derived in the first section as Equation 6.2. There we argued that equilibrium requires the ratio of the marginal utilities be same as the ratio of prices. Here we show that the MRS must equal the ratio of prices. In fact, with a little mathematics it can be shown that the MRS is indeed the same as the (negative of the) ratio of the marginal utilities: . Therefore the two conditions are in essence the same! However, it was not necessary to assume that an individual can actually measure his utility in obtaining the result that the MRS should equal the price ratio in equilibrium. The concept of ordinal utility is sufficient.
Adjusting to income changes
Suppose now that Neal's income changes from \$200 to \$300. How will this affect his consumption decisions? In Figure 6.10, this change is reflected in a parallel outward shift of the budget constraint. Since no price change occurs, the slope remains constant. By recomputing the ratio of income to price for each activity, we find that the new snowboard and jazz intercepts are 10 and 15 , respectively. Clearly, the consumer can attain a higher level of satisfaction—at a new tangency to a higher indifference curve—as a result of the size of the affordable set being expanded. In Figure 6.10, the new equilibrium is at E1.
Figure 6.10 Income and price adjustments
An income increase shifts the budget constraint from I0 to I1. This enables the consumer to attain a higher indifference curve. A price rise in jazz tickets rotates the budget line I0 inwards around the snowboard intercept to I2. The price rise reflects a lower real value of income and results in a lower equilibrium level of satisfaction.
Adjusting to price changes
Next, consider the impact of a price change from the initial equilibrium E0 in Figure 6.10. Suppose that jazz now costs more. This reduces the purchasing power of the given budget of \$200. The new jazz intercept is therefore reduced. The budget constraint becomes steeper and rotates around the snowboard intercept H, which is unchanged because its price is constant. The new equilibrium is at E2, which reflects a lower level of satisfaction because the affordable set has been reduced by the price increase. As explained in Section 6.2, E0 and E2 define points on the demand curve for jazz (J0 and J2): They reflect the consumer response to a change in the price of jazz with all other things held constant. In contrast, the price increase for jazz shifts the demand curve for snowboarding: As far as the demand curve for snowboarding is concerned, a change in the price of jazz is one of those things other than own-price that determine its position.
Philanthropy
Individuals in the foregoing analysis aim to maximize their utility, given that they have a fixed budget. Note that this behavioural assumption does not rule out the possibility that these same individuals may be philanthropic – that is, they get utility from the act of giving to their favourite charity or the United Way or Centre-aide. To see this suppose that donations give utility to the individual in question – she gets a 'warm glow' feeling as a result of giving, which is to say she gets utility from the activity. There is no reason why we cannot put charitable donations on one axis and some other good or combination of goods on the remaining axis. At equilibrium, the marginal utility per dollar of contributions to charity should equal the marginal utility per dollar of expenditure on other goods; or, stated in terms of ordinal utility, the marginal rate of substitution between philanthropy and any other good should equal the ratio of their prices. Evidently the price of a dollar of charitable donations is one dollar.
6.4 Applications of indifference analysis
Price impacts: Complements and substitutes
The nature of complements and substitutes, defined in Chapter 4, can be further understood with the help of Figure 6.10. The new equilibrium E2 has been drawn so that the increase in the price of jazz results in more snowboarding—the quantity of S increases to S2 from S0. These goods are substitutes in this picture, because snowboarding increases in response to an increase in the price of jazz. If the new equilibrium E2 were at a point yielding a lower level of S than S0, we would conclude that they were complements.
Cross-price elasticities
Continuing with the same price increase in jazz, we could compute the percentage change in the quantity of snowboarding demanded as a result of the percentage change in the jazz price. In this example, the result would be a positive elasticity value, because the quantity change in snowboarding and the price change in jazz are both in the same direction, each being positive.
Income impacts: Normal and inferior goods
We know from Chapter 4 that the quantity demanded of a normal good increases in response to an income increase, whereas the quantity demanded of an inferior good declines. Clearly, both jazz and boarding are normal goods, as illustrated in Figure 6.10, because more of each one is demanded in response to the income increase from to . It would challenge the imagination to think that either of these goods might be inferior. But if J were to denote junky (inferior) goods and S super goods, we could envisage an equilibrium to the northwest of in response to an income increase, along the constraint ; less J and more S would be consumed in response to the income increase.
Policy: Income transfers and price subsidies
Government policies that improve the purchasing power of low-income households come in two main forms: Pure income transfers and price subsidies. Social Assistance payments ("welfare") or Employment Insurance benefits, for example, provide an increase in income to the needy. Subsidies, on the other hand, enable individuals to purchase particular goods or services at a lower price—for example, rent or daycare subsidies.
In contrast to taxes, which reduce the purchasing power of the consumer, subsidies and income transfers increase purchasing power. The impact of an income transfer, compared with a pure price subsidy, can be analyzed using Figures 6.11 and 6.12.
Figure 6.11 Income transfer
An increase in income due to a government transfer shifts the budget constraint from I1 to I2. This parallel shift increases the quantity consumed of the target good (daycare) and other goods, unless one is inferior.
In Figure 6.11, an income transfer increases income from I1 to I2. The new equilibrium at E2 reflects an increase in utility, and an increase in the consumption of both daycare and other goods.
Suppose now that a government program administrator decides that, while helping this individual to purchase more daycare accords with the intent of the transfer, she does not intend that government money should be used to purchase other goods. She therefore decides that a daycare subsidy program might better meet this objective than a pure income transfer.
A daycare subsidy reduces the price of daycare and therefore rotates the budget constraint outwards around the intercept on the vertical axis. At the equilibrium in Figure 6.12, purchases of other goods change very little, and therefore most of the additional purchasing power is allocated to daycare.
Figure 6.12 Price subsidy
A subsidy to the targeted good, by reducing its price, rotates the budget constraint from I1 to I2. This induces the consumer to direct expenditure more towards daycare and less towards other goods than an income transfer that does not change the relative prices.
Let us take the example one stage further. From the initial equilibrium in Figure 6.12, suppose that, instead of a subsidy that took the individual to , we gave an income transfer that enabled the consumer to purchase the combination . Such a transfer is represented in Figure 6.13 by a parallel outward shift of the budget constraint from to , going through the point . We now have a subsidy policy and an alternative income transfer policy, each permitting the same consumption bundle (). The interesting aspect of this pair of possibilities is that the income transfer will enable the consumer to attain a higher level of satisfaction—for example, at point —and will also induce her to consume more of the good on the vertical axis. The higher level of satisfaction comes about because the consumer has more latitude in allocating the additional real income.
Application Box 6.3 Daycare subsidies in Quebec
The Quebec provincial government subsidizes daycare heavily. In the public-sector network called the "Centres de la petite enfance", families can place their children in daycare for less than \$10 per day, while families that use the private sector are permitted a generous tax allowance for their daycare costs. This policy is designed to enable households to limit the share of their income expended on daycare. It is described in Figure 6.13.
The consequences of strong subsidization are not negligible: Excess demand, to such an extent that children are frequently placed on waiting lists for daycare places long before their parents intend to use the service. Annual subsidy costs amount to almost \$2 billion per year. At the same time, it has been estimated that the policy has enabled many more parents to enter the workforce than otherwise would have.
Figure 6.13 Subsidy-transfer comparison
A price subsidy to the targeted good induces the individual to move from E1 to E2, facing a budget constraint I2. An income transfer that permits him to consume E2 is given by ; but it also permits him to attain a higher level of satisfaction, denoted by on the indifference curve U3.
The price of giving
Imagine now that the good on the horizontal axis is charitable donations, rather than daycare, and the government decides that for every dollar given the individual will see a reduction in their income tax of 50 cents. This is equivalent to cutting the 'price' of donations in half, because a donation of one dollar now costs the individual half of that amount. Graphically the budget constraint rotates outward with the vertical intercept unchanged. Since donations now cost less the individual has increased spending power as a result of the price reduction for donations. The price reduction is designed to increase the attractiveness of donations to the utility maximizing consumer.
Key Terms
Cardinal utility is a measurable concept of satisfaction.
Total utility is a measure of the total satisfaction derived from consuming a given amount of goods and services.
Marginal utility is the addition to total utility created when one more unit of a good or service is consumed.
Diminishing marginal utility implies that the addition to total utility from each extra unit of a good or service consumed is declining.
Consumer equilibrium occurs when marginal utility per dollar spent on the last unit of each good is equal.
Law of demand states that, other things being equal, more of a good is demanded the lower is its price.
Ordinal utility assumes that individuals can rank commodity bundles in accordance with the level of satisfaction associated with each bundle.
Budget constraint defines all bundles of goods that the consumer can afford with a given budget.
Affordable set of goods and services for the consumer is bounded by the budget line from above; the non-affordable set lies strictly above the budget line.
Indifference curve defines combinations of goods and services that yield the same level of satisfaction to the consumer.
Indifference map is a set of indifference curves, where curves further from the origin denote a higher level of satisfaction.
Marginal rate of substitution is the slope of the indifference curve. It defines the amount of one good the consumer is willing to sacrifice in order to obtain a given increment of the other, while maintaining utility unchanged.
Diminishing marginal rate of substitution reflects a higher marginal value being associated with smaller quantities of any good consumed.
Consumer optimum occurs where the chosen consumption bundle is a point such that the price ratio equals the marginal rate of substitution.
Exercises for Chapter 6
EXERCISE 6.1
In the example given in Table 6.1, suppose Neal experiences a small increase in income. Will he allocate it to snowboarding or jazz? [Hint: At the existing equilibrium, which activity will yield the higher MU for an additional dollar spent on it?]
EXERCISE 6.2
Suppose that utility depends on the square root of the amount of good X consumed: .
1. In a spreadsheet enter the values 1... 16 as the X column (col A), and in the adjoining column (B) compute the value of utility corresponding to each quantity of X. To do this use the 'SQRT' command. For example, the entry in cell B3 will be of the form '=SQRT(A3)'.
2. In the third column enter the marginal utility (MU) associated with each value of X – the change in utility in going from one value of X to the next.
3. Use the 'graph' tool to map the relationship between U and X.
4. Use the graph tool to map the relationship between MU and X.
EXERCISE 6.3
Instead of the square-root utility function in Exercise 6.2, suppose that utility takes the form U=x2.
1. Follow the same procedure as in the previous question – graph the utility function.
2. Why is this utility function not consistent with our beliefs on utility?
EXERCISE 6.4
1. Plot the utility function U=2X, following the same procedure as in the previous questions.
2. Next plot the marginal utility values in a graph. What do we notice about the behaviour of the MU?
EXERCISE 6.5
Let us see if we can draw a utility function for beer. In this instance the individual may reach a point where he takes too much.
1. If the utility function is of the form U=6XX2, plot the utility values for X values in the range , using either a spreadsheet or manual calculations.
2. At how many units of X (beer) is the individual's utility maximized?
3. At how many beers does the utility become negative?
EXERCISE 6.6
Cappuccinos, C, cost \$3 each, and music downloads of your favourite artist, M, cost \$1 each from your iTunes store. Income is \$24.
1. Draw the budget line, with cappuccinos on the vertical axis, and music on the horizontal axis, and compute the values of the intercepts.
2. What is the slope of the budget constraint, and what is the opportunity cost of 1 cappuccino?
3. Are the following combinations of goods in the affordable set: (4C and 9M), (6C and 2M), (3C and 15M)?
4. Which combination(s) above lie inside the affordable set, and which lie on the boundary?
EXERCISE 6.7
George spends his income on gasoline and "other goods."
1. First, draw a budget constraint, with gasoline on the horizontal axis.
2. Suppose now that, in response to a gasoline shortage in the economy, the government imposes a ration on each individual that limits the purchase of gasoline to an amount less than the gasoline intercept of the budget constraint. Draw the new effective budget constraint.
EXERCISE 6.8
Suppose that you are told that the indifference curves defining the trade-off for two goods took the form of straight lines. Which of the four properties outlines in Section 6.3 would such indifference curves violate?
EXERCISE 6.9
Draw an indifference map with several indifference curves and several budget constraints corresponding to different possible levels of income. Note that these budget constraints should all be parallel because only income changes, not prices. Now find some optimizing (tangency) points. Join all of these points. You have just constructed what is called an income-consumption curve. Can you understand why it is called an income-consumption curve?
EXERCISE 6.10
Draw an indifference map again, in conjunction with a set of budget constraints. This time the budget constraints should each have a different price of good X and the same price for good Y.
1. Draw in the resulting equilibria or tangencies and join up all of these points. You have just constructed a price-consumption curve for good X. Can you understand why the curve is so called?
2. Now repeat part (a), but keep the price of X constant and permit the price of Y to vary. The resulting set of equilibrium points will form a price consumption curve for good Y.
EXERCISE 6.11
Suppose that movies are a normal good, but public transport is inferior. Draw an indifference map with a budget constraint and initial equilibrium. Now let income increase and draw a plausible new equilibrium, noting that one of the goods is inferior.
06: Individual choice
A critical behavioural assumption in economics is that agents operate in a way that is oriented towards achieving a goal. This can be interpreted to mean that individuals and firms maximize their personal well-being and/or their profits. These players may have other goals in addition: Philanthropy and the well-being of others are consistent with individual optimization.
If individuals are to achieve their goals then they must act in a manner that will get them to their objective; broadly, they must act in a rational manner. The theory of individual maximization that we will develop in this chapter is based on that premise or assumption. In assuming individuals are rational we need not assume that they have every piece of information available to them that might be relevant for a specific decision or choice. Nor need we assume that they have super computers in their brain when they evaluate alternative possible strategies.
What we do need to assume, however, is that individuals act in a manner that is consistent with obtaining a given objective. The modern theory of behavioural economics and behavioural psychology examines decision making in a wide range of circumstances and has uncovered many fascinating behaviours – some of which are developed in Application Box 6.1 below.
We indicated in Chapter 1 that as social scientists, we require a reliable model of behaviour, that is, a way of describing the essentials of choice that is consistent with everyday observations on individual behaviour patterns. In this chapter, our aim is to understand more fully the behavioural forces that drive the demand side of the economy.
Economists analyze individual decision making using two different, yet complementary, approaches – utility analysis and indifference analysis. We begin by portraying individuals as maximizing their measurable utility (sometimes called cardinal utility); then progress to indifference analysis, where a weaker assumption is made on the ability of individuals to measure their satisfaction. In this second instance we do not assume that individuals can measure their utility numerically, only that they can say if one collection of goods and services yields them greater satisfaction than another group. This ranking of choices corresponds to what is sometimes called ordinal utility – because individuals can order groups of goods and services in ascending order of satisfaction. In each case individuals are perceived as rational maximizers or optimizers: They allocate their income so as to choose the outcome that will make them as well off as possible.
The second approach to consumer behaviour is frequently omitted in introductory texts. It can be omitted here without interpreting the flow of ideas, although it does yield additional insights into consumer choice and government policy. As in preceding chapters, we begin the analysis with a motivating numerical example.
Application Box 6.1 Rationality and impulse
A number of informative and popular books on decision making have appeared recently. Their central theme is that our decision processes should not be viewed solely as a rational computer – operating in one single mode only, and unmoved by our emotions or history. Psychologists now know that our brains have at least two decision modes, and these are developed by economics Nobel Prize winner Daniel Kahneman in his book "Thinking, Fast and Slow". One part of our brain operates in a rational goal-oriented forward-looking manner (the 'slow' part), another is motivated by immediate gratification (the 'fast' part). Decisions that we observe in the world about us reflect these different mechanisms.
Richard Thaler, a Chicago economist and his law professor colleague Cass Sunstein, have developed a role for public policy in their book entitled "Nudge". They too argue that individuals do not inevitably operate in their own best long-term interests, and as a consequence individuals frequently require a nudge by government to make the long-term choice rather than the short-term choice. For example, when individuals begin a new job, they might be automatically enrolled in the company pension plan and be given the freedom to opt out, rather than not be enrolled and given the choice to opt in. Such policies are deemed to be 'soft paternalism'. They are paternalistic for the obvious reason – another organism is directing, but they are also soft in that they are not binding. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/06%3A_Individual_choice/6.01%3A_Rationality.txt |
Neal loves to pump his way through the high-altitude powder at the Whistler ski and snowboard resort. His student-rate lift-ticket cost is \$30 per visit. He also loves to frequent the jazz bars in downtown Vancouver, and each such visit costs him \$20. With expensive passions, Neal must allocate his monthly entertainment budget carefully. He has evaluated how much satisfaction, measured in utils, he obtains from each snowboard outing and each jazz club visit. We assume that these utils are measurable, and use the term cardinal utility to denote this. These measurable utility values are listed in columns 2 and 3 of Table 6.1. They define the total utility he gets from various amounts of the two activities.
Table 6.1 Utils from snowboarding and jazz
1 2 3 4 5 6 7
Visit Total Total Marginal Marginal Marginal Marginal
# snowboard jazz snowboard jazz utils snowboard jazz utils
utils utils utils utils per \$ per \$
1 72 52 72 52 2.4 2.6
2 132 94 60 42 2.0 2.1
3 182 128 50 34 1.67 1.7
4 224 156 42 28 1.4 1.4
5 260 180 36 24 1.2 1.2
6 292 201 32 21 1.07 1.05
7 321 220 29 19 0.97 0.95
Price of snowboard visit=\$30. Price of jazz club visit=\$20.
Cardinal utility is a measurable concept of satisfaction.
Total utility is a measure of the total satisfaction derived from consuming a given amount of goods and services.
Neal's total utility from each activity in this example is independent of the amount of the other activity he engages in. These total utilities are plotted in Figures 6.1 and 6.2. Clearly, more of each activity yields more utility, so the additional or marginal utility (MU) of each activity is positive. This positive marginal utility for any amount of the good consumed, no matter how much, reflects the assumption of non-satiation—more is always better. Note, however, that the decreasing slopes of the total utility curves show that total utility is increasing at a diminishing rate. While more is certainly better, each additional visit to Whistler or a jazz club augments Neal's utility by a smaller amount. At the margin, his additional utility declines: He has diminishing marginal utility. The marginal utilities associated with snowboarding and jazz are entered in columns 4 and 5 of Table 6.1. They are the differences in total utility values when consumption increases by one unit. For example, when Neal makes a sixth visit to Whistler his total utility increases from 260 utils to 292 utils. His marginal utility for the sixth unit is therefore 32 utils, as defined in column 4. In light of this example, it should be clear that we can define marginal utility as:
(6.1)
where denotes the change in the quantity consumed of the good or service in question.
Marginal utility is the addition to total utility created when one more unit of a good or service is consumed.
Diminishing marginal utility implies that the addition to total utility from each extra unit of a good or service consumed is declining.
Figure 6.1 TU from snowboarding
Figure 6.2 TU from jazz
Figure 6.3 MU from snowboarding
Figure 6.4 MU from jazz
The marginal utilities associated with consuming different amounts of the two goods are plotted in Figures 6.3 and 6.4, using the data from columns 4 and 5 in Table 6.1. These functions are declining, as indicated by their negative slope. It should also be clear that the MU curves can be derived from the TU curves. For example, in figure 6.2, when going from 2 units to 3 units of Jazz, TU increases by 34 units. But 34/1 is the slope of the TU function in this range of consumption – the vertical distance divided by the horizontal distance. Similarly, if jazz consumption increases from 4 units to 5 units the corresponding change in TU is 24 units, again the vertical distance divided by the horizontal distance, and so the slope of the function. In short, the MU is the slope of the TU function.
Now that Neal has defined his utility schedules, he must consider the price of each activity. Ultimately, when deciding how to allocate his monthly entertainment budget, he must evaluate how much utility he gets from each dollar spent on snowboarding and jazz: What "bang for his buck" does he get? Let us see how he might go about allocating his budget. When he has fully spent his budget in the manner that will yield him greatest utility, we say that he has attained equilibrium, because he will have no incentive to change his expenditure patterns.
If he boards once, at a cost of \$30, he gets 72 utils of satisfaction, which is 2.4 utils per dollar spent (=72/30). One visit to a jazz club would yield him 2.6 utils per dollar (=52/20). Initially, therefore, his dollars give him more utility per dollar when spent on jazz. His MU per dollar spent on each activity is given in the final two columns of the table. These values are obtained by dividing the MU associated with each additional unit by the good's price.
We will assume that Neal has a budget of \$200. He realizes that his initial expenditure should be on a jazz club visit, because he gets more utility per dollar spent there. Having made one such expenditure, he sees that a second jazz outing would yield him 2.1 utils per dollar expended, while a first visit to Whistler would yield him 2.4 utils per dollar. Accordingly, his second activity is a snowboard outing.
Having made one jazz and one snowboarding visit, he then decides upon a second jazz club visit for the same reason as before—utility value for his money. He continues to allocate his budget in this way until his budget is exhausted. In our example, this occurs when he spends \$120 on four snowboarding outings and \$80 on four jazz club visits. At this consumer equilibrium, he gets the same utility value per dollar for the last unit of each activity consumed. This is a necessary condition for him to be maximizing his utility, that is, to be in equilibrium.
Consumer equilibrium occurs when marginal utility per dollar spent on the last unit of each good is equal.
To be absolutely convinced of this, imagine that Neal had chosen instead to board twice and to visit the jazz clubs seven times; this combination would also exhaust his \$200 budget exactly. With such an allocation, he would get 2.0 utils per dollar spent on his marginal (second) snowboard outing, but just 0.95 utils per dollar spent on his marginal (seventh) jazz club visit.1 If, instead, he were to reallocate his budget in favour of snowboarding, he would get 1.67 utils per dollar spent on a third visit to the hills. By reducing the number of jazz visits by one, he would lose 0.95 utils per dollar reallocated. Consequently, the utility gain from a reallocation of his budget towards snowboarding would outweigh the utility loss from allocating fewer dollars to jazz. His initial allocation, therefore, was not an optimum, or equilibrium.
Only when the utility per dollar expended on each activity is equal at the margin will Neal be optimizing. When that condition holds, a reallocation would be of no benefit to him, because the gains from one more dollar on boarding would be exactly offset by the loss from one dollar less spent on jazz. Therefore, we can write the equilibrium condition as
(6.2)
While this example has just two goods, in the more general case of many goods, this same condition must hold for all pairs of goods on which the consumer allocates his or her budget.
From utility to demand
Utility theory is a useful way of analyzing how a consumer makes choices. But in the real world we do not observe a consumer's utility, either total or marginal. Instead, his or her behaviour in the marketplace is observed through the demand curve. How are utility and demand related?
Demand functions relate the quantity of a good consumed to the price of that good, other things being equal. So let us trace out the effects of a price change on demand, with the help of this utility framework. We will introduce a simplification here: Goods are divisible, or that they come in small packages relative to income. Think, for example, of kilometres driven per year, or liters of gasoline purchased. Conceptualizing things in this way enables us to imagine more easily experiments in which small amounts of a budget are allocated one dollar at a time. In contrast, in the snowboard/jazz example, we had to reallocate the budget in lumps of \$30 or \$20 at a time because we could not "fractionalize" these goods.
The effects of a price change on a consumer's demand can be seen through the condition that describes his or her equilibrium. If income is allocated to, say, three goods , such that MUa/Pa=MUb/Pb=MUc/Pc, and the price of, say, good b falls, the consumer must reallocate the budget so that once again the MUs per dollar spent are all equated. How does he do this? Clearly, if he purchases more or less of any one good, the MU changes. If the price of good b falls, then the consumer initially gets more utility from good b for the last dollar he spends on it (the denominator in the expression MUb/Pb falls, and consequently the value of the ratio rises to a value greater than the values for goods a and c).
The consumer responds to this, in the first instance, by buying more of the cheaper good. He obtains more total utility as a consequence, and in the process will get less utility at the margin from that good. In essence, the numerator in the expression then falls, in order to realign it with the lower price. This equality also provides an underpinning for what is called the law of demand: More of a good is demanded at a lower price. If the price of any good falls, then, in order for the equilibrium condition to be re-established, the MU of that good must be driven down also. Since MU declines when more is purchased, this establishes that demand curves must slope downwards.
The law of demand states that, other things being equal, more of a good is demanded the lower is its price.
However, the effects of a price decline are normally more widespread than this, because the quantities of other goods consumed may also change. As explained in earlier chapters, the decline in the price of good b will lead the consumer to purchase more units of complementary goods and fewer units of goods that are substitutes. So the whole budget allocation process must be redetermined in response to any price change. But at the end of the day, a new equilibrium must be one where the marginal utility per dollar spent on each good is equal.
Applying the theory
The demand curves developed in Chapter 3 can be related to the foregoing utility analysis. In our example, Neal purchased four lift tickets at Whistler when the price was \$30. We can think of this combination as one point on his demand curve, where the "other things kept constant" are the price of jazz, his income, his tastes, etc.
Suppose now that the price of a lift ticket increased to \$40. How could we find another point on his demand curve corresponding to this price, using the information in Table 6.1? The marginal utility per dollar associated with each visit to Whistler could be recomputed by dividing the values in column 4 by 40 rather than 30, yielding a new column 6. We would then determine a new allocation of his budget between the two goods that would maximize utility. After such a calculation we would find that he makes three visits to Whistler and four jazz-club visits. Thus, the combination is another point on his demand curve. Note that this allocation exactly exhausts his \$200 budget.
By setting the price equal to \$20, this exercise could be performed again, and the outcome will be a quantity demanded of lift tickets equal to seven (plus three jazz club visits). Thus, the combination is another point on his demand curve. Figure 6.5 plots a demand curve going through these three points.
By repeating this exercise for many different prices, the demand curve is established. We have now linked the demand curve to utility theory.
Figure 6.5 Utility to demand
When , the consumer finds the quantity such that MU/P is equal for all purchases. The corresponding quantity purchased is 4 tickets. At prices of \$40 and \$20 the equilibrium condition implies quantities of 3 and 7 respectively.
Application Box 6.2 Individual and Collective Utility
The example developed in the text is not far removed from what economists do in practice. From a philosophical standpoint, economists are supposed to be interested in the well-being of the citizens who make up an economy or a country. To determine how 'well-off' citizens may be, social scientists frequently carry out surveys on how 'content' or 'happy' people are in their every-day lives. For example, the Earth Institute at Columbia University regularly produces a 'World Happiness Report'. The report is based upon responses to survey questions in numerous economies. One of the measures it uses to compare utility levels is the Cantril ladder. This is an 11-point scale running from 0 to 10, with the lowest value signifying the worst possible life, and 10 the highest possible quality of life. In reporting their findings, the researchers are essentially claiming that some economies have, on average, more contented or happier, people than others. Utility can be considered in exactly this way: A higher reported value on the Cantril ladder suggests higher utility.
A slightly different measure of well-being across economies is given by the United Nations Human Development Index. In this case, countries score high by having a high level of income, good health (as measured by life expectancy), and high levels of education, as measured by the number of years of education completed or envisaged.
In practice, social scientists are very comfortable using utility-based concepts to describe the economic circumstances of individuals in different economies. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/06%3A_Individual_choice/6.02%3A_Choice_with_measurable_utility.txt |
The budget constraint
In the preceding section, we assumed that utility is measurable in order to better understand how consumers allocate their budgets, and how this process is reflected in the market demands that are observed. The belief that utility might be measurable is not too extreme in the modern era. Neuroscientists are mapping more and more of the human brain and understanding how it responds to positive and negative stimuli. At the same time, numerous sociological surveys throughout the world ask individuals to rank their happiness on a scale of one to ten, or something similar, with a view to making comparisons between individual-level and group-level happiness – see Application Box 6.2. Nonetheless, not every scientist may be convinced that we should formulate behavioural rules on this basis. Accordingly we now examine the economics of consumer behaviour without this strong assumption. We assume instead that individuals are able to identify (a) different combinations of goods and services that yield equal satisfaction, and (b) combinations of goods and services that yield more satisfaction than other combinations. In contrast to measurable (or cardinal) utility, this concept is called ordinal utility, because it assumes only that consumers can order utility bundles rather than quantify the utility.
Ordinal utility assumes that individuals can rank commodity bundles in accordance with the level of satisfaction associated with each bundle.
The budget constraint
Neal's monthly expenditure limit, or budget constraint, is \$200. In addition, he faces a price of \$30 for lift tickets and \$20 per visit to jazz clubs. Therefore, using S to denote the number of snowboard outings and J the number of jazz club visits, if he spends his entire budget it must be true that the sum of expenditures on each activity exhausts his budget or income (I):
Since many different combinations of the two goods are affordable, it follows that the budget constraint defines all bundles of goods that the consumer can afford with a given budget.
The budget constraint defines all bundles of goods that the consumer can afford with a given budget.
The budget constraint, then, is just what it claims to be—a limit on behaviour. Neal's budget constraint is illustrated in Figure 6.6, where the amount of each good consumed is given on the axes. If he spends all of his \$200 income on jazz, he can make exactly ten jazz club visits . The calculation also applies to visits to Whistler. The intercept value is always obtained by dividing income by the price of the good or activity in question.
Figure 6.6 The budget line
FC is the budget constraint and defines the affordable combinations of snowboarding and jazz. F represents all income spent on snowboarding. Thus F=I/Ps. Similarly C=I/Pj. Points above FC are not attainable. The slope = OF/OC =(I/Ps)/(I/Pj)=Pj/Ps=20/30=2/3. The affordable set is 0FC.
In addition to these affordable extremes, Neal can also afford many other bundles, e.g., (S=2,J=7), or (S=4,J=4), or (S=6,J=1). The set of feasible, or affordable, combinations is bounded by the budget line, and this is illustrated in Figure 6.6.
The affordable set of goods and services for the consumer is bounded by the budget line from above; the non-affordable set lies strictly above the budget line.
The slope of the budget line is informative. As illustrated in Chapter 1, it indicates how many snowboard visits must be sacrificed for one additional jazz visit; it defines the consumer's trade-offs. To illustrate: Suppose Neal is initially at point A (J=4,S=4), and moves to point K (J=7,S=2). Clearly, both points are affordable. In making the move, he trades two snowboard outings in order to get three additional jazz club visits, a trade-off of 2/3. This trade-off is the slope of the budget line, which, in Figure 6.6, is AB/BK=–2/3, where the negative sign reflects the downward slope.
Could it be that this ratio reflects the two prices (\$20/\$30)? The answer is yes: The slope of the budget line is given by the vertical distance divided by the horizontal distance, OF/OC. The points F and C were obtained by dividing income by the respective price—remember that the jazz intercept is . Formally, that is I/PJ. The intercept on the snowboard axis is likewise I/PS. Accordingly, the slope of the budget constraint is:
Since the budget line has a negative slope, it is technically correct to define it with a negative sign. But, as with elasticities, the sign is frequently omitted.
Tastes and indifference
We now consider how to represent a consumer's tastes in two dimensions, given that he can order, or rank, different consumption bundles, and that he can define a series of different bundles that all yield the same satisfaction. We limit ourselves initially to considering just "goods," and not "bads" such as pollution.
Figure 6.7 Ranking consumption bundles
L is preferred to R since more of each good is consumed at L, while points such as V are less preferred than R. Points W and T contain more of one good and less of the other than R. Consequently, we cannot say if they are preferred to R without knowing how the consumer trades the goods off – that is, his preferences.
Figure 6.7 examines the implications of these assumptions about tastes. Each point shows a consumption bundle of snowboarding and jazz. Let us begin at bundle R. Since more of a good is preferred to less, any point such as L, which lies to the northeast of R, is preferred to R, since L offers more of both goods than R. Conversely, points to the southwest of R offer less of each good than R, and therefore R is preferred to a point such as V.
Without knowing the consumer's tastes, we cannot be sure at this stage how points in the northwest and southeast regions compare with R. At W or T, the consumer has more of one good and less of the other than at R. Someone who really likes snowboarding might prefer W to R, but a jazz buff might prefer T to R.
Let us now ask Neal to disclose his tastes, by asking him to define several combinations of snowboarding and jazz that yield him exactly the same degree of satisfaction as the combination at R. Suppose further, for reasons we shall understand shortly, that his answers define a series of points that lie on the beautifully smooth contour UR in Figure 6.8. Since he is indifferent between all points on UR by construction, this contour is an indifference curve.
Figure 6.8 Indifference curves
An indifference curve defines a series of consumption bundles, all of which yield the same satisfaction. The slope of an indifference curve is the marginal rate of substitution (MRS) and defines the number of units of the good on the vertical axis that the individual will trade for one unit of the good on the horizontal axis. The MRS declines as we move south-easterly, because the consumer values the good more highly when he has less of it.
An indifference curve defines combinations of goods and services that yield the same level of satisfaction to the consumer.
Pursuing this experiment, we could take other points in Figure 6.8, such as L and V, and ask the consumer to define bundles that would yield the same level of satisfaction, or indifference. These combinations would yield additional contours, such as UL and UV in Figure 6.8. This process yields a series of indifference curves that together form an indifference map.
An indifference map is a set of indifference curves, where curves further from the origin denote a higher level of satisfaction.
Let us now explore the properties of this map, and thereby understand why the contours have their smooth convex shape. They have four properties. The first three follow from our preceding discussion, and the fourth requires investigation.
1. Indifference curves further from the origin reflect higher levels of satisfaction.
2. Indifference curves are negatively sloped. This reflects the fact that if a consumer gets more of one good she should have less of the other in order to remain indifferent between the two combinations.
3. Indifference curves cannot intersect. If two curves were to intersect at a given point, then we would have two different levels of satisfaction being associated with the same commodity bundle—an impossibility.
4. Indifference curves are convex when viewed from the origin, reflecting a diminishing marginal rate of substitution.
The convex shape reflects an important characteristic of preferences: When consumers have a lot of some good, they value a marginal unit of it less than when they have a small amount of that good. More formally, they have a higher marginal valuation at low consumption levels—that first cup of coffee in the morning provides greater satisfaction than the second or third cup.
Consider the various points on UR, starting at M in Figure 6.8. At M Neal snowboards a lot; at N he boards much less. The convex shape of his indifference map shows that he values a marginal snowboard trip more at N than at M. To see this, consider what happens as he moves along his indifference curve, starting at M. We have chosen the coordinates on UR so that, in moving from M to R, and again from N to H, the additional amount of jazz is the same: CR=FH. From M, if Neal moves to R, he consumes an additional amount of jazz, CR. By definition of the indifference curve, he is willing to give up MC snowboard outings. The ratio MC/CR defines his willingness to substitute one good for the other. This ratio, being a vertical distance divided by a horizontal distance, is the slope of the indifference curve and is called the marginal rate of substitution, MRS.
The marginal rate of substitution is the slope of the indifference curve. It defines the amount of one good the consumer is willing to sacrifice in order to obtain a given increment of the other, while maintaining utility unchanged.
At N, the consumer is willing to sacrifice the amount NF of boarding to get the same additional amount of jazz. Note that, when he boards less, as at N, he is willing to give up less boarding than when he has a lot of it, as at M, in order to get the same additional amount of jazz. His willingness to substitute diminishes as he moves from M to N: The quantity NF is less than the quantity MC. In order to reflect this taste characteristic, the indifference curve has a diminishing marginal rate of substitution: A flatter slope as we move down along its surface.
A diminishing marginal rate of substitution reflects a higher marginal value being associated with smaller quantities of any good consumed.
Optimization
We are now in a position to examine how the consumer optimizes—how he gets to the highest level of satisfaction possible. The constraint on his behaviour is the affordable set defined in Figure 6.6, the budget line.
Figure 6.9 displays several of Neal's indifference curves in conjunction with his budget constraint. We propose that he maximizes his utility, or satisfaction, at the point E, on the indifference curve denoted by U3. While points such as F and G are also on the boundary of the affordable set, they do not yield as much satisfaction as E, because E lies on a higher indifference curve. The highest possible level of satisfaction is attained, therefore, when the budget line touches an indifference curve at just a single point—that is, where the constraint is tangent to the indifference curve. E is such a point.
Figure 6.9 The consumer optimum
The budget constraint constrains the individual to points on or below HK. The highest level of satisfaction attainable is U3, where the budget constraint just touches, or is just tangent to, it. At this optimum the slope of the budget constraint (–Pj/Ps) equals the MRS.
This tangency between the budget constraint and an indifference curve requires that the slopes of each be the same at the point of tangency. We have already established that the slope of the budget constraint is the negative of the price ratio (). The slope of the indifference curve is the marginal rate of substitution MRS. It follows, therefore, that the consumer optimizes where the marginal rate of substitution equals the slope of the price line.
Optimization requires:
(6.3)
A consumer optimum occurs where the chosen consumption bundle is a point such that the price ratio equals the marginal rate of substitution.
Notice the resemblance between this condition and the one derived in the first section as Equation 6.2. There we argued that equilibrium requires the ratio of the marginal utilities be same as the ratio of prices. Here we show that the MRS must equal the ratio of prices. In fact, with a little mathematics it can be shown that the MRS is indeed the same as the (negative of the) ratio of the marginal utilities: . Therefore the two conditions are in essence the same! However, it was not necessary to assume that an individual can actually measure his utility in obtaining the result that the MRS should equal the price ratio in equilibrium. The concept of ordinal utility is sufficient.
Adjusting to income changes
Suppose now that Neal's income changes from \$200 to \$300. How will this affect his consumption decisions? In Figure 6.10, this change is reflected in a parallel outward shift of the budget constraint. Since no price change occurs, the slope remains constant. By recomputing the ratio of income to price for each activity, we find that the new snowboard and jazz intercepts are 10 and 15 , respectively. Clearly, the consumer can attain a higher level of satisfaction—at a new tangency to a higher indifference curve—as a result of the size of the affordable set being expanded. In Figure 6.10, the new equilibrium is at E1.
Figure 6.10 Income and price adjustments
An income increase shifts the budget constraint from I0 to I1. This enables the consumer to attain a higher indifference curve. A price rise in jazz tickets rotates the budget line I0 inwards around the snowboard intercept to I2. The price rise reflects a lower real value of income and results in a lower equilibrium level of satisfaction.
Adjusting to price changes
Next, consider the impact of a price change from the initial equilibrium E0 in Figure 6.10. Suppose that jazz now costs more. This reduces the purchasing power of the given budget of \$200. The new jazz intercept is therefore reduced. The budget constraint becomes steeper and rotates around the snowboard intercept H, which is unchanged because its price is constant. The new equilibrium is at E2, which reflects a lower level of satisfaction because the affordable set has been reduced by the price increase. As explained in Section 6.2, E0 and E2 define points on the demand curve for jazz (J0 and J2): They reflect the consumer response to a change in the price of jazz with all other things held constant. In contrast, the price increase for jazz shifts the demand curve for snowboarding: As far as the demand curve for snowboarding is concerned, a change in the price of jazz is one of those things other than own-price that determine its position.
Philanthropy
Individuals in the foregoing analysis aim to maximize their utility, given that they have a fixed budget. Note that this behavioural assumption does not rule out the possibility that these same individuals may be philanthropic – that is, they get utility from the act of giving to their favourite charity or the United Way or Centre-aide. To see this suppose that donations give utility to the individual in question – she gets a 'warm glow' feeling as a result of giving, which is to say she gets utility from the activity. There is no reason why we cannot put charitable donations on one axis and some other good or combination of goods on the remaining axis. At equilibrium, the marginal utility per dollar of contributions to charity should equal the marginal utility per dollar of expenditure on other goods; or, stated in terms of ordinal utility, the marginal rate of substitution between philanthropy and any other good should equal the ratio of their prices. Evidently the price of a dollar of charitable donations is one dollar. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/06%3A_Individual_choice/6.03%3A_Choice_with_ordinal_utility.txt |
Price impacts: Complements and substitutes
The nature of complements and substitutes, defined in Chapter 4, can be further understood with the help of Figure 6.10. The new equilibrium E2 has been drawn so that the increase in the price of jazz results in more snowboarding—the quantity of S increases to S2 from S0. These goods are substitutes in this picture, because snowboarding increases in response to an increase in the price of jazz. If the new equilibrium E2 were at a point yielding a lower level of S than S0, we would conclude that they were complements.
Cross-price elasticities
Continuing with the same price increase in jazz, we could compute the percentage change in the quantity of snowboarding demanded as a result of the percentage change in the jazz price. In this example, the result would be a positive elasticity value, because the quantity change in snowboarding and the price change in jazz are both in the same direction, each being positive.
Income impacts: Normal and inferior goods
We know from Chapter 4 that the quantity demanded of a normal good increases in response to an income increase, whereas the quantity demanded of an inferior good declines. Clearly, both jazz and boarding are normal goods, as illustrated in Figure 6.10, because more of each one is demanded in response to the income increase from to . It would challenge the imagination to think that either of these goods might be inferior. But if J were to denote junky (inferior) goods and S super goods, we could envisage an equilibrium to the northwest of in response to an income increase, along the constraint ; less J and more S would be consumed in response to the income increase.
Policy: Income transfers and price subsidies
Government policies that improve the purchasing power of low-income households come in two main forms: Pure income transfers and price subsidies. Social Assistance payments ("welfare") or Employment Insurance benefits, for example, provide an increase in income to the needy. Subsidies, on the other hand, enable individuals to purchase particular goods or services at a lower price—for example, rent or daycare subsidies.
In contrast to taxes, which reduce the purchasing power of the consumer, subsidies and income transfers increase purchasing power. The impact of an income transfer, compared with a pure price subsidy, can be analyzed using Figures 6.11 and 6.12.
Figure 6.11 Income transfer
An increase in income due to a government transfer shifts the budget constraint from I1 to I2. This parallel shift increases the quantity consumed of the target good (daycare) and other goods, unless one is inferior.
In Figure 6.11, an income transfer increases income from I1 to I2. The new equilibrium at E2 reflects an increase in utility, and an increase in the consumption of both daycare and other goods.
Suppose now that a government program administrator decides that, while helping this individual to purchase more daycare accords with the intent of the transfer, she does not intend that government money should be used to purchase other goods. She therefore decides that a daycare subsidy program might better meet this objective than a pure income transfer.
A daycare subsidy reduces the price of daycare and therefore rotates the budget constraint outwards around the intercept on the vertical axis. At the equilibrium in Figure 6.12, purchases of other goods change very little, and therefore most of the additional purchasing power is allocated to daycare.
Figure 6.12 Price subsidy
A subsidy to the targeted good, by reducing its price, rotates the budget constraint from I1 to I2. This induces the consumer to direct expenditure more towards daycare and less towards other goods than an income transfer that does not change the relative prices.
Let us take the example one stage further. From the initial equilibrium in Figure 6.12, suppose that, instead of a subsidy that took the individual to , we gave an income transfer that enabled the consumer to purchase the combination . Such a transfer is represented in Figure 6.13 by a parallel outward shift of the budget constraint from to , going through the point . We now have a subsidy policy and an alternative income transfer policy, each permitting the same consumption bundle (). The interesting aspect of this pair of possibilities is that the income transfer will enable the consumer to attain a higher level of satisfaction—for example, at point —and will also induce her to consume more of the good on the vertical axis. The higher level of satisfaction comes about because the consumer has more latitude in allocating the additional real income.
Application Box 6.3 Daycare subsidies in Quebec
The Quebec provincial government subsidizes daycare heavily. In the public-sector network called the "Centres de la petite enfance", families can place their children in daycare for less than \$10 per day, while families that use the private sector are permitted a generous tax allowance for their daycare costs. This policy is designed to enable households to limit the share of their income expended on daycare. It is described in Figure 6.13.
The consequences of strong subsidization are not negligible: Excess demand, to such an extent that children are frequently placed on waiting lists for daycare places long before their parents intend to use the service. Annual subsidy costs amount to almost \$2 billion per year. At the same time, it has been estimated that the policy has enabled many more parents to enter the workforce than otherwise would have.
Figure 6.13 Subsidy-transfer comparison
A price subsidy to the targeted good induces the individual to move from E1 to E2, facing a budget constraint I2. An income transfer that permits him to consume E2 is given by ; but it also permits him to attain a higher level of satisfaction, denoted by on the indifference curve U3.
The price of giving
Imagine now that the good on the horizontal axis is charitable donations, rather than daycare, and the government decides that for every dollar given the individual will see a reduction in their income tax of 50 cents. This is equivalent to cutting the 'price' of donations in half, because a donation of one dollar now costs the individual half of that amount. Graphically the budget constraint rotates outward with the vertical intercept unchanged. Since donations now cost less the individual has increased spending power as a result of the price reduction for donations. The price reduction is designed to increase the attractiveness of donations to the utility maximizing consumer. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/06%3A_Individual_choice/6.04%3A_Applications_of_indifference_analysis.txt |
Cardinal utility is a measurable concept of satisfaction.
Total utility is a measure of the total satisfaction derived from consuming a given amount of goods and services.
Marginal utility is the addition to total utility created when one more unit of a good or service is consumed.
Diminishing marginal utility implies that the addition to total utility from each extra unit of a good or service consumed is declining.
Consumer equilibrium occurs when marginal utility per dollar spent on the last unit of each good is equal.
Law of demand states that, other things being equal, more of a good is demanded the lower is its price.
Ordinal utility assumes that individuals can rank commodity bundles in accordance with the level of satisfaction associated with each bundle.
Budget constraint defines all bundles of goods that the consumer can afford with a given budget.
Affordable set of goods and services for the consumer is bounded by the budget line from above; the non-affordable set lies strictly above the budget line.
Indifference curve defines combinations of goods and services that yield the same level of satisfaction to the consumer.
Indifference map is a set of indifference curves, where curves further from the origin denote a higher level of satisfaction.
Marginal rate of substitution is the slope of the indifference curve. It defines the amount of one good the consumer is willing to sacrifice in order to obtain a given increment of the other, while maintaining utility unchanged.
Diminishing marginal rate of substitution reflects a higher marginal value being associated with smaller quantities of any good consumed.
Consumer optimum occurs where the chosen consumption bundle is a point such that the price ratio equals the marginal rate of substitution.
6.06: Exercises for Chapter 6
EXERCISE 6.1
In the example given in Table 6.1, suppose Neal experiences a small increase in income. Will he allocate it to snowboarding or jazz? [Hint: At the existing equilibrium, which activity will yield the higher MU for an additional dollar spent on it?]
EXERCISE 6.2
Suppose that utility depends on the square root of the amount of good X consumed: .
1. In a spreadsheet enter the values 1... 16 as the X column (col A), and in the adjoining column (B) compute the value of utility corresponding to each quantity of X. To do this use the 'SQRT' command. For example, the entry in cell B3 will be of the form '=SQRT(A3)'.
2. In the third column enter the marginal utility (MU) associated with each value of X – the change in utility in going from one value of X to the next.
3. Use the 'graph' tool to map the relationship between U and X.
4. Use the graph tool to map the relationship between MU and X.
EXERCISE 6.3
Instead of the square-root utility function in Exercise 6.2, suppose that utility takes the form U=x2.
1. Follow the same procedure as in the previous question – graph the utility function.
2. Why is this utility function not consistent with our beliefs on utility?
EXERCISE 6.4
1. Plot the utility function U=2X, following the same procedure as in the previous questions.
2. Next plot the marginal utility values in a graph. What do we notice about the behaviour of the MU?
EXERCISE 6.5
Let us see if we can draw a utility function for beer. In this instance the individual may reach a point where he takes too much.
1. If the utility function is of the form U=6XX2, plot the utility values for X values in the range , using either a spreadsheet or manual calculations.
2. At how many units of X (beer) is the individual's utility maximized?
3. At how many beers does the utility become negative?
EXERCISE 6.6
Cappuccinos, C, cost \$3 each, and music downloads of your favourite artist, M, cost \$1 each from your iTunes store. Income is \$24.
1. Draw the budget line, with cappuccinos on the vertical axis, and music on the horizontal axis, and compute the values of the intercepts.
2. What is the slope of the budget constraint, and what is the opportunity cost of 1 cappuccino?
3. Are the following combinations of goods in the affordable set: (4C and 9M), (6C and 2M), (3C and 15M)?
4. Which combination(s) above lie inside the affordable set, and which lie on the boundary?
EXERCISE 6.7
George spends his income on gasoline and "other goods."
1. First, draw a budget constraint, with gasoline on the horizontal axis.
2. Suppose now that, in response to a gasoline shortage in the economy, the government imposes a ration on each individual that limits the purchase of gasoline to an amount less than the gasoline intercept of the budget constraint. Draw the new effective budget constraint.
EXERCISE 6.8
Suppose that you are told that the indifference curves defining the trade-off for two goods took the form of straight lines. Which of the four properties outlines in Section 6.3 would such indifference curves violate?
EXERCISE 6.9
Draw an indifference map with several indifference curves and several budget constraints corresponding to different possible levels of income. Note that these budget constraints should all be parallel because only income changes, not prices. Now find some optimizing (tangency) points. Join all of these points. You have just constructed what is called an income-consumption curve. Can you understand why it is called an income-consumption curve?
EXERCISE 6.10
Draw an indifference map again, in conjunction with a set of budget constraints. This time the budget constraints should each have a different price of good X and the same price for good Y.
1. Draw in the resulting equilibria or tangencies and join up all of these points. You have just constructed a price-consumption curve for good X. Can you understand why the curve is so called?
2. Now repeat part (a), but keep the price of X constant and permit the price of Y to vary. The resulting set of equilibrium points will form a price consumption curve for good Y.
EXERCISE 6.11
Suppose that movies are a normal good, but public transport is inferior. Draw an indifference map with a budget constraint and initial equilibrium. Now let income increase and draw a plausible new equilibrium, noting that one of the goods is inferior. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/06%3A_Individual_choice/6.05%3A_Key_Terms.txt |
Chapter 7: Firms, investors and capital markets
In this chapter we will explore:
7.1
Business organization
7.2
Corporate goals – profit
7.3
Risk and the investor
7.4
Pooling risks
7.1 Business organization
Suppliers of goods and services to the marketplace come in a variety of forms; some are small, some are large. But, whatever their size, suppliers choose an organizational structure that is appropriate for their business: Aircraft, oil rigs, social media and information services are produced by large corporations; dental services and family health are provided by individual professionals or private partnerships.
The initial material of this chapter addresses organizational forms, their goals and their operation. We then examine why individuals choose to invest in firms, and illustrate that such investment provides individual investors with a means both to earning a return on their savings and to managing the risk associated with investing. Uncertainty regarding the future is a central consideration.
Understanding the way firms and capital markets function is crucial to understanding our economic history and how different forms of social and economic institutions interact. For example, seventeenth-century Amsterdam had a thriving bourgeoisie, well-developed financial markets, and investors with savings. This environment facilitated the channeling of investors' funds to firms specializing in trade and nautical conquest. This tiny state was then the source of some of the world's leading explorers and traders, and it had colonies stretching to Indonesia. The result was economic growth and prosperity.
In contrast, for much of the twentieth century, the Soviet Union dominated a huge territory covering much of Asia and Europe. But capital markets were non-existent, independent firms were stifled, and economic decline ultimately ensued. Much of the enormous difference in the respective patterns of economic development can be explained by the fact that one state fostered firms, capital markets, and legal institutions, while the other did not. In terms of our production possibility frontier: One set of institutional arrangements was conducive to expanding the possibilities; the other was not. Sustainable new businesses invariably require investors at an early point in the lifecycle of the business. Accordingly, financial and legal institutions that facilitate the flow of savings and financial investment into new enterprises perform a vital function in the economy.
Businesses, or firms, have several different forms. At the smallest scale, a business takes the form of a sole proprietor or sole trader who is the exclusive owner. A sole trader gets all of the revenues from the firm and incurs all of the costs. Hence he may make profits or be personally liable for the losses. In the latter case his business or even personal assets may be confiscated to cover debts. Personal bankruptcy may result.
Sole proprietor is the single owner of a business.
If a business is to grow, partners may be required. Such partners can inject money in exchange for a share of future profits. Firms where trust is involved, such as legal or accounting firms, typically adopt this structure. A firm is given credibility when customers see that partners invest their own wealth in it.
Partnership: a business owned jointly by two or more individuals, who share in the profits and are jointly responsible for losses.
In order to expand and grow, a firm will need cash, perhaps partners, and investors. Providers of family health and dental services rely primarily on human expertise, and therefore they need relatively little physical capital. Hence their cash start-up needs are limited. But firms that produce aircraft, or develop software and organizational systems, need vast amounts of money for capital investment; pharmaceuticals may need a billion dollars worth of research and development to bring a new drug to the marketplace; ride-sharing companies need billions in order to establish their business globally. Such businesses must form corporations – also known as companies. Not all corporations are public; some are privately held, but relatively few large corporations are not publicly traded.
Large organizations have several inherent advantages over small organizations when a high output level is required. Specialization in particular tasks leads to increased efficiency for production workers. At the same time, non-production workers can perform a multitude of different tasks. If a large corporation decided to contract out every task involved in bringing its product to market, the costs of such agreements would be prohibitively high. In addition, synergies can arise from teamwork. New ideas and better work flow are more likely to materialize when individuals work in close proximity than when working as isolated units, no matter how efficient they may be individually. A key aspect of such large organizations is that they have a legal identity separate from the managers and owners.
Corporation or company is an organization with a legal identity separate from its owners that produces and trades.
The owners of a corporation are known as its shareholders, and their object is usually to make profits. There also exist non-profit corporations whose objective may be philanthropic. Since our focus is upon markets, we will generally assume that profits form the objective of a typical corporation. The profits that accrue to a corporation may be paid to the shareholders in the form of a dividend, or retained in the corporation for future use. When large profits (or losses) accrue the value of the corporation increases (or decreases), and this is reflected in the value of each share of the company. If the value of each share in the company increases (decreases) there is a capital gain (loss) to the owners of the shares – the shareholders. In any given year shareholders may receive a dividend and also obtain a capital gain (or loss). The sum of the dividend and capital gain represents the return to owning corporate stock in that year. When this sum is adjusted for inflation it is termed the real return on corporate stock
Shareholders invest in corporations and therefore are the owners.
Dividends are payments made from after-tax profits to company shareholders.
Capital gains (losses) arise from the ownership of a corporation when an individual sells a share at a price higher (lower) than when the share was purchased.
Real return to corporate stock is the inflation-adjusted sum of dividends and capital gain (or loss).
A key difference between a company and a partnership is that a company involves limited liability, whereas a partnership does not. Limited liability means that the liability of the company is limited to the value of the company's assets. Shareholders cannot be further liable for any wrongdoing on the part of the company. Accordingly, partnerships and sole traders normally insure themselves and their operations. For example, all specialist doctors carry malpractice insurance, and engineers insure themselves against error.
Limited liability means that the liability of the company is limited to the value of the company's assets.
Corporations use capital, labour, and human expertise to produce a good, to supply a service, or to act as an intermediary. Corporations are required to produce an annual income statement that accurately describes the operation of the firm. An example is given in Table 7.1.
Table 7.1 The Regal Bank of Toronto, 2025
Total Revenue \$ 32.0b
Net income post tax \$ 4.80b
Shares outstanding 640m
Net income/share \$ 7.50
Dividends/share \$ 2.50
Share price \$ 72.0
Market capitalization \$ 46.08b
The data in Table 7.1 define the main financial characteristics of an imaginary bank: the Regal Bank of Toronto in the year 2025. "Net income post-tax" represents after-tax profits. There are 640 million shares outstanding, and thus each share could be attributed a profit of . Of this amount, \$2.50 is distributed to shareholders in the form of dividends per share. The remainder is held by the Corporation in the form of retained earnings - to be used for future investment primarily. Each share traded at a price of \$72.00. Given that there were 640 million shares, the total market valuation of the corporation at that time stood at \$46.08 billion ().
Such information is publicly available for a vast number of corporations at the 'finance' section of major search engines such as Google or Yahoo.
Retained earnings are the profits retained by a company for reinvestment and not distributed as dividends.
In Canada, the corporate sector as a whole tends to hold on to more than half of after-tax profits in the form of retained earnings. However there exists considerable variety in the behaviour of corporations, and most firms establish a pattern of how profits are allocated between dividends and retained earnings. In the Table 7.1 example, one third of profits are distributed; yet some corporations have a no-dividend policy. In these latter cases the benefit to investing in a firm must come in the form of capital gain to the owners of the shares.
7.2 Profit
Ownership and corporate goals
As economists, we believe that profit maximization accurately describes a typical firm's objective. However, since large firms are not run by their owners but by their executives or agents, it is frequently hard for the shareholders to know exactly what happens within a company. Even the board of directors—the guiding managerial group—may not be fully aware of the decisions, strategies, and practices of their executives and managers. Occasionally things go wrong, sometimes as a result of managers deciding to follow their own interests rather than the interests of the company. In technical terms, the interests of the corporation and its shareholders might not be aligned with the interests of its managers. For example, managers might have a short horizon and take steps to increase their own income in the short term, knowing that they will move to another job before the long-term effects of their decisions impact the firm.
At the same time, the marketplace for the ownership of corporations exerts a certain discipline: If firms are not as productive or profitable as possible, they may become subject to takeover by other firms. Fear of such takeover can induce executives and boards to maximize profits.
The shareholder-manager relationship is sometimes called a principal-agent relationship, and it can give rise to a principal-agent problem. If it is costly or difficult to monitor the behaviour of an agent because the agent has additional information about his own performance, the principal may not know if the agent is working to achieve the firm's goals. This is the principal-agent problem.
Principal or owner: delegates decisions to an agent, or manager.
Agent: usually a manager who works in a corporation and is directed to follow the corporation's interests.
Principal-agent problem: arises when the principal cannot easily monitor the actions of the agent, who therefore may not act in the best interests of the principal.
In an effort to deal with such a challenge, corporate executives frequently get bonuses or stock options that are related to the overall profitability of their firm. Stock options usually take the form of an executive being allowed to purchase the company's stock in the future – but at a price that is predetermined. If the company's profits do increase, then the price of the company's stock will reflect this and increase likewise. Hence the executive has an incentive to work with the objective of increasing profits because that will enable him to buy the company stock in the future at a lower price than it will be worth.
Stock option: an option to buy the stock of the company at a future date for a fixed, predetermined price.
The threat of takeover and the structure of rewards, together, imply that the assumption of profit maximization is a reasonable one.
Application Box 7.1 The 'Sub-Prime' mortgage crisis: A principal-agent problem
With a decline in interest and mortgage rates in the early part of the twenty first century, many individuals believed they could afford to buy a house because the borrowing costs were lower than before. Employees and managers of lending companies believed likewise, and they structured loans in such a way as to provide an incentive to low-income individuals to borrow. These mortgage loans frequently enabled purchasers to buy a house with only a 5% down payment, in some cases even less, coupled with a repayment schedule that saw low repayments initially but higher repayments subsequently. The initial interest cost was so low in many of these mortgages that it was even lower than the 'prime' rate – the rate banks charge to their most prized customers.
The crisis that resulted became known as the 'sub-prime' mortgage crisis. In many cases loan officers got bonuses based on the total value of loans they oversaw, regardless of the quality or risk associated with the loan. The consequence was that they had the incentive to make loans to customers to whom they would not have lent, had these employees and managers been lending their own money, or had they been remunerated differently. The outcomes were disastrous for numerous lending institutions. When interest rates climbed, borrowers could not repay their loans. The construction industry produced a flood of houses that, combined with the sale of houses that buyers could no longer afford, sent housing prices through the floor. This in turn meant that recent house purchasers were left with negative value in their homes – the value of their property was less than what they paid for it. Many such 'owners' simply returned the keys to their bank, declared bankruptcy and walked away. Some lenders went bankrupt; some were bailed out by the government, others bought by surviving firms. This is a perfect example of the principal agent problem – the managers of the lending institutions and their loan officers did not have the incentive to act in the interest of the owners of those institutions.
The broader consequence of this lending practice was a financial collapse greater than any since the Depression of the nineteen thirties. Assets of the world's commercial and investment banks plummeted in value. Their assets included massive loans and investments both directly and indirectly to the real estate market, and when real estate values fell, so inevitably did the value of the assets based on this sector. Governments around the world had to buy up bad financial assets from financial institutions, or invest massive amounts of taxpayer money in these same institutions. Otherwise the world's financial system might have collapsed, with unknowable consequences.
Taxpayers and shareholders together bore the burden of this disastrous investment policy. Shareholders in many banks saw their shares drop in value to just a few percent of what they had been worth a year or two prior to the collapse.
Economic and accounting profit
Economists and accountants frequently differ in how they measure profits. An accountant stresses the financial flows of corporate activity; the economist is, in addition, concerned with opportunity cost. Imagine that Felicity has just inherited \$250,000 and decides to pursue her dream by opening a clothing boutique. She quits her job that pays her \$55,000 per annum, invests her inheritance in the purchase of a small retail space on the high street and launches her business. At the end of her first year she records \$110,000 in clothing sales, which she purchased from the wholesaler for \$50,000. She pays herself a salary of \$35,000 and has no other accounting costs because she owns her physical capital – the store. Her accounting profit for the year is given by the margin returned between the buying and selling price of her clothing (\$60,000) minus her incurred costs (\$35,000) in salary. Her accounting profit is thus \$25,000. Should she be content with this sum?
Felicity's economist friend, Prudence, informs Felicity that her enterprise is not returning a profit by economic standards. Prudence points out that Felicity could earn \$55,000 as an alternative to working in her own store, hence there is an additional implicit cost of \$20,000 to be considered, because Felicity only draws a salary of \$35,000. Furthermore, Felicity has invested \$250,000 in her business to avoid rent. But that sum, invested at the going interest rate of 4%, could earn her \$10,000 per annum. That too is a foregone income stream so it is an implicit cost. Altogether, the additional implicit costs, not included in the accounting flows, amount to \$30,000, and these implicit costs exceed the 'accounting profits'. Thus no economic profits are being made, because the economist includes implicit costs in her profit calculation. In economic terms Felicity would be better off by returning to her job and investing her inheritance. That strategy would generate an income of \$65,000, as opposed to the income of \$60,000 that she generates from the boutique – a salary of \$35,000 plus an accounting profit of \$25,000.
We can summarize this: Accounting profit is the difference between revenues and explicit costs. Economic profit is the difference between revenue and the sum of explicit and implicit costs. Explicit costs are the measured financial costs; Implicit costs represent the opportunity cost of the resources used in production.
Accounting profit: is the difference between revenues and explicit costs.
Economic profit: is the difference between revenue and the sum of explicit and implicit costs.
Explicit costs: are the measured financial costs.
Implicit costs: represent the opportunity cost of the resources used in production.
We will return to these concepts in the following chapters. Opportunity cost, or implicit costs, are critical in determining the long-run structure of certain sectors in the economy.
7.3 Risk and the investor
Firms cannot grow without investors. A successful firm's founder always arrives at a point where more investment is required if her enterprise is to expand. Frequently, she will not be able to secure a sufficiently large loan for such growth, and therefore must induce outsiders to buy shares in her firm. She may also realize that expansion carries risk, and she may want others to share in this risk. Risk plays a central role in the life of the firm and the investor. Most investors prefer to avoid risk, but are prepared to assume a limited amount of it if the anticipated rewards are sufficiently attractive.
An illustration of risk-avoidance is to be seen in the purchase of home insurance. Most home owners who run even a small risk of seeing their house burn down, being flooded, or damaged by a gas leak purchase insurance. By doing so they are avoiding risk. But how much are they willing to pay for such insurance? If the house is worth \$500,000 and the probability of its being destroyed is one in one thousand in a given year then, using an averaging perspective, individuals should be willing to pay an insurance premium of \$500 per annum. That insurance premium represents what actuaries call a 'fair' gamble: If the probability of disaster is one in one thousand, then the 'fair' premium should be one thousandth the value of the home that is being insured. If the insurance company insures millions of homes, then on average it will have to pay for the replacement of one house for every one thousand houses it insures each year. So by charging homeowners a price that exceeds \$500 the insurer will cover not only the replacement cost of homes, but in addition cover her administrative costs and perhaps make a profit. Insurers operate on the basis of what we sometimes call the 'law of large numbers'.
In fact however, most individuals are willing to pay more than this 'fair' amount, and actually do pay more. If the insurance premium is \$750 or \$1,000 the home-owner is paying more than is actuarially 'fair', but a person who dislikes risk may be willing to pay such an amount in order to avoid the risk of being uninsured.
Our challenge now is to explain why individuals who purchase home insurance on terms that are less than actuarially 'fair' in order to avoid risk are simultaneously willing to invest their retirement savings into risky companies. Companies, like homes, are risky; while they may not collapse or implode in any given year, they can have good or bad returns in any given year. Corporate returns are inherently unpredictable and therefore risky. The key to understanding the willingness of risk-averse individuals to invest in risky firms is to be found in the pooling of risks.
7.4 Risk pooling and diversification
Silicon Valley: from angel investors to public corporation
Risky firms frequently succeed in attracting investment through the capital market in the modern economy. A typical start-up firm in the modern economy originates in the form of an idea. The developers of Uber got the idea of simplifying and streamlining the ride sharing business (sometimes called the taxi business). In its simplest form the inventors developed an App that would link users to drivers. The developers of Airbnb got the idea that spare accommodations in individual homes could be used to satisfy the needs of travellers. The founders developed an efficient means of putting potential renters/guests in communication with suppliers of rooms, houses and condominiums. WeWork was founded on the belief that workers and small corporations, particularly those in the technology sector, have immediate and changing space needs. The result is that WeWork provides flexible work space on a 'just in time' basis, frequently on a shared overhead basis. Each of these corporations acts as an intermediary, and sells intermediation services.
Typically the initial funding for new ideas comes from a couple of founding partners who develop a model or prototype of their software or their business. Following trials, the founders may approach potential investors for 'small' amounts that will fund expansion. Such investors are frequently 'angel' investors because they are a source of funding that makes the difference between expansion and death for the venture in question. If the venture shows promise the founders seek 'round A' funding, and this funding may come from venture capitalists who specialize in new ventures. Further evidence of possible success may result in 'round B' funding, and this frequently amounts to hundreds of millions of dollars.
Venture funds are managed by partners, or capitalists, with reputations for being better able than most to predict which start-ups will ultimately see profitability. These venture capitalists invest both their own funds and the funds of individuals who entrust their accumulated savings to the investing partnership.
But extremely high risk is associated with most start-ups. Funding frequently takes place in an environment where the venture has no revenue; merely a product in the course of development. Winners in the new economy are recognized and celebrated. Bill Gates' Microsoft, Jeff Bezos' Amazon, Steve Jobs Apple, and Larry Page and Sergey Brin's Google are corporate giants with valuations approach one trillion dollars. But Elizabeth Holmes' Theranos, once with an implicit valuation of several billion dollars has expired. Theranos hired several hundred employees with the aim of developing blood tests for scores of purposes using just a pin-prick of blood. But it was a failure, despite attracting hundreds of millions of dollars in investment. In the year 2019 Canada had dozens of cannabis-based firms listed on the Canadian Securities Exchange. None of these is earning a profit in 2020, some have negligible earnings, yet several have a value in excess of one billion dollars. It is highly improbable that all will survive.
Capital market: a set of financial institutions that funnels financing from investors into bonds and stocks.
Venture capital: investment in a business venture, where the ultimate outcome is highly unpredictable.
How can we reconcile the fact that, while these firms carry extraordinary uncertainty, investors are still willing to part with large sums of money to fund development? And the investors are not only billionaires with a good sense of the marketplace; private individuals who save for their retirement also invest in risky firms on the advice of their financial manager. Let us explore how and why.
Dealing with risk
Most (sensible) investors hold a portfolio of investments, which is a combination of different stocks and bonds. By investing in different stocks and bonds rather than concentrating in one single investment or type of investment, an individual diversifies her portfolio, which is to say she engages in risk pooling. Venture capital partnerships act in the same way. They recognize that their investments in start-ups will yield both complete failures and some roaring successes; the variation in their outcomes will exceed the variation in the outcomes of an investor who invests in 'mature' corporations.
Portfolio: a combination of assets that is designed to secure an income from investing and to reduce risk.
Risk pooling: Combining individual risks in such a way that the aggregate risk is reduced.
A rigorous theory underlies this "don't put all of your eggs in the one basket" philosophy. The essentials of diversification or pooling are illustrated in the example given in Table 7.2 below.1 There are two risky stocks here: Natural Gas (NG) and technology (Tech). Each stock is priced at \$100, and over time it is observed that each yields a \$10 return in good times and \$0 in bad times. The investor has \$200 to invest, and each sector independently has a 50% probability (p=0.5) of good or bad times. This means that each stock should yield a \$5 return on average: half of all outcomes will yield \$10 and half will yield zero. The challenge here is to develop an investment strategy that minimizes the risk for the investor.
At this point we need a specific working definition of risk. We define it in terms of how much variation a stock might experience in its returns from year to year. Each of NG and Tech have returns of either \$0 or \$10, with equal probability. But what if the Tech returns were either or with equal probability; or or with equal probability? In each of these alternative scenarios the average outcome remains the same: A positive average return of \$5. If the returns profile to NG remains unchanged we would say that Tech is a riskier stock (than NG) if its returns were defined by one of the alternatives here. Note that the average return is unchanged, and we are defining risk in terms of the greater spread in the possible returns around an unchanged average. The key to minimizing risk in the investor's portfolio lies in exploring how the variation in returns can be minimized by pooling risks.
Risk measurement: A higher degree of risk is associated with increased variation in the possible returns around an unchanged mean return.
Table 7.2 Investment strategies with risky assets
Strategy Expected returns with probabilities
\$200 in NG 220 (p=0.5) 200 (p=0.5)
\$200 in Tech 220 (p=0.5) 200 (p=0.5)
\$100 in each 220 (p=0.25) 210 (p=0.5) 200 (p=0.25)
The outcomes from three different investment strategies are illustrated in Table 7.2. By investing all of her \$200 in either NG or Tech, she will obtain \$220 half of the time and \$200 half of the time, as indicated in the first two outcome rows. But by diversifying through buying one of each stock, as illustrated in the final row, she reduces the variability of her portfolio. To see why note that, since the performance of each stock is independent, there is now only a one chance in four that both stocks do well, and therefore there is a 25 percent probability of earning \$220. By the same reasoning, there is a 25 percent probability of earning \$200. But there is a 50 percent chance that one stock will perform well and the other poorly. When that happens, she gets a return of \$210. In contrast to the outcomes defined in rows 1 and 2, the diversification strategy in row 3 yields fewer extreme potential outcomes and more potential outcomes that lie closer to the mean outcome.
Diversification reduces the total risk of a portfolio by pooling risks across several different assets whose individual returns behave independently.
Further diversification could reduce the variation in possible returns even further. To see this, imagine that, rather than having a choice between investing in one or two stocks, we could invest in four different stocks with the same returns profile as the two given in the table above. In such a case, the likelihood of getting extreme returns would be even lower than when investing in two stocks. This is because, if the returns to each stock are independent of the returns on the remaining stocks, it becomes increasingly improbable that all, or almost all, of the stocks will experience favorable (or unfavorable) returns in the same year. Now, imagine that we had 8 stocks, or 16, or 32, or 64, etc. The "magic" of diversification is that the same average return can be attained, yet variability can be reduced. If it can be reduced sufficiently by adding ever more stocks to the portfolio, then even a highly risk-averse individual can build a portfolio that is compatible with buying into risky firms.
We can conclude from this simple example that there need be no surprise over the fact that risk-averse individuals are willing, at the same time, to pay a high home-insurance premium to avoid risk, and simultaneously invest in risky ventures.
Application Box 7.2 The value of a financial advisor
The modern economy has thousands of highly-trained financial advisors. The successful ones earn huge salaries. But there is a puzzle: Why do such advisors exist? Can they predict the behaviour of the market any better than an uninformed advisor? Two insights help us answer the question.
First, Burton Malkiel wrote a best seller called A Random Walk down Wall Street. He provided ample evidence that a portfolio chosen on the basis of a monkey throwing darts at a list of stocks would do just as well as the average portfolio constructed by your friendly financial advisor.
Second, there are costs of transacting: An investor who builds a portfolio must devote time to the undertaking, and incur the associated financial trading cost. In recognizing this, investors may choose to invest in what they call mutual funds – a diversified collection of stocks – or may choose to employ a financial advisor who will essentially perform the same task of building a diversified portfolio. But, on average, financial advisors cannot beat the market, even though many individual investors would like to believe otherwise.
At this point we may reasonably ask why individuals choose to invest any of their funds in a "safe" asset – perhaps cash or Canadian Government bonds. After all, if their return to bonds is lower on average than the return to stocks, and they can diversify away much of the risk associated with stocks, why not get the higher average returns associated with stocks and put little or nothing in the safer asset? The reason is that it is impossible to fully diversify. When a recession hits, for example, the whole stock market may take a dive, because profits fall across the whole economy. On account of this possibility, we cannot ever arrive at a portfolio where the returns to the different stocks are completely independent. As a consequence, the rational investor will decide to put some funds in bonds in order to reduce this systematic risk component that is associated with the whole market. This is not a completely risk-free strategy because such assets can depreciate in value with inflation.
To see how the whole market can change dramatically students can go to any publicly accessible financial data site – such as Yahoo Finance and attempt to plot the TSX for the period 2005 – present, or the NASDAQ index from the mid-nineties to the present. The year 2020 is a particularly appropriate year to examine. In that year the coronavirus pandemic struck with disastrous impacts on stock markets worldwide. Initially almost all stocks declined in value. But within a matter of days investors realized that some firms would perform better in this particular downturn: those specializing in home delivery and those specializing in home exercise equipment for example. The stock valuations of firms such as Shopify, Amazon and Peloton shot up, while the valuations of traditional auto makers languished.
Efficiency and Allocation
We have now come full circle. We started this chapter by describing the key role in economic development and growth played by firms and capital markets. Capital markets channel the funds of individual investors to risk-taking firms. Such firms—whether they are Dutch spice importers in the seventeenth century, the Hudson's Bay Company in nineteenth-century Canada, communications corporations such as Airbnb or Expedia, or some high tech start-ups in Silicon Valley—are engines of growth and play a pivotal role in an economy's development. Capital markets are what make it possible for these firms to attract the savings of risk-averse individuals. By enabling individuals to diversify their portfolios, capital markets form the link between individuals and firms.
But capital markets fulfill another function, or at least they frequently do. They are a means of funnelling financial capital into ventures that appear to have a future return. It is not possible for each individual saver to perform the research necessary on a series of existing or new corporations, or 'ventures', in order to be able to invest in a knowledgeable manner. That is one reason we have financial intermediaries. When individuals deposit their savings with a bank, or with a financial manager, these individuals are anticipating that their savings will be protected and that a return will be forthcoming. A bank may promise a return of a fixed percent if an individual deposits her money in a guaranteed investment certificate. Alternatively, if the individual saver wishes to take on some risk she can place her savings with her financial manager, an equity fund, or even a venture capitalist. These intermediaries are better at assessing risks and returns than most private individuals. This in turn means that the return to the individual from entrusting their savings to one of them should on average exceed the returns that the individual would earn herself by following some investment strategy.
If the professional investor indeed invests in more profitable ventures than an amateur investor, then that intermediary is performing an efficiency function for the whole economy: He does better at directing the economy's savings to where it is more productive on a macro level. This in turn means that the economy should have a higher growth rate than if savings are allocated towards ventures that are less likely to grow and satisfy a need or a demand in the economy.
Consider the example of Airbnb that we cited earlier. The original intent of this corporation was to provide the owners of unused (home) space the opportunity to earn a return on that space. Airbnb was thus a transformative mechanism, in that it enabled unused resources to be more fully utilized - by linking potential buyers who were willing to pay for the product, with potential sellers who were willing to supply at a price buyers were willing to pay. Unused resources became utilized, created a surplus and contributed to growth in the macro economy.
While financial intermediaries perform a valuable service to both individual savers, and the economy at large, we should not expect that intermediaries always make optimal decisions. However, these analysts have research resources available, and thus they have a comparative advantage over individuals for whom investing is a part-time activity. By being more efficient than individuals, financial intermediaries perform their broader economic allocation function, even if that is an unintended by-product of their professional activity.
At times professional investors suffer from what has been called 'irrational exuberance'. Crowd psychology creeps into the investment world from time to time, sometimes with devastating consequences. In the late 1990s tech stocks were all the rage and the stock market that specialized in trading such stocks saw the capital value of these stocks rise to stratospheric heights. The NASDAQ index stood at about 5,000 in March 2,000 but crashed to 1,300 by January of 2003. The run-up in NASDAQ valuations in the late nineties turned out to be a bubble.
Conclusion
We next turn to examine decision making within the firm. Firms must make the right decisions if they are to grow and provide investors with a satisfactory return. Firms that survive the growth process and ultimately bring a product to market are the survivors of the uncertainty surrounding product development.
Key Terms
Sole proprietor is the single owner of a business and is responsible for all profits and losses.
Partnership: a business owned jointly by two or more individuals, who share in the profits and are jointly responsible for losses.
Corporation or company is an organization with a legal identity separate from its owners that produces and trades.
Shareholders invest in corporations and therefore are the owners. They have limited liability personally if the firm incurs losses.
Dividends are payments made from after-tax profits to company shareholders.
Capital gains (losses) arise from the ownership of a corporation when an individual sells a share at a price higher (lower) than when the share was purchased.
Real return on corporate stock: the sum of dividend plus capital gain, adjusted for inflation.
Real return: the nominal return minus the rate of inflation.
Limited liability means that the liability of the company is limited to the value of the company's assets.
Retained earnings are the profits retained by a company for reinvestment and not distributed as dividends.
Principal or owner: delegates decisions to an agent, or manager.
Agent: usually a manager who works in a corporation and is directed to follow the corporation's interests.
Principal-agent problem: arises when the principal cannot easily monitor the actions of the agent, who therefore may not act in the best interests of the principal.
Stock option: an option to buy the stock of the company at a future date for a fixed, predetermined price.
Accounting profit: is the difference between revenues and explicit costs.
Economic profit: is the difference between revenue and the sum of explicit and implicit costs.
Explicit costs: are the measured financial costs.
Implicit costs: represent the opportunity cost of the resources used in production.
Capital market: a set of financial institutions that funnels financing from investors into bonds and stocks.
Portfolio: a combination of assets that is designed to secure an income from investing and to reduce risk.
Risk pooling: a means of reducing risk and increasing utility by aggregating or pooling multiple independent risks.
Risk: the risk associated with an investment can be measured by the dispersion in possible outcomes. A greater dispersion in outcomes implies more risk.
Diversification reduces the total risk of a portfolio by pooling risks across several different assets whose individual returns behave independently.
Exercises for Chapter 7
EXERCISE 7.1
Henry is contemplating opening a microbrewery and investing his savings of \$100,000 in it. He will quit his current job as a quality controller at Megaweiser where he is paid an annual salary of \$50,000. He plans on paying himself a salary of \$40,000 at the microbrewery. He also anticipates that his beer sales minus all costs other than his salary will yield him a surplus of \$55,000 per annum. The rate of return on savings is 7%.
1. Calculate the accounting profits envisaged by Henry.
2. Calculate the economic profits.
3. Should Henry open the microbrewery?
4. If all values except the return on savings remain the same, what rate of return would leave him indifferent between opening the brewery and not?
EXERCISE 7.2
You see an advertisement for life insurance for everyone 55 years of age and older. The advertisement says that no medical examination is required prior to purchasing insurance. If you are a very healthy 57-year old, do you think you will get a good deal from purchasing this insurance?
EXERCISE 7.3
In which of the following are risks being pooled, and in which would risks likely be spread by insurance companies?
1. Insurance against Alberta's Bow River Valley flooding.
2. Life insurance.
3. Insurance for the voice of Avril Lavigne or Celine Dion.
4. Insuring the voices of the lead vocalists in Metallica, Black Eyed Peas, Incubus, Evanescence, Green Day, and Jurassic Five.
EXERCISE 7.4
Your house has a one in five hundred probability chance of burning down in any given year. It is valued at \$350,000.
1. What insurance premium would be actuarially fair for this situation?
2. If the owner is willing to pay a premium of \$900, does she dislike risk or is she indifferent to risk?
EXERCISE 7.5
If individuals experience diminishing marginal utility from income it means that their utility function will resemble the total utility functions developed graphically in Section 6.2. Let us imagine specifically that if Y is income and U is utility, the individual gets utility from income according to the relation .
1. In a spreadsheet or using a calculator, calculate the amount of utility the individual gets for all income values running from \$1 to \$25.
2. Graph the result with utility on the vertical axis and income on the horizontal axis, and verify from its shape that the marginal utility of income is declining.
3. Using your calculations, how much utility will the individual get from \$4, \$9 and \$16?
4. Suppose now that income results from a lottery and half of the time the individual gets \$4 and half of the time he gets \$16. How much utility will he get on average?
5. Now suppose he gets \$10 each time with certainty. How much utility will he get from this?
6. Since \$10 is exactly an average of \$4 and \$16, can you explain why \$10 with certainty gives him more utility than getting \$4 and \$16 each half of the time?
EXERCISE 7.6
In Question 7.5, suppose that the individual gets utility according to the relation Repeat the calculations for each part of the question and see if you can understand why the answers are different.
07: Firms investors and capital markets
Suppliers of goods and services to the marketplace come in a variety of forms; some are small, some are large. But, whatever their size, suppliers choose an organizational structure that is appropriate for their business: Aircraft, oil rigs, social media and information services are produced by large corporations; dental services and family health are provided by individual professionals or private partnerships.
The initial material of this chapter addresses organizational forms, their goals and their operation. We then examine why individuals choose to invest in firms, and illustrate that such investment provides individual investors with a means both to earning a return on their savings and to managing the risk associated with investing. Uncertainty regarding the future is a central consideration.
Understanding the way firms and capital markets function is crucial to understanding our economic history and how different forms of social and economic institutions interact. For example, seventeenth-century Amsterdam had a thriving bourgeoisie, well-developed financial markets, and investors with savings. This environment facilitated the channeling of investors' funds to firms specializing in trade and nautical conquest. This tiny state was then the source of some of the world's leading explorers and traders, and it had colonies stretching to Indonesia. The result was economic growth and prosperity.
In contrast, for much of the twentieth century, the Soviet Union dominated a huge territory covering much of Asia and Europe. But capital markets were non-existent, independent firms were stifled, and economic decline ultimately ensued. Much of the enormous difference in the respective patterns of economic development can be explained by the fact that one state fostered firms, capital markets, and legal institutions, while the other did not. In terms of our production possibility frontier: One set of institutional arrangements was conducive to expanding the possibilities; the other was not. Sustainable new businesses invariably require investors at an early point in the lifecycle of the business. Accordingly, financial and legal institutions that facilitate the flow of savings and financial investment into new enterprises perform a vital function in the economy.
Businesses, or firms, have several different forms. At the smallest scale, a business takes the form of a sole proprietor or sole trader who is the exclusive owner. A sole trader gets all of the revenues from the firm and incurs all of the costs. Hence he may make profits or be personally liable for the losses. In the latter case his business or even personal assets may be confiscated to cover debts. Personal bankruptcy may result.
Sole proprietor is the single owner of a business.
If a business is to grow, partners may be required. Such partners can inject money in exchange for a share of future profits. Firms where trust is involved, such as legal or accounting firms, typically adopt this structure. A firm is given credibility when customers see that partners invest their own wealth in it.
Partnership: a business owned jointly by two or more individuals, who share in the profits and are jointly responsible for losses.
In order to expand and grow, a firm will need cash, perhaps partners, and investors. Providers of family health and dental services rely primarily on human expertise, and therefore they need relatively little physical capital. Hence their cash start-up needs are limited. But firms that produce aircraft, or develop software and organizational systems, need vast amounts of money for capital investment; pharmaceuticals may need a billion dollars worth of research and development to bring a new drug to the marketplace; ride-sharing companies need billions in order to establish their business globally. Such businesses must form corporations – also known as companies. Not all corporations are public; some are privately held, but relatively few large corporations are not publicly traded.
Large organizations have several inherent advantages over small organizations when a high output level is required. Specialization in particular tasks leads to increased efficiency for production workers. At the same time, non-production workers can perform a multitude of different tasks. If a large corporation decided to contract out every task involved in bringing its product to market, the costs of such agreements would be prohibitively high. In addition, synergies can arise from teamwork. New ideas and better work flow are more likely to materialize when individuals work in close proximity than when working as isolated units, no matter how efficient they may be individually. A key aspect of such large organizations is that they have a legal identity separate from the managers and owners.
Corporation or company is an organization with a legal identity separate from its owners that produces and trades.
The owners of a corporation are known as its shareholders, and their object is usually to make profits. There also exist non-profit corporations whose objective may be philanthropic. Since our focus is upon markets, we will generally assume that profits form the objective of a typical corporation. The profits that accrue to a corporation may be paid to the shareholders in the form of a dividend, or retained in the corporation for future use. When large profits (or losses) accrue the value of the corporation increases (or decreases), and this is reflected in the value of each share of the company. If the value of each share in the company increases (decreases) there is a capital gain (loss) to the owners of the shares – the shareholders. In any given year shareholders may receive a dividend and also obtain a capital gain (or loss). The sum of the dividend and capital gain represents the return to owning corporate stock in that year. When this sum is adjusted for inflation it is termed the real return on corporate stock
Shareholders invest in corporations and therefore are the owners.
Dividends are payments made from after-tax profits to company shareholders.
Capital gains (losses) arise from the ownership of a corporation when an individual sells a share at a price higher (lower) than when the share was purchased.
Real return to corporate stock is the inflation-adjusted sum of dividends and capital gain (or loss).
A key difference between a company and a partnership is that a company involves limited liability, whereas a partnership does not. Limited liability means that the liability of the company is limited to the value of the company's assets. Shareholders cannot be further liable for any wrongdoing on the part of the company. Accordingly, partnerships and sole traders normally insure themselves and their operations. For example, all specialist doctors carry malpractice insurance, and engineers insure themselves against error.
Limited liability means that the liability of the company is limited to the value of the company's assets.
Corporations use capital, labour, and human expertise to produce a good, to supply a service, or to act as an intermediary. Corporations are required to produce an annual income statement that accurately describes the operation of the firm. An example is given in Table 7.1.
Table 7.1 The Regal Bank of Toronto, 2025
Total Revenue \$ 32.0b
Net income post tax \$ 4.80b
Shares outstanding 640m
Net income/share \$ 7.50
Dividends/share \$ 2.50
Share price \$ 72.0
Market capitalization \$ 46.08b
The data in Table 7.1 define the main financial characteristics of an imaginary bank: the Regal Bank of Toronto in the year 2025. "Net income post-tax" represents after-tax profits. There are 640 million shares outstanding, and thus each share could be attributed a profit of . Of this amount, \$2.50 is distributed to shareholders in the form of dividends per share. The remainder is held by the Corporation in the form of retained earnings - to be used for future investment primarily. Each share traded at a price of \$72.00. Given that there were 640 million shares, the total market valuation of the corporation at that time stood at \$46.08 billion ().
Such information is publicly available for a vast number of corporations at the 'finance' section of major search engines such as Google or Yahoo.
Retained earnings are the profits retained by a company for reinvestment and not distributed as dividends.
In Canada, the corporate sector as a whole tends to hold on to more than half of after-tax profits in the form of retained earnings. However there exists considerable variety in the behaviour of corporations, and most firms establish a pattern of how profits are allocated between dividends and retained earnings. In the Table 7.1 example, one third of profits are distributed; yet some corporations have a no-dividend policy. In these latter cases the benefit to investing in a firm must come in the form of capital gain to the owners of the shares. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/07%3A_Firms_investors_and_capital_markets/7.01%3A_Business_organization.txt |
Ownership and corporate goals
As economists, we believe that profit maximization accurately describes a typical firm's objective. However, since large firms are not run by their owners but by their executives or agents, it is frequently hard for the shareholders to know exactly what happens within a company. Even the board of directors—the guiding managerial group—may not be fully aware of the decisions, strategies, and practices of their executives and managers. Occasionally things go wrong, sometimes as a result of managers deciding to follow their own interests rather than the interests of the company. In technical terms, the interests of the corporation and its shareholders might not be aligned with the interests of its managers. For example, managers might have a short horizon and take steps to increase their own income in the short term, knowing that they will move to another job before the long-term effects of their decisions impact the firm.
At the same time, the marketplace for the ownership of corporations exerts a certain discipline: If firms are not as productive or profitable as possible, they may become subject to takeover by other firms. Fear of such takeover can induce executives and boards to maximize profits.
The shareholder-manager relationship is sometimes called a principal-agent relationship, and it can give rise to a principal-agent problem. If it is costly or difficult to monitor the behaviour of an agent because the agent has additional information about his own performance, the principal may not know if the agent is working to achieve the firm's goals. This is the principal-agent problem.
Principal or owner: delegates decisions to an agent, or manager.
Agent: usually a manager who works in a corporation and is directed to follow the corporation's interests.
Principal-agent problem: arises when the principal cannot easily monitor the actions of the agent, who therefore may not act in the best interests of the principal.
In an effort to deal with such a challenge, corporate executives frequently get bonuses or stock options that are related to the overall profitability of their firm. Stock options usually take the form of an executive being allowed to purchase the company's stock in the future – but at a price that is predetermined. If the company's profits do increase, then the price of the company's stock will reflect this and increase likewise. Hence the executive has an incentive to work with the objective of increasing profits because that will enable him to buy the company stock in the future at a lower price than it will be worth.
Stock option: an option to buy the stock of the company at a future date for a fixed, predetermined price.
The threat of takeover and the structure of rewards, together, imply that the assumption of profit maximization is a reasonable one.
Application Box 7.1 The 'Sub-Prime' mortgage crisis: A principal-agent problem
With a decline in interest and mortgage rates in the early part of the twenty first century, many individuals believed they could afford to buy a house because the borrowing costs were lower than before. Employees and managers of lending companies believed likewise, and they structured loans in such a way as to provide an incentive to low-income individuals to borrow. These mortgage loans frequently enabled purchasers to buy a house with only a 5% down payment, in some cases even less, coupled with a repayment schedule that saw low repayments initially but higher repayments subsequently. The initial interest cost was so low in many of these mortgages that it was even lower than the 'prime' rate – the rate banks charge to their most prized customers.
The crisis that resulted became known as the 'sub-prime' mortgage crisis. In many cases loan officers got bonuses based on the total value of loans they oversaw, regardless of the quality or risk associated with the loan. The consequence was that they had the incentive to make loans to customers to whom they would not have lent, had these employees and managers been lending their own money, or had they been remunerated differently. The outcomes were disastrous for numerous lending institutions. When interest rates climbed, borrowers could not repay their loans. The construction industry produced a flood of houses that, combined with the sale of houses that buyers could no longer afford, sent housing prices through the floor. This in turn meant that recent house purchasers were left with negative value in their homes – the value of their property was less than what they paid for it. Many such 'owners' simply returned the keys to their bank, declared bankruptcy and walked away. Some lenders went bankrupt; some were bailed out by the government, others bought by surviving firms. This is a perfect example of the principal agent problem – the managers of the lending institutions and their loan officers did not have the incentive to act in the interest of the owners of those institutions.
The broader consequence of this lending practice was a financial collapse greater than any since the Depression of the nineteen thirties. Assets of the world's commercial and investment banks plummeted in value. Their assets included massive loans and investments both directly and indirectly to the real estate market, and when real estate values fell, so inevitably did the value of the assets based on this sector. Governments around the world had to buy up bad financial assets from financial institutions, or invest massive amounts of taxpayer money in these same institutions. Otherwise the world's financial system might have collapsed, with unknowable consequences.
Taxpayers and shareholders together bore the burden of this disastrous investment policy. Shareholders in many banks saw their shares drop in value to just a few percent of what they had been worth a year or two prior to the collapse.
Economic and accounting profit
Economists and accountants frequently differ in how they measure profits. An accountant stresses the financial flows of corporate activity; the economist is, in addition, concerned with opportunity cost. Imagine that Felicity has just inherited \$250,000 and decides to pursue her dream by opening a clothing boutique. She quits her job that pays her \$55,000 per annum, invests her inheritance in the purchase of a small retail space on the high street and launches her business. At the end of her first year she records \$110,000 in clothing sales, which she purchased from the wholesaler for \$50,000. She pays herself a salary of \$35,000 and has no other accounting costs because she owns her physical capital – the store. Her accounting profit for the year is given by the margin returned between the buying and selling price of her clothing (\$60,000) minus her incurred costs (\$35,000) in salary. Her accounting profit is thus \$25,000. Should she be content with this sum?
Felicity's economist friend, Prudence, informs Felicity that her enterprise is not returning a profit by economic standards. Prudence points out that Felicity could earn \$55,000 as an alternative to working in her own store, hence there is an additional implicit cost of \$20,000 to be considered, because Felicity only draws a salary of \$35,000. Furthermore, Felicity has invested \$250,000 in her business to avoid rent. But that sum, invested at the going interest rate of 4%, could earn her \$10,000 per annum. That too is a foregone income stream so it is an implicit cost. Altogether, the additional implicit costs, not included in the accounting flows, amount to \$30,000, and these implicit costs exceed the 'accounting profits'. Thus no economic profits are being made, because the economist includes implicit costs in her profit calculation. In economic terms Felicity would be better off by returning to her job and investing her inheritance. That strategy would generate an income of \$65,000, as opposed to the income of \$60,000 that she generates from the boutique – a salary of \$35,000 plus an accounting profit of \$25,000.
We can summarize this: Accounting profit is the difference between revenues and explicit costs. Economic profit is the difference between revenue and the sum of explicit and implicit costs. Explicit costs are the measured financial costs; Implicit costs represent the opportunity cost of the resources used in production.
Accounting profit: is the difference between revenues and explicit costs.
Economic profit: is the difference between revenue and the sum of explicit and implicit costs.
Explicit costs: are the measured financial costs.
Implicit costs: represent the opportunity cost of the resources used in production.
We will return to these concepts in the following chapters. Opportunity cost, or implicit costs, are critical in determining the long-run structure of certain sectors in the economy.
7.03: Risk and the investor
Firms cannot grow without investors. A successful firm's founder always arrives at a point where more investment is required if her enterprise is to expand. Frequently, she will not be able to secure a sufficiently large loan for such growth, and therefore must induce outsiders to buy shares in her firm. She may also realize that expansion carries risk, and she may want others to share in this risk. Risk plays a central role in the life of the firm and the investor. Most investors prefer to avoid risk, but are prepared to assume a limited amount of it if the anticipated rewards are sufficiently attractive.
An illustration of risk-avoidance is to be seen in the purchase of home insurance. Most home owners who run even a small risk of seeing their house burn down, being flooded, or damaged by a gas leak purchase insurance. By doing so they are avoiding risk. But how much are they willing to pay for such insurance? If the house is worth \$500,000 and the probability of its being destroyed is one in one thousand in a given year then, using an averaging perspective, individuals should be willing to pay an insurance premium of \$500 per annum. That insurance premium represents what actuaries call a 'fair' gamble: If the probability of disaster is one in one thousand, then the 'fair' premium should be one thousandth the value of the home that is being insured. If the insurance company insures millions of homes, then on average it will have to pay for the replacement of one house for every one thousand houses it insures each year. So by charging homeowners a price that exceeds \$500 the insurer will cover not only the replacement cost of homes, but in addition cover her administrative costs and perhaps make a profit. Insurers operate on the basis of what we sometimes call the 'law of large numbers'.
In fact however, most individuals are willing to pay more than this 'fair' amount, and actually do pay more. If the insurance premium is \$750 or \$1,000 the home-owner is paying more than is actuarially 'fair', but a person who dislikes risk may be willing to pay such an amount in order to avoid the risk of being uninsured.
Our challenge now is to explain why individuals who purchase home insurance on terms that are less than actuarially 'fair' in order to avoid risk are simultaneously willing to invest their retirement savings into risky companies. Companies, like homes, are risky; while they may not collapse or implode in any given year, they can have good or bad returns in any given year. Corporate returns are inherently unpredictable and therefore risky. The key to understanding the willingness of risk-averse individuals to invest in risky firms is to be found in the pooling of risks. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/07%3A_Firms_investors_and_capital_markets/7.02%3A_Profit.txt |
Silicon Valley: from angel investors to public corporation
Risky firms frequently succeed in attracting investment through the capital market in the modern economy. A typical start-up firm in the modern economy originates in the form of an idea. The developers of Uber got the idea of simplifying and streamlining the ride sharing business (sometimes called the taxi business). In its simplest form the inventors developed an App that would link users to drivers. The developers of Airbnb got the idea that spare accommodations in individual homes could be used to satisfy the needs of travellers. The founders developed an efficient means of putting potential renters/guests in communication with suppliers of rooms, houses and condominiums. WeWork was founded on the belief that workers and small corporations, particularly those in the technology sector, have immediate and changing space needs. The result is that WeWork provides flexible work space on a 'just in time' basis, frequently on a shared overhead basis. Each of these corporations acts as an intermediary, and sells intermediation services.
Typically the initial funding for new ideas comes from a couple of founding partners who develop a model or prototype of their software or their business. Following trials, the founders may approach potential investors for 'small' amounts that will fund expansion. Such investors are frequently 'angel' investors because they are a source of funding that makes the difference between expansion and death for the venture in question. If the venture shows promise the founders seek 'round A' funding, and this funding may come from venture capitalists who specialize in new ventures. Further evidence of possible success may result in 'round B' funding, and this frequently amounts to hundreds of millions of dollars.
Venture funds are managed by partners, or capitalists, with reputations for being better able than most to predict which start-ups will ultimately see profitability. These venture capitalists invest both their own funds and the funds of individuals who entrust their accumulated savings to the investing partnership.
But extremely high risk is associated with most start-ups. Funding frequently takes place in an environment where the venture has no revenue; merely a product in the course of development. Winners in the new economy are recognized and celebrated. Bill Gates' Microsoft, Jeff Bezos' Amazon, Steve Jobs Apple, and Larry Page and Sergey Brin's Google are corporate giants with valuations approach one trillion dollars. But Elizabeth Holmes' Theranos, once with an implicit valuation of several billion dollars has expired. Theranos hired several hundred employees with the aim of developing blood tests for scores of purposes using just a pin-prick of blood. But it was a failure, despite attracting hundreds of millions of dollars in investment. In the year 2019 Canada had dozens of cannabis-based firms listed on the Canadian Securities Exchange. None of these is earning a profit in 2020, some have negligible earnings, yet several have a value in excess of one billion dollars. It is highly improbable that all will survive.
Capital market: a set of financial institutions that funnels financing from investors into bonds and stocks.
Venture capital: investment in a business venture, where the ultimate outcome is highly unpredictable.
How can we reconcile the fact that, while these firms carry extraordinary uncertainty, investors are still willing to part with large sums of money to fund development? And the investors are not only billionaires with a good sense of the marketplace; private individuals who save for their retirement also invest in risky firms on the advice of their financial manager. Let us explore how and why.
Dealing with risk
Most (sensible) investors hold a portfolio of investments, which is a combination of different stocks and bonds. By investing in different stocks and bonds rather than concentrating in one single investment or type of investment, an individual diversifies her portfolio, which is to say she engages in risk pooling. Venture capital partnerships act in the same way. They recognize that their investments in start-ups will yield both complete failures and some roaring successes; the variation in their outcomes will exceed the variation in the outcomes of an investor who invests in 'mature' corporations.
Portfolio: a combination of assets that is designed to secure an income from investing and to reduce risk.
Risk pooling: Combining individual risks in such a way that the aggregate risk is reduced.
A rigorous theory underlies this "don't put all of your eggs in the one basket" philosophy. The essentials of diversification or pooling are illustrated in the example given in Table 7.2 below.1 There are two risky stocks here: Natural Gas (NG) and technology (Tech). Each stock is priced at \$100, and over time it is observed that each yields a \$10 return in good times and \$0 in bad times. The investor has \$200 to invest, and each sector independently has a 50% probability (p=0.5) of good or bad times. This means that each stock should yield a \$5 return on average: half of all outcomes will yield \$10 and half will yield zero. The challenge here is to develop an investment strategy that minimizes the risk for the investor.
At this point we need a specific working definition of risk. We define it in terms of how much variation a stock might experience in its returns from year to year. Each of NG and Tech have returns of either \$0 or \$10, with equal probability. But what if the Tech returns were either or with equal probability; or or with equal probability? In each of these alternative scenarios the average outcome remains the same: A positive average return of \$5. If the returns profile to NG remains unchanged we would say that Tech is a riskier stock (than NG) if its returns were defined by one of the alternatives here. Note that the average return is unchanged, and we are defining risk in terms of the greater spread in the possible returns around an unchanged average. The key to minimizing risk in the investor's portfolio lies in exploring how the variation in returns can be minimized by pooling risks.
Risk measurement: A higher degree of risk is associated with increased variation in the possible returns around an unchanged mean return.
Table 7.2 Investment strategies with risky assets
Strategy Expected returns with probabilities
\$200 in NG 220 (p=0.5) 200 (p=0.5)
\$200 in Tech 220 (p=0.5) 200 (p=0.5)
\$100 in each 220 (p=0.25) 210 (p=0.5) 200 (p=0.25)
The outcomes from three different investment strategies are illustrated in Table 7.2. By investing all of her \$200 in either NG or Tech, she will obtain \$220 half of the time and \$200 half of the time, as indicated in the first two outcome rows. But by diversifying through buying one of each stock, as illustrated in the final row, she reduces the variability of her portfolio. To see why note that, since the performance of each stock is independent, there is now only a one chance in four that both stocks do well, and therefore there is a 25 percent probability of earning \$220. By the same reasoning, there is a 25 percent probability of earning \$200. But there is a 50 percent chance that one stock will perform well and the other poorly. When that happens, she gets a return of \$210. In contrast to the outcomes defined in rows 1 and 2, the diversification strategy in row 3 yields fewer extreme potential outcomes and more potential outcomes that lie closer to the mean outcome.
Diversification reduces the total risk of a portfolio by pooling risks across several different assets whose individual returns behave independently.
Further diversification could reduce the variation in possible returns even further. To see this, imagine that, rather than having a choice between investing in one or two stocks, we could invest in four different stocks with the same returns profile as the two given in the table above. In such a case, the likelihood of getting extreme returns would be even lower than when investing in two stocks. This is because, if the returns to each stock are independent of the returns on the remaining stocks, it becomes increasingly improbable that all, or almost all, of the stocks will experience favorable (or unfavorable) returns in the same year. Now, imagine that we had 8 stocks, or 16, or 32, or 64, etc. The "magic" of diversification is that the same average return can be attained, yet variability can be reduced. If it can be reduced sufficiently by adding ever more stocks to the portfolio, then even a highly risk-averse individual can build a portfolio that is compatible with buying into risky firms.
We can conclude from this simple example that there need be no surprise over the fact that risk-averse individuals are willing, at the same time, to pay a high home-insurance premium to avoid risk, and simultaneously invest in risky ventures.
Application Box 7.2 The value of a financial advisor
The modern economy has thousands of highly-trained financial advisors. The successful ones earn huge salaries. But there is a puzzle: Why do such advisors exist? Can they predict the behaviour of the market any better than an uninformed advisor? Two insights help us answer the question.
First, Burton Malkiel wrote a best seller called A Random Walk down Wall Street. He provided ample evidence that a portfolio chosen on the basis of a monkey throwing darts at a list of stocks would do just as well as the average portfolio constructed by your friendly financial advisor.
Second, there are costs of transacting: An investor who builds a portfolio must devote time to the undertaking, and incur the associated financial trading cost. In recognizing this, investors may choose to invest in what they call mutual funds – a diversified collection of stocks – or may choose to employ a financial advisor who will essentially perform the same task of building a diversified portfolio. But, on average, financial advisors cannot beat the market, even though many individual investors would like to believe otherwise.
At this point we may reasonably ask why individuals choose to invest any of their funds in a "safe" asset – perhaps cash or Canadian Government bonds. After all, if their return to bonds is lower on average than the return to stocks, and they can diversify away much of the risk associated with stocks, why not get the higher average returns associated with stocks and put little or nothing in the safer asset? The reason is that it is impossible to fully diversify. When a recession hits, for example, the whole stock market may take a dive, because profits fall across the whole economy. On account of this possibility, we cannot ever arrive at a portfolio where the returns to the different stocks are completely independent. As a consequence, the rational investor will decide to put some funds in bonds in order to reduce this systematic risk component that is associated with the whole market. This is not a completely risk-free strategy because such assets can depreciate in value with inflation.
To see how the whole market can change dramatically students can go to any publicly accessible financial data site – such as Yahoo Finance and attempt to plot the TSX for the period 2005 – present, or the NASDAQ index from the mid-nineties to the present. The year 2020 is a particularly appropriate year to examine. In that year the coronavirus pandemic struck with disastrous impacts on stock markets worldwide. Initially almost all stocks declined in value. But within a matter of days investors realized that some firms would perform better in this particular downturn: those specializing in home delivery and those specializing in home exercise equipment for example. The stock valuations of firms such as Shopify, Amazon and Peloton shot up, while the valuations of traditional auto makers languished.
Efficiency and Allocation
We have now come full circle. We started this chapter by describing the key role in economic development and growth played by firms and capital markets. Capital markets channel the funds of individual investors to risk-taking firms. Such firms—whether they are Dutch spice importers in the seventeenth century, the Hudson's Bay Company in nineteenth-century Canada, communications corporations such as Airbnb or Expedia, or some high tech start-ups in Silicon Valley—are engines of growth and play a pivotal role in an economy's development. Capital markets are what make it possible for these firms to attract the savings of risk-averse individuals. By enabling individuals to diversify their portfolios, capital markets form the link between individuals and firms.
But capital markets fulfill another function, or at least they frequently do. They are a means of funnelling financial capital into ventures that appear to have a future return. It is not possible for each individual saver to perform the research necessary on a series of existing or new corporations, or 'ventures', in order to be able to invest in a knowledgeable manner. That is one reason we have financial intermediaries. When individuals deposit their savings with a bank, or with a financial manager, these individuals are anticipating that their savings will be protected and that a return will be forthcoming. A bank may promise a return of a fixed percent if an individual deposits her money in a guaranteed investment certificate. Alternatively, if the individual saver wishes to take on some risk she can place her savings with her financial manager, an equity fund, or even a venture capitalist. These intermediaries are better at assessing risks and returns than most private individuals. This in turn means that the return to the individual from entrusting their savings to one of them should on average exceed the returns that the individual would earn herself by following some investment strategy.
If the professional investor indeed invests in more profitable ventures than an amateur investor, then that intermediary is performing an efficiency function for the whole economy: He does better at directing the economy's savings to where it is more productive on a macro level. This in turn means that the economy should have a higher growth rate than if savings are allocated towards ventures that are less likely to grow and satisfy a need or a demand in the economy.
Consider the example of Airbnb that we cited earlier. The original intent of this corporation was to provide the owners of unused (home) space the opportunity to earn a return on that space. Airbnb was thus a transformative mechanism, in that it enabled unused resources to be more fully utilized - by linking potential buyers who were willing to pay for the product, with potential sellers who were willing to supply at a price buyers were willing to pay. Unused resources became utilized, created a surplus and contributed to growth in the macro economy.
While financial intermediaries perform a valuable service to both individual savers, and the economy at large, we should not expect that intermediaries always make optimal decisions. However, these analysts have research resources available, and thus they have a comparative advantage over individuals for whom investing is a part-time activity. By being more efficient than individuals, financial intermediaries perform their broader economic allocation function, even if that is an unintended by-product of their professional activity.
At times professional investors suffer from what has been called 'irrational exuberance'. Crowd psychology creeps into the investment world from time to time, sometimes with devastating consequences. In the late 1990s tech stocks were all the rage and the stock market that specialized in trading such stocks saw the capital value of these stocks rise to stratospheric heights. The NASDAQ index stood at about 5,000 in March 2,000 but crashed to 1,300 by January of 2003. The run-up in NASDAQ valuations in the late nineties turned out to be a bubble. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/07%3A_Firms_investors_and_capital_markets/7.04%3A_Risk_pooling_and_diversification.txt |
We next turn to examine decision making within the firm. Firms must make the right decisions if they are to grow and provide investors with a satisfactory return. Firms that survive the growth process and ultimately bring a product to market are the survivors of the uncertainty surrounding product development.
7.06: Key Terms
Sole proprietor is the single owner of a business and is responsible for all profits and losses.
Partnership: a business owned jointly by two or more individuals, who share in the profits and are jointly responsible for losses.
Corporation or company is an organization with a legal identity separate from its owners that produces and trades.
Shareholders invest in corporations and therefore are the owners. They have limited liability personally if the firm incurs losses.
Dividends are payments made from after-tax profits to company shareholders.
Capital gains (losses) arise from the ownership of a corporation when an individual sells a share at a price higher (lower) than when the share was purchased.
Real return on corporate stock: the sum of dividend plus capital gain, adjusted for inflation.
Real return: the nominal return minus the rate of inflation.
Limited liability means that the liability of the company is limited to the value of the company's assets.
Retained earnings are the profits retained by a company for reinvestment and not distributed as dividends.
Principal or owner: delegates decisions to an agent, or manager.
Agent: usually a manager who works in a corporation and is directed to follow the corporation's interests.
Principal-agent problem: arises when the principal cannot easily monitor the actions of the agent, who therefore may not act in the best interests of the principal.
Stock option: an option to buy the stock of the company at a future date for a fixed, predetermined price.
Accounting profit: is the difference between revenues and explicit costs.
Economic profit: is the difference between revenue and the sum of explicit and implicit costs.
Explicit costs: are the measured financial costs.
Implicit costs: represent the opportunity cost of the resources used in production.
Capital market: a set of financial institutions that funnels financing from investors into bonds and stocks.
Portfolio: a combination of assets that is designed to secure an income from investing and to reduce risk.
Risk pooling: a means of reducing risk and increasing utility by aggregating or pooling multiple independent risks.
Risk: the risk associated with an investment can be measured by the dispersion in possible outcomes. A greater dispersion in outcomes implies more risk.
Diversification reduces the total risk of a portfolio by pooling risks across several different assets whose individual returns behave independently.
7.07: Exercises for Chapter 7
EXERCISE 7.1
Henry is contemplating opening a microbrewery and investing his savings of \$100,000 in it. He will quit his current job as a quality controller at Megaweiser where he is paid an annual salary of \$50,000. He plans on paying himself a salary of \$40,000 at the microbrewery. He also anticipates that his beer sales minus all costs other than his salary will yield him a surplus of \$55,000 per annum. The rate of return on savings is 7%.
1. Calculate the accounting profits envisaged by Henry.
2. Calculate the economic profits.
3. Should Henry open the microbrewery?
4. If all values except the return on savings remain the same, what rate of return would leave him indifferent between opening the brewery and not?
EXERCISE 7.2
You see an advertisement for life insurance for everyone 55 years of age and older. The advertisement says that no medical examination is required prior to purchasing insurance. If you are a very healthy 57-year old, do you think you will get a good deal from purchasing this insurance?
EXERCISE 7.3
In which of the following are risks being pooled, and in which would risks likely be spread by insurance companies?
1. Insurance against Alberta's Bow River Valley flooding.
2. Life insurance.
3. Insurance for the voice of Avril Lavigne or Celine Dion.
4. Insuring the voices of the lead vocalists in Metallica, Black Eyed Peas, Incubus, Evanescence, Green Day, and Jurassic Five.
EXERCISE 7.4
Your house has a one in five hundred probability chance of burning down in any given year. It is valued at \$350,000.
1. What insurance premium would be actuarially fair for this situation?
2. If the owner is willing to pay a premium of \$900, does she dislike risk or is she indifferent to risk?
EXERCISE 7.5
If individuals experience diminishing marginal utility from income it means that their utility function will resemble the total utility functions developed graphically in Section 6.2. Let us imagine specifically that if Y is income and U is utility, the individual gets utility from income according to the relation .
1. In a spreadsheet or using a calculator, calculate the amount of utility the individual gets for all income values running from \$1 to \$25.
2. Graph the result with utility on the vertical axis and income on the horizontal axis, and verify from its shape that the marginal utility of income is declining.
3. Using your calculations, how much utility will the individual get from \$4, \$9 and \$16?
4. Suppose now that income results from a lottery and half of the time the individual gets \$4 and half of the time he gets \$16. How much utility will he get on average?
5. Now suppose he gets \$10 each time with certainty. How much utility will he get from this?
6. Since \$10 is exactly an average of \$4 and \$16, can you explain why \$10 with certainty gives him more utility than getting \$4 and \$16 each half of the time?
EXERCISE 7.6
In Question 7.5, suppose that the individual gets utility according to the relation Repeat the calculations for each part of the question and see if you can understand why the answers are different. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/07%3A_Firms_investors_and_capital_markets/7.05%3A_Conclusion.txt |
Chapter 8: Production and cost
In this chapter we will explore:
8.1
Efficient production
8.2
Time frames: The short run and the long run
8.3
Production in the short run
8.4
Costs in the short run
8.5
Fixed costs and sunk costs
8.6
Production and costs in the long run
8.7
Technological change and globalization
8.8
Clusters, externalities, learning by doing, and scope economies
8.1 Efficient production
Firms that fail to operate efficiently seldom survive. They are dominated by their competitors because the latter produce more efficiently and can sell at a lower price. The drive for profitability is everywhere present in the modern economy. Companies that promise more profit, by being more efficient, are valued more highly on the stock exchange. For example: In July of 2015 Google announced that, going forward, it would be more attentive to cost management in its numerous research endeavours that aim to bring new products to the marketplace. This policy, put in place by the Company's new Chief Financial Officer, was welcomed by investors who, as a result, bought up the stock. The Company's stock increased in value by 16% in one day – equivalent to about \$50 billion.
The remuneration of managers in virtually all corporations is linked to profitability. Efficient production, a.k.a. cost reduction, is critical to achieving this goal. In this chapter we will examine cost management and efficient production from the ground up – by exploring how a small entrepreneur brings his or her product to market in the most efficient way possible. As we shall see, efficient production and cost minimization amount to the same thing: Cost minimization is the financial reflection of efficient production.
Efficient production is critical in any budget-driven organization, not just in the private sector. Public institutions equally are, and should be, concerned with costs and efficiency.
Entrepreneurs employ factors of production (capital and labour) in order to transform raw materials and other inputs into goods or services. The relationship between output and the inputs used in the production process is called a production function. It specifies how much output can be produced with given combinations of inputs. A production function is not restricted to profit-driven organizations. Municipal road repairs are carried out with labour and capital. Students are educated with teachers, classrooms, computers, and books. Each of these is a production process.
Production function: a technological relationship that specifies how much output can be produced with specific amounts of inputs.
Economists distinguish between two concepts of efficiency: One is technological efficiency; the other is economic efficiency. To illustrate the difference, consider the case of auto assembly: the assembler could produce its vehicles either by using a large number of assembly workers and a plant that has a relatively small amount of machinery, or it could use fewer workers accompanied by more machinery in the form of robots. Each of these processes could be deemed technologically efficient, provided that there is no waste. If the workers without robots are combined with their capital to produce as much as possible, then that production process is technologically efficient. Likewise, in the scenario with robots, if the workers and capital are producing as much as possible, then that process too is efficient in the technological sense.
Technological efficiency means that the maximum output is produced with the given set of inputs.
Economic efficiency is concerned with more than just technological efficiency. Since the entrepreneur's goal is to make profit, she must consider which technologically efficient process best achieves that objective. More broadly, any budget-driven process should focus on being economically efficient, whether in the public or private sector. An economically efficient production structure is the one that produces output at least cost.
Economic efficiency defines a production structure that produces output at least cost.
Auto-assembly plants the world over have moved to using robots during the last two decades. Why? The reason is not that robots were invented 20 years ago; they were invented long before that. The real reason is that, until recently, this technology was not economically efficient. Robots were too expensive; they were not capable of high-precision assembly. But once their cost declined and their accuracy increased they became economically efficient. The development of robots represented technological progress. When this progress reached a critical point, entrepreneurs embraced it.
To illustrate the point further, consider the case of garment assembly. There is no doubt that engineers could make robots capable of joining the pieces of fabric that form garments. This is not beyond our technological abilities. Why, then, do we not have such capital-intensive production processes for garment making, similar to the production process chosen by vehicle producers? The answer is that, while such a concept could be technologically efficient, it would not be economically efficient. It is more profitable to use large amounts of labour and relatively traditional machines to assemble garments, particularly when labour in Asia costs less and the garments can be shipped back to Canada inexpensively. Containerization and scale economies in shipping mean that a garment can be shipped to Canada from Asia for a few cents per unit.
Efficiency in production is not limited to the manufacturing sector. Farmers must choose the optimal combination of labour, capital and fertilizer to use. In the health and education sectors, efficient supply involves choices on how many high- and low-skill workers to employ, how much traditional physical capital to use, how much information technology to use, based upon the productivity and cost of each. Professors and physicians are costly inputs. When they work with new technology (capital) they become more efficient at performing their tasks: It is less costly to have a single professor teach in a 300-seat classroom that is equipped with the latest technology, than have several professors each teaching 60-seat classes with chalk and a blackboard.
8.2 The time frame
We distinguish initially between the short run and the long run. When discussing technological change, we use the term very long run. These concepts have little to do with clocks or calendars; rather, they are defined by the degree of flexibility an entrepreneur or manager has in her production process. A key decision variable is capital.
A customary assumption is that a producer can hire more labour immediately, if necessary, either by taking on new workers (since there are usually some who are unemployed and looking for work), or by getting the existing workers to work longer hours. In contrast, getting new capital in place is usually more time consuming: The entrepreneur may have to place an order for new machinery, which will involve a production and delivery time lag. Or she may have to move to a more spacious location in order to accommodate the added capital. Whether this calendar time is one week, one month, or one year is of no concern to us. We define the long run as a period of sufficient length to enable the entrepreneur to adjust her capital stock, whereas in the short run at least one factor of production is fixed. Note that it matters little whether it is labour or capital that is fixed in the short run. A software development company may be able to install new capital (computing power) instantaneously but have to train new developers. In such a case capital is variable and labour is fixed in the short run. The definition of the short run is that one of the factors is fixed, and in our examples we will assume that it is capital.
Short run: a period during which at least one factor of production is fixed. If capital is fixed, then more output is produced by using additional labour.
Long run: a period of time that is sufficient to enable all factors of production to be adjusted.
Very long run: a period sufficiently long for new technology to develop.
8.3 Production in the short run
Black Diamond Snowboards (BDS) is a start-up snowboard producing enterprise. Its founder has invented a new lamination process that gives extra strength to his boards. He has set up a production line in his garage that has four workstations: Laminating, attaching the steel edge, waxing, and packing.
With this process in place, he must examine how productive his firm can be. After extensive testing, he has determined exactly how his productivity depends upon the number of workers. If he employs only one worker, then that worker must perform several tasks, and will encounter 'down time' between workstations. Extra workers would therefore not only increase the total output; they could, in addition, increase output per worker. He also realizes that once he has employed a critical number of workers, additional workers may not be so productive: Because they will have to share the fixed amount of machinery in his garage, they may have to wait for another worker to finish using a machine. At such a point, the productivity of his plant will begin to fall off, and he may want to consider capital expansion. But for the moment he is constrained to using this particular assembly plant. Testing leads him to formulate the relationship between workers and output that is described in Table 8.1.
Table 8.1 Snowboard production and productivity
1 2 3 4 5
Workers Output Marginal Average Stages of
(TP) product product production
(MPL) (APL)
0 0 MPL increasing
1 15 15 15
2 40 25 20
3 70 30 23.3
4 110 40 27.5
5 145 35 29 MPL positive and declining
6 175 30 29.2
7 200 25 28.6
8 220 20 27.5
9 235 15 26.1
10 240 5 24.0
11 235 -5 21.4 MPL negative
By increasing the number of workers in the plant, BDS produces more boards. The relationship between these two variables in columns 1 and 2 in the table is plotted in Figure 8.1. This is called the total product function (TP), and it defines the output produced with different amounts of labour in a plant of fixed size.
Figure 8.1 Total product curve
Output increases with the amount of labour used. Initially the increase in output due to using more labour is high, subsequently it is lower. The initial phase characterizes increasing productivity, the later phase defines declining productivity.
Total product is the relationship between total output produced and the number of workers employed, for a given amount of capital.
This relationship is positive, indicating that more workers produce more boards. But the curve has an interesting pattern. In the initial expansion of employment it becomes progressively steeper – its curvature is slightly convex; following this phase the function's increase becomes progressively less steep – its curvature is concave. These different stages in the TP curve tell us a great deal about productivity in BDS. To see this, consider the additional number of boards produced by each worker. The first worker produces 15. When a second worker is hired, the total product rises to 40, so the additional product attributable to the second worker is 25. A third worker increases output by 30 units, and so on. We refer to this additional output as the marginal product (MP) of an additional worker, because it defines the incremental, or marginal, contribution of the worker. These values are entered in column 3.
More generally the MP of labour is defined as the change in output divided by the change in the number of units of labour employed. Using, as before, the Greek capital delta () to denote a change, we can define
In this example the change in labour is one unit at each stage and hence the marginal product of labour is simply the corresponding change in output. It is also the case that the MPL is the slope of the TP curve – the change in the value on the vertical axis due to a change in the value of the variable on the horizontal axis.
Marginal product of labour is the addition to output produced by each additional worker. It is also the slope of the total product curve.
Figure 8.2 Average and marginal product curves
The productivity curves initially rise and then decline, reflecting increasing and decreasing productivity. The MPL curves must intersect the APL curve at the maximum of the APL: The average must increase if the marginal exceeds the average and must decline if the marginal is less than the average.
During the initial stage of production expansion, the marginal product of each worker is increasing. It increases from 15 to 40 as BDS moves from having one employee to four employees. This increasing MP is made possible by the fact that each worker is able to spend more time at his workstation, and less time moving between tasks. But, at a certain point in the employment expansion, the MP reaches a maximum and then begins to tail off. At this stage – in the concave region of the TP curve – additional workers continue to produce additional output, but at a diminishing rate. For example, while the fourth worker adds 40 units to output, the fifth worker adds 35, the sixth worker 30, and so on. This declining MP is due to the constraint of a fixed number of machines: All workers must share the same capital. The MP function is plotted in Figure 8.2.
The phenomenon we have just described has the status of a law in economics: The law of diminishing returns states that, in the face of a fixed amount of capital, the contribution of additional units of a variable factor must eventually decline.
Law of diminishing returns: when increments of a variable factor (labour) are added to a fixed amount of another factor (capital), the marginal product of the variable factor must eventually decline.
The relationship between Figures 8.1 and 8.2 should be noted. First, the MPL reaches a maximum at an output of 4 units – where the slope of the TP curve is greatest. The MPL curve remains positive beyond this output, but declines: The TP curve reaches a maximum when the tenth unit of labour is employed. An eleventh unit actually reduces total output; therefore, the MP of this eleventh worker is negative! In Figure 8.2, the MP curve becomes negative at this point. The garage is now so crowded with workers that they are beginning to obstruct the operation of the production process. Thus the producer would never employ an eleventh unit of labour.
Next, consider the information in the fourth column of the table. It defines the average product of labour (APL)—the amount of output produced, on average, by workers at different employment levels:
This function is also plotted in Figure 8.2. Referring to the table: The AP column indicates, for example, that when two units of labour are employed and forty units of output are produced, the average production level of each worker is 20 units (=40/2). When three workers produce 70 units, their average production is 23.3 (=70/3), and so forth. Like the MP function, this one also increases and subsequently decreases, reflecting exactly the same productivity forces that are at work on the MP curve.
Average product of labour is the number of units of output produced per unit of labour at different levels of employment.
The AP and MP functions intersect at the point where the AP is at its peak. This is no accident, and has a simple explanation. Imagine a softball player who is batting .280 coming into today's game—she has been hitting her way onto base 28 percent of the time when batting, so far this season. This is her average product, AP.
In today's game, if she bats .500 (hits her way to base on half of her at-bats), then she will improve her average. Today's batting (MP) at .500 therefore pulls up the season's AP. Accordingly, whenever the MP exceeds the AP, the AP is pulled up. By the same reasoning, if her MP is less than the season average, her average will be pulled down. It follows that the two functions must intersect at the peak of the AP curve. To summarize:
If the MP exceeds the AP, then the AP increases;
If the MP is less than the AP, then the AP declines.
While the owner of BDS may understand his productivity relations, his ultimate goal is to make profit, and for this he must figure out how productivity translates into cost.
8.4 Costs in the short run
The cost structure for the production of snowboards at Black Diamond is illustrated in Table 8.2. Employees are skilled and are paid a weekly wage of \$1,000. The cost of capital is \$3,000 and it is fixed, which means that it does not vary with output. As in Table 8.1, the number of employees and the output are given in the first two columns. The following three columns define the capital costs, the labour costs, and the sum of these in producing different levels of output. We use the terms fixed, variable, and total costs to define the cost structure of a firm. Fixed costs do not vary with output, whereas variable costs do, and total costs are the sum of fixed and variable costs. To keep this example as simple as possible, we will ignore the cost of raw materials. We could add an additional column of costs, but doing so will not change the conclusions.
Table 8.2 Snowboard production costs
Workers Output Capital Labour Total Average Average Average Marginal
cost cost costs fixed variable total cost
fixed variable cost cost cost
0 0 3,000 0 3,000
1 15 3,000 1,000 4,000 200.0 66.7 266.7 66.7
2 40 3,000 2,000 5,000 75.0 50.0 125.0 40.0
3 70 3,000 3,000 6,000 42.9 42.9 85.7 33.3
4 110 3,000 4,000 7,000 27.3 36.4 63.6 25.0
5 145 3,000 5,000 8,000 20.7 34.5 55.2 28.6
6 175 3,000 6,000 9,000 17.1 34.3 51.4 33.3
7 200 3,000 7,000 10,000 15.0 35.0 50.0 40.0
8 220 3,000 8,000 11,000 13.6 36.4 50.0 50.0
9 235 3,000 9,000 12,000 12.8 38.3 51.1 66.7
10 240 3,000 10,000 13,000 12.5 41.7 54.2 200.0
Fixed costs are costs that are independent of the level of output.
Variable costs are related to the output produced.
Total cost is the sum of fixed cost and variable cost.
Total costs are illustrated in Figure 8.3 as the vertical sum of variable and fixed costs. For example, Table 8.2 indicates that the total cost of producing 220 units of output is the sum of \$3,000 in fixed costs plus \$8,000 in variable costs. Therefore, at the output level 220 on the horizontal axis in Figure 8.3, the sum of the cost components yields a value of \$11,000 that forms one point on the total cost curve. Performing a similar calculation for every possible output yields a series of points that together form the complete total cost curve.
Figure 8.3 Total cost curves
Total cost is the vertical sum of the variable and fixed costs.
Average costs are given in the next three columns of Table 8.2. Average cost is the cost per unit of output, and we can define an average cost corresponding to each of the fixed, variable, and total costs defined above. Average fixed cost (AFC) is the total fixed cost divided by output; average variable cost (AVC) is the total variable cost divided by output; and average total cost (ATC) is the total cost divided by output.
AFC
AVC
ATC =AFC+AVC
Average fixed cost is the total fixed cost per unit of output.
Average variable cost is the total variable cost per unit of output.
Average total cost is the sum of all costs per unit of output.
The productivity-cost relationship
Consider the average variable cost - average product relationship, as developed in column 7 of Table 8.2; its corresponding variable cost curve is plotted in Figure 8.4. In this example, AVC first decreases and then increases. The intuition behind its shape is straightforward (and realistic) if you have understood why productivity varies in the short run: The variable cost, which represents the cost of labour, is constant per unit of labour, because the wage paid to each worker does not change. However, each worker's productivity varies. Initially, when we hire more workers, they become more productive, perhaps because they have less 'down time' in switching between tasks. This means that the labour costs per snowboard must decline. At some point, however, the law of diminishing returns sets in: As before, each additional worker is paid a constant amount, but as productivity declines the labour cost per snowboard increases.
Figure 8.4 Average and marginal cost curves
The MC intersects the ATC and AVC at their minimum values. The AFC declines indefinitely as fixed costs are spread over a greater output.
In this numerical example the AP is at a maximum when six units of labour are employed and output is 175. This is also the point where the AVC is at a minimum. This maximum/minimum relationship is also illustrated in Figures 8.2 and 8.4.
Now consider the marginal cost - marginal product relationship. The marginal cost (MC) defines the cost of producing one more unit of output. In Table 8.2, the marginal cost of output is given in the final column. It is the additional cost of production divided by the additional number of units produced. For example, in going from 15 units of output to 40, total costs increase from \$4,000 to \$5,000. The MC is the cost of those additional units divided by the number of additional units. In this range of output, MC is . We could also calculate the MC as the addition to variable costs rather than the addition to total costs, because the addition to each is the same—fixed costs are fixed. Hence:
MC
Marginal cost of production is the cost of producing each additional unit of output.
Just as the behaviour of the AVC curve is determined by the AP curve, so too the behaviour of the MC is determined by the MP curve. When the MP of an additional worker exceeds the MP of the previous worker, this implies that the cost of the additional output produced by the last worker hired must be declining. To summarize:
If the marginal product of labour increases, then the marginal cost of output declines;
If the marginal product of labour declines, then the marginal cost of output increases.
In our example, the reaches a maximum when the fourth unit of labour is employed (or 110 units of output are produced), and this also is where the MC is at a minimum. This illustrates that the marginal cost reaches a minimum at the output level where the marginal product reaches a maximum.
The average total cost is the sum of the fixed cost per unit of output and the variable cost per unit of output. Typically, fixed costs are the dominant component of total costs at low output levels, but become less dominant at higher output levels. Unlike average variable costs, note that the average fixed cost must always decline with output, because a fixed cost is being spread over more units of output. Hence, when the ATC curve eventually increases, it is because the increasing variable cost component eventually dominates the declining AFC component. In our example, this occurs when output increases from 220 units (8 workers) to 235 (9 workers).
Finally, observe the interrelationship between the MC curve on the one hand and the ATC and AVC on the other. Note from Figure 8.4 that the MC cuts the AVC and the ATC at the minimum point of each of the latter. The logic behind this pattern is analogous to the logic of the relationship between marginal and average product curves: When the cost of an additional unit of output is less than the average, this reduces the average cost; whereas, if the cost of an additional unit of output is above the average, this raises the average cost. This must hold true regardless of whether we relate the MC to the ATC or the AVC.
When the marginal cost is less than the average cost, the average cost must decline;
When the marginal cost exceeds the average cost, the average cost must increase.
Notation: We use both the abbreviations and to denote average total cost. The term 'average cost' is understood in economics to include both fixed and variable costs.
Teams and services
The choice faced by the producer in the example above is slightly 'stylized', yet it still provides an appropriate rule for analyzing hiring decisions. In practice, it is quite difficult to isolate or identify the marginal product of an individual worker. One reason is that individuals work in teams within organizations. The accounting department, the marketing department, the sales department, the assembly unit, the chief executive's unit are all composed of teams. Adding one more person to human resources may have no impact on the number of units of output produced by the company in a measurable way, but it may influence worker morale and hence longer-term productivity. Nonetheless, if we consider expanding, or contracting, any one department within an organization, management can attempt to estimate the net impact of additional hires (or layoffs) on the contribution of each team to the firm's profitability. Adding a person in marketing may increase sales, laying off a person in research and development may reduce costs by more than it reduces future value to the firm. In practice this is what firms do: they attempt to assess the contribution of each team in their organization to costs and revenues, and on that basis determine the appropriate number of employees.
The manufacturing sector of the macro economy is dominated, sizewise, by the services sector. But the logic that drives hiring decisions, as developed above, applies equally to services. For example, how does a law firm determine the optimal number of paralegals to employ per lawyer? How many nurses are required to support a surgeon? How many university professors are required to teach a given number of students?
All of these employment decisions involve optimization at the margin. The goal of the decision maker is not always profit, but she should attempt to estimate the cost and value of adding personnel at the margin.
8.5 Fixed costs and sunk costs
The distinction between fixed and variable costs is important for producers who are not making a profit. If a producer has committed himself to setting up a plant, then he has made a decision to incur a fixed cost. Having done this, he must now decide on a production strategy that will maximize profit. However, the price that consumers are willing to pay may not be sufficient to yield a profit. So, if Black Diamond Snowboards cannot make a profit, should it shut down? The answer is that if it can cover its variable costs, having already incurred its fixed costs, it should stay in production, at least temporarily. By covering the variable cost of its operation, Black Diamond is at least earning some return. A sunk cost is a fixed cost that has already been incurred and cannot be recovered. But if the pressures of the marketplace are so great that the total costs cannot be covered in the longer run, then this is not a profitable business and the firm should close its doors.
Is a fixed cost always a sunk cost? No: Any production that involves capital will incur a fixed cost component. Such capital can be financed in several ways however: It might be financed on a very short-term lease basis, or it might have been purchased by the entrepreneur. If it is leased on a month-to-month basis, an unprofitable entrepreneur who can only cover variable costs (and who does not foresee better market conditions ahead) can exit the industry quickly – by not renewing the lease on the capital. But an individual who has actually purchased equipment that cannot readily be resold has essentially sunk money into the fixed cost component of his production. This entrepreneur should continue to produce as long as he can cover variable costs.
Sunk cost is a fixed cost that has already been incurred and cannot be recovered, even by producing a zero output.
R & D as a sunk cost
Sunk costs in the modern era are frequently in the form of research and development costs, not the cost of building a plant or purchasing machinery. The prototypical example is the pharmaceutical industry, where it is becoming progressively more challenging to make new drug breakthroughs – both because the 'easier' breakthroughs have already been made, and because it is necessary to meet tighter safety conditions attaching to new drugs. Research frequently leads to drugs that are not sufficiently effective in meeting their target. As a consequence, the pharmaceutical sector regularly writes off hundreds of millions of dollars of lost sunk costs – unfruitful research and development.
Finally, we need to keep in mind the opportunity costs of running the business. The owner pays himself a salary, and ultimately he must recognize that the survival of the business should not depend upon his drawing a salary that is less than his opportunity cost. As developed in Section 7.2, if he underpays himself in order to avoid shutting down, he might be better off in the long run to close the business and earn his opportunity cost elsewhere in the marketplace.
A dynamic setting
We need to ask why it might be possible to cover all costs in a longer run horizon, while in the near-term costs are not covered. The principal reason is that demand may grow, particularly for a new product. For example, in 2019 numerous cannabis producing firms were listed on the Canadian Securities Exchange, and collectively were valued at about fifty billion dollars. None had revenues that covered costs, yet investors poured money into this sector. Investors evidently envisaged that the market for legal cannabis would grow. As of 2020 it appears that these investors were excessively optimistic. Sales growth has been slow and stock valuations have plummeted.
8.6 Long-run production and costs
The snowboard manufacturer we portray produces a relatively low level of output; in reality, millions of snowboards are produced each year in the global market. Black Diamond Snowboards may have hoped to get a start by going after a local market—the "free-ride" teenagers at Mont Sainte Anne in Quebec or at Fernie in British Columbia. If this business takes off, the owner must increase production, take the business out of his garage and set up a larger-scale operation. But how will this affect his cost structure? Will he be able to produce boards at a lower cost than when he was producing a very limited number of boards each season? Real-world experience would indicate yes.
Production costs almost always decline when the scale of the operation initially increases. We refer to this phenomenon simply as economies of scale. There are several reasons why scale economies are encountered. One is that production flows can be organized in a more efficient manner when more is being produced. Another is that the opportunity to make greater use of task specialization presents itself; for example, Black Diamond Snowboards may be able to subdivide tasks within the laminating and packaging stations. With a larger operating scale the replacement of labor with capital may be economically efficient. If scale economies do define the real world, then a bigger plant—one that is geared to produce a higher level of output—should have an average total cost curve that is "lower" than the cost curve corresponding to the smaller scale of operation we considered in the example above.
Average costs in the long run
Figure 8.5 illustrates a possible relationship between the ATC curves for four different scales of operation. is the average total cost curve associated with a small-sized plant; think of it as the plant built in the entrepreneur's garage. is associated with a somewhat larger plant, perhaps one she has put together in a rented industrial or commercial space. The further a cost curve is located to the right of the diagram the larger the production facility it defines, given that output is measured on the horizontal axis. If there are economies associated with a larger scale of operation, then the average costs associated with producing larger outputs in a larger plant should be lower than the average costs associated with lower outputs in a smaller plant, assuming that the plants are producing the output levels they were designed to produce. For this reason, the cost curve and the cost curve each have a segment that is lower than the lowest segment on . However, in Figure 8.5 the cost curve has moved upwards. What behaviours are implied here?
Figure 8.5 Long-run and short-run average costs
The long-run ATC curve, LATC, is the lower envelope of all short-run ATC curves. It defines the least cost per unit of output when all inputs are variable. Minimum efficient scale is that output level at which the LATC is a minimum, indicating that further increases in the scale of production will not reduce unit costs.
In many production environments, beyond some large scale of operation, it becomes increasingly difficult to reap further cost reductions from specialization, organizational economies, or marketing economies. At such a point, the scale economies are effectively exhausted, and larger plant sizes no longer give rise to lower (short-run) ATC curves. This is reflected in the similarity of the and the curves. The pattern suggests that we have almost exhausted the possibilities of further scale advantages once we build a plant size corresponding to . Consider next what is implied by the position of the curve relative to the and curves. The relatively higher position of the curve implies that unit costs will be higher in a yet larger plant. Stated differently: If we increase the scale of this firm to extremely high output levels, we are actually encountering diseconomies of scale. Diseconomies of scale imply that unit costs increase as a result of the firm's becoming too large: Perhaps co-ordination difficulties have set in at the very high output levels, or quality-control monitoring costs have risen. These coordination and management difficulties are reflected in increasing unit costs in the long run.
The terms increasing, constant, and decreasing returns to scale underlie the concepts of scale economies and diseconomies: Increasing returns to scale (IRS) implies that, when all inputs are increased by a given proportion, output increases more than proportionately. Constant returns to scale (CRS) implies that output increases in direct proportion to an equal proportionate increase in all inputs. Decreasing returns to scale (DRS) implies that an equal proportionate increase in all inputs leads to a less than proportionate increase in output.
Increasing returns to scale implies that, when all inputs are increased by a given proportion, output increases more than proportionately.
Constant returns to scale implies that output increases in direct proportion to an equal proportionate increase in all inputs.
Decreasing returns to scale implies that an equal proportionate increase in all inputs leads to a less than proportionate increase in output.
These are pure production function relationships, but, if the prices of inputs are fixed for producers, they translate directly into the various cost structures illustrated in Figure 8.5. For example, if a 40% increase in capital and labour use allows for better production flows than when in the smaller plant, and therefore yields more than a 40% increase in output, this implies that the cost per snowboard produced must fall in the new plant. In contrast, if a 40% increase in capital and labour leads to say just a 30% increase in output, then the cost per snowboard in the new larger plant must be higher. Between these extremes, there may be a range of relatively constant unit costs, corresponding to where the production relation is subject to constant returns to scale. In Figure 8.5, the falling unit costs output region has increasing returns to scale, the region that has relatively constant unit costs has constant returns to scale, and the increasing cost region has decreasing returns to scale.
Increasing returns to scale characterize businesses with large initial costs and relatively low costs of producing each unit of output. Computer chip manufacturers, pharmaceutical manufacturers, vehicle rental agencies, booking agencies such as booking.com or hotels.com, intermediaries such as airbnb.com, even brewers, all benefit from scale economies. In the beer market, brewing, bottling and shipping are all low-cost operations relative to the capital cost of setting up a brewery. Consequently, we observe surprisingly few breweries in any brewing company, even in large land-mass economies such as Canada or the US.
In addition to the four short-run average total cost curves, Figure 8.5 contains a curve that forms an envelope around the bottom of these short-run average cost curves. This envelope is the long-run average total cost (LATC) curve, because it defines average cost as we move from one plant size to another. Remember that in the long run both labour and capital are variable, and as we move from one short-run average cost curve to another, that is exactly what happens—all factors of production are variable. Hence, the collection of short-run cost curves in Figure 8.5 provides the ingredients for a long-run average total cost curve1.
Long-run average total cost is the lower envelope of all the short-run ATC curves.
The particular range of output on the LATC where it begins to flatten out is called the range of minimum efficient scale. This is an important concept in industrial policy, as we shall see in later chapters. At such an output level, the producer has expanded sufficiently to take advantage of virtually all the scale economies available.
Minimum efficient scale defines a threshold size of operation such that scale
economies are almost exhausted.
In view of this discussion and the shape of the LATC in Figure 8.5, it is obvious that economies of scale can also be defined in terms of the curvature of the LATC. Where the LATC declines there are IRS, where the LATC is flat there are CRS, where the LATC slopes upward there are DRS.
Table 8.3 LATC elements for two plants (thousands \$)
Q
20 50 30 80 100 25 125
40 25 30 55 50 25 75
60 16.67 30 46.67 33.33 25 58.33
80 12.5 30 42.5 25 25 50
100 10 30 40 20 25 45
120 8.33 30 38.33 16.67 25 41.67
140 7.14 30 37.14 14.29 25 39.29
160 6.25 30 36.25 12.5 25 37.5
180 5.56 30 35.56 11.11 25 36.11
200 5 30 35 10 25 35
220 4.55 30 34.55 9.09 25 34.09
240 4.17 30 34.17 8.33 25 33.33
260 3.85 30 33.85 7.69 25 32.69
280 3.57 30 33.57 7.14 25 32.14
Plant 1 m. Plant 2 m. For Q<200, ; for Q>200, ; and for Q=200, ATC1=ATC2. LATC defined by data in bold font.
Long-run costs – a simple numerical example
Kitt is an automobile designer specializing in the production of off-road vehicles sold to a small clientele. He has a choice of two (and only two) plant sizes; one involving mainly labour and the other employing robots extensively. The set-up (i.e. fixed) costs of these two assembly plants are \$1 million and \$2 million respectively. The advantage to having the more costly plant is that the pure production costs (variable costs) are less. The cost components are defined in Table 8.3. The variable cost (equal to the marginal cost here) is \$30,000 in the plant that relies primarily on labour, and \$25,000 in the plant that has robots. The ATC for each plant size is the sum of AFC and AVC. The AFC declines as the fixed cost is spread over more units produced. The variable cost per unit is constant in each case. By comparing the fourth and final columns, it is clear that the robot-intensive plant has lower costs if it produces a large number of vehicles. At an output of 200 vehicles the average costs in each plant are identical: The higher fixed costs associated with the robots are exactly offset by the lower variable costs at this output level.
The ATC curve corresponding to each plant size is given in Figure 8.6. There are two short-run ATC curves. The positions of these curves indicate that if the manufacturer believes he can produce at least 200 vehicles his unit costs will be less with the plant involving robots; but at output levels less than this his unit costs would be less in the labour-intensive plant.
Figure 8.6 LATC for two plants in \$000
The long-run average cost curve for this producer is the lower envelope of these two cost curves: ATC1 up to output 200 and ATC2 thereafter. Two features of this example are to be noted. First we do not encounter decreasing returns – the LATC curve never increases. ATC1 tends asymptotically to a lower bound of , while ATC2 tends towards . Second, in the interests of simplicity we have assumed just two plant sizes are possible. With more possibilities on the introduction of robots we could imagine more short-run ATC curves which would form the lower-envelope LATC.
8.7 Technological change: globalization and localization
Technological change represents innovation that can reduce the cost of production or bring new products on line. As stated earlier, the very long run is a period that is sufficiently long for new technology to evolve and be implemented.
Technological change represents innovation that can reduce the cost of production or bring new products on line.
Technological change has had an enormous impact on economic life for several centuries. It is not something that is defined in terms of the recent telecommunications revolution. The industrial revolution began in eighteenth century Britain. It was accompanied by a less well-recognized, but equally important, agricultural revolution. The improvement in cultivation technology, and ensuing higher yields, freed up enough labour to populate the factories that were the core of the industrial revolution2. The development and spread of mechanical power dominated the nineteenth century, and the mass production line of Henry Ford in autos or Andrew Carnegie in steel heralded in the twentieth century.
Globalization
The modern communications revolution has reduced costs, just like its predecessors. But it has also greatly sped up globalization, the increasing integration of national markets.
Globalization is the tendency for international markets to be ever more integrated.
Globalization has several drivers: lower transportation and communication costs; reduced barriers to trade and capital mobility; the spread of new technologies that facilitate cost and quality control; different wage rates between developed and less developed economies. New technology and better communications have been critical in both increasing the minimum efficient scale of operation and reducing diseconomies of scale; they facilitate the efficient management of large companies.
The continued reduction in trade barriers in the post-World War II era has also meant that the effective marketplace has become the globe rather than the national economy for many products. Companies like Apple, Microsoft, and Facebook are visible worldwide. Globalization has been accompanied by the collapse of the Soviet Union, the adoption of an outward looking philosophy on the part of China, and an increasing role for the market place in India. These developments together have facilitated the outsourcing of much of the West's manufacturing to lower-wage economies.
But new technology not only helps existing companies grow large; it also enables new ones to start up. It is now cheaper for small producers to manage their inventories and maintain contact with their own suppliers.
The impact of technology is to reduce the cost of production, hence it will lower the average cost curve in both the short and long run. First, decreasing returns to scale become less probable due to improved communications, so the upward sloping section of the LRAC curve may disappear altogether. Second, capital costs are now lower than in earlier times, because much modern technology has transformed some fixed costs into variable cost: Both software and hardware functions can be subcontracted to specialty firms, who in turn may use cloud computing services, and it is thus no longer necessary to have a substantial in-house computing department. The use of almost-free software such as Skype, Hangouts and WhatsApp reduces communication costs. Advertising on social media is more effective and less costly than in traditional hard-print form. Hiring may be cheaper through LinkedIn than through a traditional human resources department. These developments may actually reduce the minimum efficient scale of operation because they reduce the need for large outlays on fixed capital. On the other hand, changes in technology may induce producers to use more capital and less labor, with the passage of time. That would increase the minimum efficient scale. An example of this phenomenon is in mining, or tunnel drilling, where capital investment per worker is greater than when technology was less developed. A further example is the introduction of robotic assistants in Amazon warehouses. In these scenarios the minimum efficient scale should increase, and that is illustrated in Figure 8.7.
Figure 8.7 Technological change and LAC
Technological change reduces the unit production cost for any output produced and may also increase the minimum efficient scale (MES) threshold.
The local diffusion of technology
The impacts of technological change are not just evident in a global context. Technological change impacts every sector of the domestic economy. For example, the modern era in dentistry sees specialists in root canals (endodentists) performing root canals in the space of a single hour with the help of new technology; dental implants into bone, as an alternative to dentures, are commonplace; crowns can be machined with little human intervention; and X-rays are now performed with about one hundredth of the power formerly required. These technologies spread and are adopted through several channels. Dental practices do not usually compete on the basis of price, but if they do not adopt best practices and new technologies, then community word of mouth will see patients shifting to more efficient operators.
Some technological developments are protected by patents. But patent protection rarely inhibits new and more efficient practices that in some way mimic patent breakthroughs.
8.8 Clusters, learning by doing, scope economies
Clusters
The phenomenon of a grouping of firms that specialize in producing related products is called a cluster. For example, Ottawa has more than its share of software development firms; Montreal has a disproportionate share of Canada's pharmaceutical producers and electronic game developers; Calgary has its 'oil patch'; Hollywood has movies; Toronto is Canada's financial capital, San Francisco and Seattle are leaders in new electronic products. Provincial and state capitals have most of their province's bureaucracy. Clusters give rise to externalities, frequently in the form of ideas that flow between firms, which in turn result in cost reductions and new products.
Cluster: a group of firms producing similar products, or engaged in similar research.
The most famous example of clustering is Silicon Valley, surrounding San Francisco, in California, the original high-tech cluster. The presence of a large group of firms with a common focus serves as a signal to workers with the right skill set that they are in demand in such a region. Furthermore, if these clusters are research oriented, as they frequently are, then knowledge spillovers benefit virtually all of the contiguous firms; when workers change employers, they bring their previously-learned skills with them; on social occasions, friends may chat about their work and interests and share ideas. This is a positive externality.
Learning by doing
Learning from production-related experiences frequently reduces costs: The accumulation of knowledge that is associated with having produced a large volume of output over a considerable time period enables managers to implement more efficient production methods and avoid errors. We give the term learning by doing to this accumulation of knowledge.
Examples abound, but the best known may be the continual improvement in the capacity of computer chips, whose efficiency has doubled about every eighteen months for several decades – a phenomenon known as Moore's Law. As Intel Corporation continues to produce chips it learns how to produce each succeeding generation of chips at lower cost. Past experience is key. Economies of scale and learning by doing therefore may not be independent: Large firms usually require time to grow or to attain a dominant role in their market, and this time and experience enables them to produce at lower cost. This lower cost in turn can solidify their market position further.
Learning by doing can reduce costs. A longer history of production enables firms to accumulate knowledge and thereby implement more efficient production processes.
Economies of scope
Economies of scope define a production process if the production of multiple products results in lower unit costs per product than if those products were produced alone. Scope economies, therefore, define the returns or cost reductions associated with broadening a firm's product range.
Corporations like Proctor and Gamble do not produce a single product in their health line; rather, they produce first aid, dental care, and baby care products. Cable companies offer their customers TV, high-speed Internet, and telephone services either individually or packaged. A central component of some new-economy multi-product firms is a technology platform that can be used for multiple purposes. We shall analyze the operation of these firms in more detail in Chapter 11.
Economies of scope occur if the unit cost of producing particular products is less when combined with the production of other products than when produced alone.
A platform is a hardware-cum-software capital installation that has multiple production capabilities
Conclusion
Efficient production is critical to the survival of firms. Firms that do not adopt the most efficient production methods are likely to be left behind by their competitors. Efficiency translates into cost considerations, and the structure of costs in turn has a major impact on market type. Some sectors of the economy have very many firms (the restaurant business or the dry-cleaning business), whereas other sectors have few (internet providers or airlines). We will see in the following chapters how market structures depend critically upon the concept of scale economies that we have developed here.
Key Terms
Production function: a technological relationship that specifies how much output can be produced with specific amounts of inputs.
Technological efficiency means that the maximum output is produced with the given set of inputs.
Economic efficiency defines a production structure that produces output at least cost.
Short run: a period during which at least one factor of production is fixed. If capital is fixed, then more output is produced by using additional labour.
Long run: a period of time that is sufficient to enable all factors of production to be adjusted.
Very long run: a period sufficiently long for new technology to develop.
Total product is the relationship between total output produced and the number of workers employed, for a given amount of capital.
Marginal product of labour is the addition to output produced by each additional worker. It is also the slope of the total product curve.
Law of diminishing returns: when increments of a variable factor (labour) are added to a fixed amount of another factor (capital), the marginal product of the variable factor must eventually decline.
Average product of labour is the number of units of output produced per unit of labour at different levels of employment.
Fixed costs are costs that are independent of the level of output.
Variable costs are related to the output produced.
Total cost is the sum of fixed cost and variable cost.
Average fixed cost is the total fixed cost per unit of output.
Average variable cost is the total variable cost per unit of output.
Average total cost is the sum of all costs per unit of output.
Marginal cost of production is the cost of producing each additional unit of output.
Sunk cost is a fixed cost that has already been incurred and cannot be recovered, even by producing a zero output.
Increasing returns to scale implies that, when all inputs are increased by a given proportion, output increases more than proportionately.
Constant returns to scale implies that output increases in direct proportion to an equal proportionate increase in all inputs.
Decreasing returns to scale implies that an equal proportionate increase in all inputs leads to a less than proportionate increase in output.
Long-run average total cost is the lower envelope of all the short-run ATC curves.
Minimum efficient scale defines a threshold size of operation such that scale economies are almost exhausted.
Long-run marginal cost is the increment in cost associated with producing one more unit of output when all inputs are adjusted in a cost minimizing manner.
Technological change represents innovation that can reduce the cost of production or bring new products on line.
Globalization is the tendency for international markets to be ever more integrated.
Cluster: a group of firms producing similar products, or engaged in similar research.
Learning by doing can reduce costs. A longer history of production enables firms to accumulate knowledge and thereby implement more efficient production processes.
Economies of scope occur if the unit cost of producing particular products is less when combined with the production of other products than when produced alone.
A platform is a hardware-cum-software capital installation that has multiple production capabilities
Exercises for Chapter 8
EXERCISE 8.1
The relationship between output Q and the single variable input L is given by the form . Capital is fixed. This relationship is given in the table below for a range of L values.
L 1 2 3 4 5 6 7 8 9 10 11 12
Q 5 7.07 8.66 10 11.18 12.25 13.23 14.14 15 15.81 16.58 17.32
1. Add a row to this table and compute the MP.
2. Draw the total product (TP) curve to scale, either on graph paper or in a spreadsheet.
3. Inspect your graph to see if it displays diminishing MP.
EXERCISE 8.2
The TP for different output levels for Primitive Products is given in the table below.
Q 1 6 12 20 30 42 53 60 66 70
L 1 2 3 4 5 6 7 8 9 10
1. Graph the TP curve to scale.
2. Add a row to the table and enter the values of the MP of labour. Graph this in a separate diagram.
3. Add a further row and compute the AP of labour. Add it to the graph containing the MP of labour.
4. By inspecting the AP and MP graph, can you tell if you have drawn the curves correctly? How?
EXERCISE 8.3
A short-run relationship between output and total cost is given in the table below.
Output 0 1 2 3 4 5 6 7 8 9
Total Cost 12 27 40 51 61 70 80 91 104 120
1. What is the total fixed cost of production in this example?
2. Add four rows to the table and compute the TVC, AFC, AVC and ATC values for each level of output.
3. Add one more row and compute the MC of producing additional output levels.
4. Graph the MC and AC curves using the information you have developed.
EXERCISE 8.4
Consider the long-run total cost structure for the two firms A and B below.
Output 1 2 3 4 5 6 7
Total cost A 40 52 65 80 97 119 144
Total cost B 30 40 50 60 70 80 90
1. Compute the long-run ATC curve for each firm.
2. Plot these curves and examine the type of scale economies each firm experiences at different output levels.
EXERCISE 8.5
Use the data in Exercise 8.4,
1. Calculate the long-run MC at each level of output for the two firms.
2. Verify in a graph that these LMC values are consistent with the LAC values.
EXERCISE 8.6
Optional: Suppose you are told that a firm of interest has a long-run average total cost that is defined by the relationship LATC=4+48/q.
1. In a table, compute the LATC for output values ranging from . Plot the resulting LATC curve.
2. What kind of returns to scale does this firm never experience?
3. By examining your graph, what will be the numerical value of the LATC as output becomes very large?
4. Can you guess what the form of the long-run MC curve is?
08: Production and cost
Firms that fail to operate efficiently seldom survive. They are dominated by their competitors because the latter produce more efficiently and can sell at a lower price. The drive for profitability is everywhere present in the modern economy. Companies that promise more profit, by being more efficient, are valued more highly on the stock exchange. For example: In July of 2015 Google announced that, going forward, it would be more attentive to cost management in its numerous research endeavours that aim to bring new products to the marketplace. This policy, put in place by the Company's new Chief Financial Officer, was welcomed by investors who, as a result, bought up the stock. The Company's stock increased in value by 16% in one day – equivalent to about \$50 billion.
The remuneration of managers in virtually all corporations is linked to profitability. Efficient production, a.k.a. cost reduction, is critical to achieving this goal. In this chapter we will examine cost management and efficient production from the ground up – by exploring how a small entrepreneur brings his or her product to market in the most efficient way possible. As we shall see, efficient production and cost minimization amount to the same thing: Cost minimization is the financial reflection of efficient production.
Efficient production is critical in any budget-driven organization, not just in the private sector. Public institutions equally are, and should be, concerned with costs and efficiency.
Entrepreneurs employ factors of production (capital and labour) in order to transform raw materials and other inputs into goods or services. The relationship between output and the inputs used in the production process is called a production function. It specifies how much output can be produced with given combinations of inputs. A production function is not restricted to profit-driven organizations. Municipal road repairs are carried out with labour and capital. Students are educated with teachers, classrooms, computers, and books. Each of these is a production process.
Production function: a technological relationship that specifies how much output can be produced with specific amounts of inputs.
Economists distinguish between two concepts of efficiency: One is technological efficiency; the other is economic efficiency. To illustrate the difference, consider the case of auto assembly: the assembler could produce its vehicles either by using a large number of assembly workers and a plant that has a relatively small amount of machinery, or it could use fewer workers accompanied by more machinery in the form of robots. Each of these processes could be deemed technologically efficient, provided that there is no waste. If the workers without robots are combined with their capital to produce as much as possible, then that production process is technologically efficient. Likewise, in the scenario with robots, if the workers and capital are producing as much as possible, then that process too is efficient in the technological sense.
Technological efficiency means that the maximum output is produced with the given set of inputs.
Economic efficiency is concerned with more than just technological efficiency. Since the entrepreneur's goal is to make profit, she must consider which technologically efficient process best achieves that objective. More broadly, any budget-driven process should focus on being economically efficient, whether in the public or private sector. An economically efficient production structure is the one that produces output at least cost.
Economic efficiency defines a production structure that produces output at least cost.
Auto-assembly plants the world over have moved to using robots during the last two decades. Why? The reason is not that robots were invented 20 years ago; they were invented long before that. The real reason is that, until recently, this technology was not economically efficient. Robots were too expensive; they were not capable of high-precision assembly. But once their cost declined and their accuracy increased they became economically efficient. The development of robots represented technological progress. When this progress reached a critical point, entrepreneurs embraced it.
To illustrate the point further, consider the case of garment assembly. There is no doubt that engineers could make robots capable of joining the pieces of fabric that form garments. This is not beyond our technological abilities. Why, then, do we not have such capital-intensive production processes for garment making, similar to the production process chosen by vehicle producers? The answer is that, while such a concept could be technologically efficient, it would not be economically efficient. It is more profitable to use large amounts of labour and relatively traditional machines to assemble garments, particularly when labour in Asia costs less and the garments can be shipped back to Canada inexpensively. Containerization and scale economies in shipping mean that a garment can be shipped to Canada from Asia for a few cents per unit.
Efficiency in production is not limited to the manufacturing sector. Farmers must choose the optimal combination of labour, capital and fertilizer to use. In the health and education sectors, efficient supply involves choices on how many high- and low-skill workers to employ, how much traditional physical capital to use, how much information technology to use, based upon the productivity and cost of each. Professors and physicians are costly inputs. When they work with new technology (capital) they become more efficient at performing their tasks: It is less costly to have a single professor teach in a 300-seat classroom that is equipped with the latest technology, than have several professors each teaching 60-seat classes with chalk and a blackboard. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.01%3A_Efficient_production.txt |
We distinguish initially between the short run and the long run. When discussing technological change, we use the term very long run. These concepts have little to do with clocks or calendars; rather, they are defined by the degree of flexibility an entrepreneur or manager has in her production process. A key decision variable is capital.
A customary assumption is that a producer can hire more labour immediately, if necessary, either by taking on new workers (since there are usually some who are unemployed and looking for work), or by getting the existing workers to work longer hours. In contrast, getting new capital in place is usually more time consuming: The entrepreneur may have to place an order for new machinery, which will involve a production and delivery time lag. Or she may have to move to a more spacious location in order to accommodate the added capital. Whether this calendar time is one week, one month, or one year is of no concern to us. We define the long run as a period of sufficient length to enable the entrepreneur to adjust her capital stock, whereas in the short run at least one factor of production is fixed. Note that it matters little whether it is labour or capital that is fixed in the short run. A software development company may be able to install new capital (computing power) instantaneously but have to train new developers. In such a case capital is variable and labour is fixed in the short run. The definition of the short run is that one of the factors is fixed, and in our examples we will assume that it is capital.
Short run: a period during which at least one factor of production is fixed. If capital is fixed, then more output is produced by using additional labour.
Long run: a period of time that is sufficient to enable all factors of production to be adjusted.
Very long run: a period sufficiently long for new technology to develop.
8.03: Production in the short run
Black Diamond Snowboards (BDS) is a start-up snowboard producing enterprise. Its founder has invented a new lamination process that gives extra strength to his boards. He has set up a production line in his garage that has four workstations: Laminating, attaching the steel edge, waxing, and packing.
With this process in place, he must examine how productive his firm can be. After extensive testing, he has determined exactly how his productivity depends upon the number of workers. If he employs only one worker, then that worker must perform several tasks, and will encounter 'down time' between workstations. Extra workers would therefore not only increase the total output; they could, in addition, increase output per worker. He also realizes that once he has employed a critical number of workers, additional workers may not be so productive: Because they will have to share the fixed amount of machinery in his garage, they may have to wait for another worker to finish using a machine. At such a point, the productivity of his plant will begin to fall off, and he may want to consider capital expansion. But for the moment he is constrained to using this particular assembly plant. Testing leads him to formulate the relationship between workers and output that is described in Table 8.1.
Table 8.1 Snowboard production and productivity
1 2 3 4 5
Workers Output Marginal Average Stages of
(TP) product product production
(MPL) (APL)
0 0 MPL increasing
1 15 15 15
2 40 25 20
3 70 30 23.3
4 110 40 27.5
5 145 35 29 MPL positive and declining
6 175 30 29.2
7 200 25 28.6
8 220 20 27.5
9 235 15 26.1
10 240 5 24.0
11 235 -5 21.4 MPL negative
By increasing the number of workers in the plant, BDS produces more boards. The relationship between these two variables in columns 1 and 2 in the table is plotted in Figure 8.1. This is called the total product function (TP), and it defines the output produced with different amounts of labour in a plant of fixed size.
Figure 8.1 Total product curve
Output increases with the amount of labour used. Initially the increase in output due to using more labour is high, subsequently it is lower. The initial phase characterizes increasing productivity, the later phase defines declining productivity.
Total product is the relationship between total output produced and the number of workers employed, for a given amount of capital.
This relationship is positive, indicating that more workers produce more boards. But the curve has an interesting pattern. In the initial expansion of employment it becomes progressively steeper – its curvature is slightly convex; following this phase the function's increase becomes progressively less steep – its curvature is concave. These different stages in the TP curve tell us a great deal about productivity in BDS. To see this, consider the additional number of boards produced by each worker. The first worker produces 15. When a second worker is hired, the total product rises to 40, so the additional product attributable to the second worker is 25. A third worker increases output by 30 units, and so on. We refer to this additional output as the marginal product (MP) of an additional worker, because it defines the incremental, or marginal, contribution of the worker. These values are entered in column 3.
More generally the MP of labour is defined as the change in output divided by the change in the number of units of labour employed. Using, as before, the Greek capital delta () to denote a change, we can define
In this example the change in labour is one unit at each stage and hence the marginal product of labour is simply the corresponding change in output. It is also the case that the MPL is the slope of the TP curve – the change in the value on the vertical axis due to a change in the value of the variable on the horizontal axis.
Marginal product of labour is the addition to output produced by each additional worker. It is also the slope of the total product curve.
Figure 8.2 Average and marginal product curves
The productivity curves initially rise and then decline, reflecting increasing and decreasing productivity. The MPL curves must intersect the APL curve at the maximum of the APL: The average must increase if the marginal exceeds the average and must decline if the marginal is less than the average.
During the initial stage of production expansion, the marginal product of each worker is increasing. It increases from 15 to 40 as BDS moves from having one employee to four employees. This increasing MP is made possible by the fact that each worker is able to spend more time at his workstation, and less time moving between tasks. But, at a certain point in the employment expansion, the MP reaches a maximum and then begins to tail off. At this stage – in the concave region of the TP curve – additional workers continue to produce additional output, but at a diminishing rate. For example, while the fourth worker adds 40 units to output, the fifth worker adds 35, the sixth worker 30, and so on. This declining MP is due to the constraint of a fixed number of machines: All workers must share the same capital. The MP function is plotted in Figure 8.2.
The phenomenon we have just described has the status of a law in economics: The law of diminishing returns states that, in the face of a fixed amount of capital, the contribution of additional units of a variable factor must eventually decline.
Law of diminishing returns: when increments of a variable factor (labour) are added to a fixed amount of another factor (capital), the marginal product of the variable factor must eventually decline.
The relationship between Figures 8.1 and 8.2 should be noted. First, the MPL reaches a maximum at an output of 4 units – where the slope of the TP curve is greatest. The MPL curve remains positive beyond this output, but declines: The TP curve reaches a maximum when the tenth unit of labour is employed. An eleventh unit actually reduces total output; therefore, the MP of this eleventh worker is negative! In Figure 8.2, the MP curve becomes negative at this point. The garage is now so crowded with workers that they are beginning to obstruct the operation of the production process. Thus the producer would never employ an eleventh unit of labour.
Next, consider the information in the fourth column of the table. It defines the average product of labour (APL)—the amount of output produced, on average, by workers at different employment levels:
This function is also plotted in Figure 8.2. Referring to the table: The AP column indicates, for example, that when two units of labour are employed and forty units of output are produced, the average production level of each worker is 20 units (=40/2). When three workers produce 70 units, their average production is 23.3 (=70/3), and so forth. Like the MP function, this one also increases and subsequently decreases, reflecting exactly the same productivity forces that are at work on the MP curve.
Average product of labour is the number of units of output produced per unit of labour at different levels of employment.
The AP and MP functions intersect at the point where the AP is at its peak. This is no accident, and has a simple explanation. Imagine a softball player who is batting .280 coming into today's game—she has been hitting her way onto base 28 percent of the time when batting, so far this season. This is her average product, AP.
In today's game, if she bats .500 (hits her way to base on half of her at-bats), then she will improve her average. Today's batting (MP) at .500 therefore pulls up the season's AP. Accordingly, whenever the MP exceeds the AP, the AP is pulled up. By the same reasoning, if her MP is less than the season average, her average will be pulled down. It follows that the two functions must intersect at the peak of the AP curve. To summarize:
If the MP exceeds the AP, then the AP increases;
If the MP is less than the AP, then the AP declines.
While the owner of BDS may understand his productivity relations, his ultimate goal is to make profit, and for this he must figure out how productivity translates into cost. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.02%3A_The_time_frame.txt |
The cost structure for the production of snowboards at Black Diamond is illustrated in Table 8.2. Employees are skilled and are paid a weekly wage of \$1,000. The cost of capital is \$3,000 and it is fixed, which means that it does not vary with output. As in Table 8.1, the number of employees and the output are given in the first two columns. The following three columns define the capital costs, the labour costs, and the sum of these in producing different levels of output. We use the terms fixed, variable, and total costs to define the cost structure of a firm. Fixed costs do not vary with output, whereas variable costs do, and total costs are the sum of fixed and variable costs. To keep this example as simple as possible, we will ignore the cost of raw materials. We could add an additional column of costs, but doing so will not change the conclusions.
Table 8.2 Snowboard production costs
Workers Output Capital Labour Total Average Average Average Marginal
cost cost costs fixed variable total cost
fixed variable cost cost cost
0 0 3,000 0 3,000
1 15 3,000 1,000 4,000 200.0 66.7 266.7 66.7
2 40 3,000 2,000 5,000 75.0 50.0 125.0 40.0
3 70 3,000 3,000 6,000 42.9 42.9 85.7 33.3
4 110 3,000 4,000 7,000 27.3 36.4 63.6 25.0
5 145 3,000 5,000 8,000 20.7 34.5 55.2 28.6
6 175 3,000 6,000 9,000 17.1 34.3 51.4 33.3
7 200 3,000 7,000 10,000 15.0 35.0 50.0 40.0
8 220 3,000 8,000 11,000 13.6 36.4 50.0 50.0
9 235 3,000 9,000 12,000 12.8 38.3 51.1 66.7
10 240 3,000 10,000 13,000 12.5 41.7 54.2 200.0
Fixed costs are costs that are independent of the level of output.
Variable costs are related to the output produced.
Total cost is the sum of fixed cost and variable cost.
Total costs are illustrated in Figure 8.3 as the vertical sum of variable and fixed costs. For example, Table 8.2 indicates that the total cost of producing 220 units of output is the sum of \$3,000 in fixed costs plus \$8,000 in variable costs. Therefore, at the output level 220 on the horizontal axis in Figure 8.3, the sum of the cost components yields a value of \$11,000 that forms one point on the total cost curve. Performing a similar calculation for every possible output yields a series of points that together form the complete total cost curve.
Figure 8.3 Total cost curves
Total cost is the vertical sum of the variable and fixed costs.
Average costs are given in the next three columns of Table 8.2. Average cost is the cost per unit of output, and we can define an average cost corresponding to each of the fixed, variable, and total costs defined above. Average fixed cost (AFC) is the total fixed cost divided by output; average variable cost (AVC) is the total variable cost divided by output; and average total cost (ATC) is the total cost divided by output.
AFC
AVC
ATC =AFC+AVC
Average fixed cost is the total fixed cost per unit of output.
Average variable cost is the total variable cost per unit of output.
Average total cost is the sum of all costs per unit of output.
The productivity-cost relationship
Consider the average variable cost - average product relationship, as developed in column 7 of Table 8.2; its corresponding variable cost curve is plotted in Figure 8.4. In this example, AVC first decreases and then increases. The intuition behind its shape is straightforward (and realistic) if you have understood why productivity varies in the short run: The variable cost, which represents the cost of labour, is constant per unit of labour, because the wage paid to each worker does not change. However, each worker's productivity varies. Initially, when we hire more workers, they become more productive, perhaps because they have less 'down time' in switching between tasks. This means that the labour costs per snowboard must decline. At some point, however, the law of diminishing returns sets in: As before, each additional worker is paid a constant amount, but as productivity declines the labour cost per snowboard increases.
Figure 8.4 Average and marginal cost curves
The MC intersects the ATC and AVC at their minimum values. The AFC declines indefinitely as fixed costs are spread over a greater output.
In this numerical example the AP is at a maximum when six units of labour are employed and output is 175. This is also the point where the AVC is at a minimum. This maximum/minimum relationship is also illustrated in Figures 8.2 and 8.4.
Now consider the marginal cost - marginal product relationship. The marginal cost (MC) defines the cost of producing one more unit of output. In Table 8.2, the marginal cost of output is given in the final column. It is the additional cost of production divided by the additional number of units produced. For example, in going from 15 units of output to 40, total costs increase from \$4,000 to \$5,000. The MC is the cost of those additional units divided by the number of additional units. In this range of output, MC is . We could also calculate the MC as the addition to variable costs rather than the addition to total costs, because the addition to each is the same—fixed costs are fixed. Hence:
MC
Marginal cost of production is the cost of producing each additional unit of output.
Just as the behaviour of the AVC curve is determined by the AP curve, so too the behaviour of the MC is determined by the MP curve. When the MP of an additional worker exceeds the MP of the previous worker, this implies that the cost of the additional output produced by the last worker hired must be declining. To summarize:
If the marginal product of labour increases, then the marginal cost of output declines;
If the marginal product of labour declines, then the marginal cost of output increases.
In our example, the reaches a maximum when the fourth unit of labour is employed (or 110 units of output are produced), and this also is where the MC is at a minimum. This illustrates that the marginal cost reaches a minimum at the output level where the marginal product reaches a maximum.
The average total cost is the sum of the fixed cost per unit of output and the variable cost per unit of output. Typically, fixed costs are the dominant component of total costs at low output levels, but become less dominant at higher output levels. Unlike average variable costs, note that the average fixed cost must always decline with output, because a fixed cost is being spread over more units of output. Hence, when the ATC curve eventually increases, it is because the increasing variable cost component eventually dominates the declining AFC component. In our example, this occurs when output increases from 220 units (8 workers) to 235 (9 workers).
Finally, observe the interrelationship between the MC curve on the one hand and the ATC and AVC on the other. Note from Figure 8.4 that the MC cuts the AVC and the ATC at the minimum point of each of the latter. The logic behind this pattern is analogous to the logic of the relationship between marginal and average product curves: When the cost of an additional unit of output is less than the average, this reduces the average cost; whereas, if the cost of an additional unit of output is above the average, this raises the average cost. This must hold true regardless of whether we relate the MC to the ATC or the AVC.
When the marginal cost is less than the average cost, the average cost must decline;
When the marginal cost exceeds the average cost, the average cost must increase.
Notation: We use both the abbreviations and to denote average total cost. The term 'average cost' is understood in economics to include both fixed and variable costs.
Teams and services
The choice faced by the producer in the example above is slightly 'stylized', yet it still provides an appropriate rule for analyzing hiring decisions. In practice, it is quite difficult to isolate or identify the marginal product of an individual worker. One reason is that individuals work in teams within organizations. The accounting department, the marketing department, the sales department, the assembly unit, the chief executive's unit are all composed of teams. Adding one more person to human resources may have no impact on the number of units of output produced by the company in a measurable way, but it may influence worker morale and hence longer-term productivity. Nonetheless, if we consider expanding, or contracting, any one department within an organization, management can attempt to estimate the net impact of additional hires (or layoffs) on the contribution of each team to the firm's profitability. Adding a person in marketing may increase sales, laying off a person in research and development may reduce costs by more than it reduces future value to the firm. In practice this is what firms do: they attempt to assess the contribution of each team in their organization to costs and revenues, and on that basis determine the appropriate number of employees.
The manufacturing sector of the macro economy is dominated, sizewise, by the services sector. But the logic that drives hiring decisions, as developed above, applies equally to services. For example, how does a law firm determine the optimal number of paralegals to employ per lawyer? How many nurses are required to support a surgeon? How many university professors are required to teach a given number of students?
All of these employment decisions involve optimization at the margin. The goal of the decision maker is not always profit, but she should attempt to estimate the cost and value of adding personnel at the margin. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.04%3A_Costs_in_the_short_run.txt |
The distinction between fixed and variable costs is important for producers who are not making a profit. If a producer has committed himself to setting up a plant, then he has made a decision to incur a fixed cost. Having done this, he must now decide on a production strategy that will maximize profit. However, the price that consumers are willing to pay may not be sufficient to yield a profit. So, if Black Diamond Snowboards cannot make a profit, should it shut down? The answer is that if it can cover its variable costs, having already incurred its fixed costs, it should stay in production, at least temporarily. By covering the variable cost of its operation, Black Diamond is at least earning some return. A sunk cost is a fixed cost that has already been incurred and cannot be recovered. But if the pressures of the marketplace are so great that the total costs cannot be covered in the longer run, then this is not a profitable business and the firm should close its doors.
Is a fixed cost always a sunk cost? No: Any production that involves capital will incur a fixed cost component. Such capital can be financed in several ways however: It might be financed on a very short-term lease basis, or it might have been purchased by the entrepreneur. If it is leased on a month-to-month basis, an unprofitable entrepreneur who can only cover variable costs (and who does not foresee better market conditions ahead) can exit the industry quickly – by not renewing the lease on the capital. But an individual who has actually purchased equipment that cannot readily be resold has essentially sunk money into the fixed cost component of his production. This entrepreneur should continue to produce as long as he can cover variable costs.
Sunk cost is a fixed cost that has already been incurred and cannot be recovered, even by producing a zero output.
R & D as a sunk cost
Sunk costs in the modern era are frequently in the form of research and development costs, not the cost of building a plant or purchasing machinery. The prototypical example is the pharmaceutical industry, where it is becoming progressively more challenging to make new drug breakthroughs – both because the 'easier' breakthroughs have already been made, and because it is necessary to meet tighter safety conditions attaching to new drugs. Research frequently leads to drugs that are not sufficiently effective in meeting their target. As a consequence, the pharmaceutical sector regularly writes off hundreds of millions of dollars of lost sunk costs – unfruitful research and development.
Finally, we need to keep in mind the opportunity costs of running the business. The owner pays himself a salary, and ultimately he must recognize that the survival of the business should not depend upon his drawing a salary that is less than his opportunity cost. As developed in Section 7.2, if he underpays himself in order to avoid shutting down, he might be better off in the long run to close the business and earn his opportunity cost elsewhere in the marketplace.
A dynamic setting
We need to ask why it might be possible to cover all costs in a longer run horizon, while in the near-term costs are not covered. The principal reason is that demand may grow, particularly for a new product. For example, in 2019 numerous cannabis producing firms were listed on the Canadian Securities Exchange, and collectively were valued at about fifty billion dollars. None had revenues that covered costs, yet investors poured money into this sector. Investors evidently envisaged that the market for legal cannabis would grow. As of 2020 it appears that these investors were excessively optimistic. Sales growth has been slow and stock valuations have plummeted. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.05%3A_Fixed_costs_and_sunk_costs.txt |
The snowboard manufacturer we portray produces a relatively low level of output; in reality, millions of snowboards are produced each year in the global market. Black Diamond Snowboards may have hoped to get a start by going after a local market—the "free-ride" teenagers at Mont Sainte Anne in Quebec or at Fernie in British Columbia. If this business takes off, the owner must increase production, take the business out of his garage and set up a larger-scale operation. But how will this affect his cost structure? Will he be able to produce boards at a lower cost than when he was producing a very limited number of boards each season? Real-world experience would indicate yes.
Production costs almost always decline when the scale of the operation initially increases. We refer to this phenomenon simply as economies of scale. There are several reasons why scale economies are encountered. One is that production flows can be organized in a more efficient manner when more is being produced. Another is that the opportunity to make greater use of task specialization presents itself; for example, Black Diamond Snowboards may be able to subdivide tasks within the laminating and packaging stations. With a larger operating scale the replacement of labor with capital may be economically efficient. If scale economies do define the real world, then a bigger plant—one that is geared to produce a higher level of output—should have an average total cost curve that is "lower" than the cost curve corresponding to the smaller scale of operation we considered in the example above.
Average costs in the long run
Figure 8.5 illustrates a possible relationship between the ATC curves for four different scales of operation. is the average total cost curve associated with a small-sized plant; think of it as the plant built in the entrepreneur's garage. is associated with a somewhat larger plant, perhaps one she has put together in a rented industrial or commercial space. The further a cost curve is located to the right of the diagram the larger the production facility it defines, given that output is measured on the horizontal axis. If there are economies associated with a larger scale of operation, then the average costs associated with producing larger outputs in a larger plant should be lower than the average costs associated with lower outputs in a smaller plant, assuming that the plants are producing the output levels they were designed to produce. For this reason, the cost curve and the cost curve each have a segment that is lower than the lowest segment on . However, in Figure 8.5 the cost curve has moved upwards. What behaviours are implied here?
Figure 8.5 Long-run and short-run average costs
The long-run ATC curve, LATC, is the lower envelope of all short-run ATC curves. It defines the least cost per unit of output when all inputs are variable. Minimum efficient scale is that output level at which the LATC is a minimum, indicating that further increases in the scale of production will not reduce unit costs.
In many production environments, beyond some large scale of operation, it becomes increasingly difficult to reap further cost reductions from specialization, organizational economies, or marketing economies. At such a point, the scale economies are effectively exhausted, and larger plant sizes no longer give rise to lower (short-run) ATC curves. This is reflected in the similarity of the and the curves. The pattern suggests that we have almost exhausted the possibilities of further scale advantages once we build a plant size corresponding to . Consider next what is implied by the position of the curve relative to the and curves. The relatively higher position of the curve implies that unit costs will be higher in a yet larger plant. Stated differently: If we increase the scale of this firm to extremely high output levels, we are actually encountering diseconomies of scale. Diseconomies of scale imply that unit costs increase as a result of the firm's becoming too large: Perhaps co-ordination difficulties have set in at the very high output levels, or quality-control monitoring costs have risen. These coordination and management difficulties are reflected in increasing unit costs in the long run.
The terms increasing, constant, and decreasing returns to scale underlie the concepts of scale economies and diseconomies: Increasing returns to scale (IRS) implies that, when all inputs are increased by a given proportion, output increases more than proportionately. Constant returns to scale (CRS) implies that output increases in direct proportion to an equal proportionate increase in all inputs. Decreasing returns to scale (DRS) implies that an equal proportionate increase in all inputs leads to a less than proportionate increase in output.
Increasing returns to scale implies that, when all inputs are increased by a given proportion, output increases more than proportionately.
Constant returns to scale implies that output increases in direct proportion to an equal proportionate increase in all inputs.
Decreasing returns to scale implies that an equal proportionate increase in all inputs leads to a less than proportionate increase in output.
These are pure production function relationships, but, if the prices of inputs are fixed for producers, they translate directly into the various cost structures illustrated in Figure 8.5. For example, if a 40% increase in capital and labour use allows for better production flows than when in the smaller plant, and therefore yields more than a 40% increase in output, this implies that the cost per snowboard produced must fall in the new plant. In contrast, if a 40% increase in capital and labour leads to say just a 30% increase in output, then the cost per snowboard in the new larger plant must be higher. Between these extremes, there may be a range of relatively constant unit costs, corresponding to where the production relation is subject to constant returns to scale. In Figure 8.5, the falling unit costs output region has increasing returns to scale, the region that has relatively constant unit costs has constant returns to scale, and the increasing cost region has decreasing returns to scale.
Increasing returns to scale characterize businesses with large initial costs and relatively low costs of producing each unit of output. Computer chip manufacturers, pharmaceutical manufacturers, vehicle rental agencies, booking agencies such as booking.com or hotels.com, intermediaries such as airbnb.com, even brewers, all benefit from scale economies. In the beer market, brewing, bottling and shipping are all low-cost operations relative to the capital cost of setting up a brewery. Consequently, we observe surprisingly few breweries in any brewing company, even in large land-mass economies such as Canada or the US.
In addition to the four short-run average total cost curves, Figure 8.5 contains a curve that forms an envelope around the bottom of these short-run average cost curves. This envelope is the long-run average total cost (LATC) curve, because it defines average cost as we move from one plant size to another. Remember that in the long run both labour and capital are variable, and as we move from one short-run average cost curve to another, that is exactly what happens—all factors of production are variable. Hence, the collection of short-run cost curves in Figure 8.5 provides the ingredients for a long-run average total cost curve1.
Long-run average total cost is the lower envelope of all the short-run ATC curves.
The particular range of output on the LATC where it begins to flatten out is called the range of minimum efficient scale. This is an important concept in industrial policy, as we shall see in later chapters. At such an output level, the producer has expanded sufficiently to take advantage of virtually all the scale economies available.
Minimum efficient scale defines a threshold size of operation such that scale
economies are almost exhausted.
In view of this discussion and the shape of the LATC in Figure 8.5, it is obvious that economies of scale can also be defined in terms of the curvature of the LATC. Where the LATC declines there are IRS, where the LATC is flat there are CRS, where the LATC slopes upward there are DRS.
Table 8.3 LATC elements for two plants (thousands \$)
Q
20 50 30 80 100 25 125
40 25 30 55 50 25 75
60 16.67 30 46.67 33.33 25 58.33
80 12.5 30 42.5 25 25 50
100 10 30 40 20 25 45
120 8.33 30 38.33 16.67 25 41.67
140 7.14 30 37.14 14.29 25 39.29
160 6.25 30 36.25 12.5 25 37.5
180 5.56 30 35.56 11.11 25 36.11
200 5 30 35 10 25 35
220 4.55 30 34.55 9.09 25 34.09
240 4.17 30 34.17 8.33 25 33.33
260 3.85 30 33.85 7.69 25 32.69
280 3.57 30 33.57 7.14 25 32.14
Plant 1 m. Plant 2 m. For Q<200, ; for Q>200, ; and for Q=200, ATC1=ATC2. LATC defined by data in bold font.
Long-run costs – a simple numerical example
Kitt is an automobile designer specializing in the production of off-road vehicles sold to a small clientele. He has a choice of two (and only two) plant sizes; one involving mainly labour and the other employing robots extensively. The set-up (i.e. fixed) costs of these two assembly plants are \$1 million and \$2 million respectively. The advantage to having the more costly plant is that the pure production costs (variable costs) are less. The cost components are defined in Table 8.3. The variable cost (equal to the marginal cost here) is \$30,000 in the plant that relies primarily on labour, and \$25,000 in the plant that has robots. The ATC for each plant size is the sum of AFC and AVC. The AFC declines as the fixed cost is spread over more units produced. The variable cost per unit is constant in each case. By comparing the fourth and final columns, it is clear that the robot-intensive plant has lower costs if it produces a large number of vehicles. At an output of 200 vehicles the average costs in each plant are identical: The higher fixed costs associated with the robots are exactly offset by the lower variable costs at this output level.
The ATC curve corresponding to each plant size is given in Figure 8.6. There are two short-run ATC curves. The positions of these curves indicate that if the manufacturer believes he can produce at least 200 vehicles his unit costs will be less with the plant involving robots; but at output levels less than this his unit costs would be less in the labour-intensive plant.
Figure 8.6 LATC for two plants in \$000
The long-run average cost curve for this producer is the lower envelope of these two cost curves: ATC1 up to output 200 and ATC2 thereafter. Two features of this example are to be noted. First we do not encounter decreasing returns – the LATC curve never increases. ATC1 tends asymptotically to a lower bound of , while ATC2 tends towards . Second, in the interests of simplicity we have assumed just two plant sizes are possible. With more possibilities on the introduction of robots we could imagine more short-run ATC curves which would form the lower-envelope LATC. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.06%3A_Long-run_production_and_costs.txt |
Technological change represents innovation that can reduce the cost of production or bring new products on line. As stated earlier, the very long run is a period that is sufficiently long for new technology to evolve and be implemented.
Technological change represents innovation that can reduce the cost of production or bring new products on line.
Technological change has had an enormous impact on economic life for several centuries. It is not something that is defined in terms of the recent telecommunications revolution. The industrial revolution began in eighteenth century Britain. It was accompanied by a less well-recognized, but equally important, agricultural revolution. The improvement in cultivation technology, and ensuing higher yields, freed up enough labour to populate the factories that were the core of the industrial revolution2. The development and spread of mechanical power dominated the nineteenth century, and the mass production line of Henry Ford in autos or Andrew Carnegie in steel heralded in the twentieth century.
Globalization
The modern communications revolution has reduced costs, just like its predecessors. But it has also greatly sped up globalization, the increasing integration of national markets.
Globalization is the tendency for international markets to be ever more integrated.
Globalization has several drivers: lower transportation and communication costs; reduced barriers to trade and capital mobility; the spread of new technologies that facilitate cost and quality control; different wage rates between developed and less developed economies. New technology and better communications have been critical in both increasing the minimum efficient scale of operation and reducing diseconomies of scale; they facilitate the efficient management of large companies.
The continued reduction in trade barriers in the post-World War II era has also meant that the effective marketplace has become the globe rather than the national economy for many products. Companies like Apple, Microsoft, and Facebook are visible worldwide. Globalization has been accompanied by the collapse of the Soviet Union, the adoption of an outward looking philosophy on the part of China, and an increasing role for the market place in India. These developments together have facilitated the outsourcing of much of the West's manufacturing to lower-wage economies.
But new technology not only helps existing companies grow large; it also enables new ones to start up. It is now cheaper for small producers to manage their inventories and maintain contact with their own suppliers.
The impact of technology is to reduce the cost of production, hence it will lower the average cost curve in both the short and long run. First, decreasing returns to scale become less probable due to improved communications, so the upward sloping section of the LRAC curve may disappear altogether. Second, capital costs are now lower than in earlier times, because much modern technology has transformed some fixed costs into variable cost: Both software and hardware functions can be subcontracted to specialty firms, who in turn may use cloud computing services, and it is thus no longer necessary to have a substantial in-house computing department. The use of almost-free software such as Skype, Hangouts and WhatsApp reduces communication costs. Advertising on social media is more effective and less costly than in traditional hard-print form. Hiring may be cheaper through LinkedIn than through a traditional human resources department. These developments may actually reduce the minimum efficient scale of operation because they reduce the need for large outlays on fixed capital. On the other hand, changes in technology may induce producers to use more capital and less labor, with the passage of time. That would increase the minimum efficient scale. An example of this phenomenon is in mining, or tunnel drilling, where capital investment per worker is greater than when technology was less developed. A further example is the introduction of robotic assistants in Amazon warehouses. In these scenarios the minimum efficient scale should increase, and that is illustrated in Figure 8.7.
Figure 8.7 Technological change and LAC
Technological change reduces the unit production cost for any output produced and may also increase the minimum efficient scale (MES) threshold.
The local diffusion of technology
The impacts of technological change are not just evident in a global context. Technological change impacts every sector of the domestic economy. For example, the modern era in dentistry sees specialists in root canals (endodentists) performing root canals in the space of a single hour with the help of new technology; dental implants into bone, as an alternative to dentures, are commonplace; crowns can be machined with little human intervention; and X-rays are now performed with about one hundredth of the power formerly required. These technologies spread and are adopted through several channels. Dental practices do not usually compete on the basis of price, but if they do not adopt best practices and new technologies, then community word of mouth will see patients shifting to more efficient operators.
Some technological developments are protected by patents. But patent protection rarely inhibits new and more efficient practices that in some way mimic patent breakthroughs. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.07%3A_Technological_change-_globalization_and_localization.txt |
Clusters
The phenomenon of a grouping of firms that specialize in producing related products is called a cluster. For example, Ottawa has more than its share of software development firms; Montreal has a disproportionate share of Canada's pharmaceutical producers and electronic game developers; Calgary has its 'oil patch'; Hollywood has movies; Toronto is Canada's financial capital, San Francisco and Seattle are leaders in new electronic products. Provincial and state capitals have most of their province's bureaucracy. Clusters give rise to externalities, frequently in the form of ideas that flow between firms, which in turn result in cost reductions and new products.
Cluster: a group of firms producing similar products, or engaged in similar research.
The most famous example of clustering is Silicon Valley, surrounding San Francisco, in California, the original high-tech cluster. The presence of a large group of firms with a common focus serves as a signal to workers with the right skill set that they are in demand in such a region. Furthermore, if these clusters are research oriented, as they frequently are, then knowledge spillovers benefit virtually all of the contiguous firms; when workers change employers, they bring their previously-learned skills with them; on social occasions, friends may chat about their work and interests and share ideas. This is a positive externality.
Learning by doing
Learning from production-related experiences frequently reduces costs: The accumulation of knowledge that is associated with having produced a large volume of output over a considerable time period enables managers to implement more efficient production methods and avoid errors. We give the term learning by doing to this accumulation of knowledge.
Examples abound, but the best known may be the continual improvement in the capacity of computer chips, whose efficiency has doubled about every eighteen months for several decades – a phenomenon known as Moore's Law. As Intel Corporation continues to produce chips it learns how to produce each succeeding generation of chips at lower cost. Past experience is key. Economies of scale and learning by doing therefore may not be independent: Large firms usually require time to grow or to attain a dominant role in their market, and this time and experience enables them to produce at lower cost. This lower cost in turn can solidify their market position further.
Learning by doing can reduce costs. A longer history of production enables firms to accumulate knowledge and thereby implement more efficient production processes.
Economies of scope
Economies of scope define a production process if the production of multiple products results in lower unit costs per product than if those products were produced alone. Scope economies, therefore, define the returns or cost reductions associated with broadening a firm's product range.
Corporations like Proctor and Gamble do not produce a single product in their health line; rather, they produce first aid, dental care, and baby care products. Cable companies offer their customers TV, high-speed Internet, and telephone services either individually or packaged. A central component of some new-economy multi-product firms is a technology platform that can be used for multiple purposes. We shall analyze the operation of these firms in more detail in Chapter 11.
Economies of scope occur if the unit cost of producing particular products is less when combined with the production of other products than when produced alone.
A platform is a hardware-cum-software capital installation that has multiple production capabilities
8.09: Conclusion
Efficient production is critical to the survival of firms. Firms that do not adopt the most efficient production methods are likely to be left behind by their competitors. Efficiency translates into cost considerations, and the structure of costs in turn has a major impact on market type. Some sectors of the economy have very many firms (the restaurant business or the dry-cleaning business), whereas other sectors have few (internet providers or airlines). We will see in the following chapters how market structures depend critically upon the concept of scale economies that we have developed here. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.08%3A_Clusters_learning_by_doing_scope_economics.txt |
Production function: a technological relationship that specifies how much output can be produced with specific amounts of inputs.
Technological efficiency means that the maximum output is produced with the given set of inputs.
Economic efficiency defines a production structure that produces output at least cost.
Short run: a period during which at least one factor of production is fixed. If capital is fixed, then more output is produced by using additional labour.
Long run: a period of time that is sufficient to enable all factors of production to be adjusted.
Very long run: a period sufficiently long for new technology to develop.
Total product is the relationship between total output produced and the number of workers employed, for a given amount of capital.
Marginal product of labour is the addition to output produced by each additional worker. It is also the slope of the total product curve.
Law of diminishing returns: when increments of a variable factor (labour) are added to a fixed amount of another factor (capital), the marginal product of the variable factor must eventually decline.
Average product of labour is the number of units of output produced per unit of labour at different levels of employment.
Fixed costs are costs that are independent of the level of output.
Variable costs are related to the output produced.
Total cost is the sum of fixed cost and variable cost.
Average fixed cost is the total fixed cost per unit of output.
Average variable cost is the total variable cost per unit of output.
Average total cost is the sum of all costs per unit of output.
Marginal cost of production is the cost of producing each additional unit of output.
Sunk cost is a fixed cost that has already been incurred and cannot be recovered, even by producing a zero output.
Increasing returns to scale implies that, when all inputs are increased by a given proportion, output increases more than proportionately.
Constant returns to scale implies that output increases in direct proportion to an equal proportionate increase in all inputs.
Decreasing returns to scale implies that an equal proportionate increase in all inputs leads to a less than proportionate increase in output.
Long-run average total cost is the lower envelope of all the short-run ATC curves.
Minimum efficient scale defines a threshold size of operation such that scale economies are almost exhausted.
Long-run marginal cost is the increment in cost associated with producing one more unit of output when all inputs are adjusted in a cost minimizing manner.
Technological change represents innovation that can reduce the cost of production or bring new products on line.
Globalization is the tendency for international markets to be ever more integrated.
Cluster: a group of firms producing similar products, or engaged in similar research.
Learning by doing can reduce costs. A longer history of production enables firms to accumulate knowledge and thereby implement more efficient production processes.
Economies of scope occur if the unit cost of producing particular products is less when combined with the production of other products than when produced alone.
A platform is a hardware-cum-software capital installation that has multiple production capabilities
8.11: Exercises for Chapter 8
EXERCISE 8.1
The relationship between output Q and the single variable input L is given by the form . Capital is fixed. This relationship is given in the table below for a range of L values.
L 1 2 3 4 5 6 7 8 9 10 11 12
Q 5 7.07 8.66 10 11.18 12.25 13.23 14.14 15 15.81 16.58 17.32
1. Add a row to this table and compute the MP.
2. Draw the total product (TP) curve to scale, either on graph paper or in a spreadsheet.
3. Inspect your graph to see if it displays diminishing MP.
EXERCISE 8.2
The TP for different output levels for Primitive Products is given in the table below.
Q 1 6 12 20 30 42 53 60 66 70
L 1 2 3 4 5 6 7 8 9 10
1. Graph the TP curve to scale.
2. Add a row to the table and enter the values of the MP of labour. Graph this in a separate diagram.
3. Add a further row and compute the AP of labour. Add it to the graph containing the MP of labour.
4. By inspecting the AP and MP graph, can you tell if you have drawn the curves correctly? How?
EXERCISE 8.3
A short-run relationship between output and total cost is given in the table below.
Output 0 1 2 3 4 5 6 7 8 9
Total Cost 12 27 40 51 61 70 80 91 104 120
1. What is the total fixed cost of production in this example?
2. Add four rows to the table and compute the TVC, AFC, AVC and ATC values for each level of output.
3. Add one more row and compute the MC of producing additional output levels.
4. Graph the MC and AC curves using the information you have developed.
EXERCISE 8.4
Consider the long-run total cost structure for the two firms A and B below.
Output 1 2 3 4 5 6 7
Total cost A 40 52 65 80 97 119 144
Total cost B 30 40 50 60 70 80 90
1. Compute the long-run ATC curve for each firm.
2. Plot these curves and examine the type of scale economies each firm experiences at different output levels.
EXERCISE 8.5
Use the data in Exercise 8.4,
1. Calculate the long-run MC at each level of output for the two firms.
2. Verify in a graph that these LMC values are consistent with the LAC values.
EXERCISE 8.6
Optional: Suppose you are told that a firm of interest has a long-run average total cost that is defined by the relationship LATC=4+48/q.
1. In a table, compute the LATC for output values ranging from . Plot the resulting LATC curve.
2. What kind of returns to scale does this firm never experience?
3. By examining your graph, what will be the numerical value of the LATC as output becomes very large?
4. Can you guess what the form of the long-run MC curve is? | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/03%3A_Decision_Making_by_Consumer_and_Producers/08%3A_Production_and_cost/8.10%3A_Key_Terms.txt |
Chapter 9: Perfect competition
In this chapter we will explore:
9.1
The competitive marketplace
9.2
Market characteristics
9.3
Supply in the short run
9.4
Dynamics: Entry and exit
9.5
Industry supply in the long run
9.6
Globalization and technological change
9.7
Perfect competition and market efficiency
9.1 The perfect competition paradigm
A competitive market is one that encompasses a very large number of suppliers, each producing a similar or identical product. Each supplier produces an output that forms a small part of the total market, and the sum of all of these individual outputs represents the production of that sector of the economy. Florists, barber shops, corner stores and dry cleaners all fit this description.
At the other extreme, a market that has just a single supplier is a monopolist. For example, the National Hockey League is the sole supplier of top-quality professional hockey games in North America; Hydro Quebec is a monopoly electricity distributor in Quebec; Via Rail is the only supplier of passenger rail services between Windsor, Ontario and the city of Quebec.
We use the word 'paradigm' in the title to this section: It implies that we will develop a model of supply behaviour for a market in which there are many small suppliers, producing essentially the same product, competing with one-another to meet the demands of consumers.
The structures that we call perfect competition and monopoly are extremes in the market place. Most sectors of the economy lie somewhere between these limiting cases. For example, the market for internet services usually contains several providers in any area – some provide using a fibre cable, others by satellite. The market for smart-phones in North America is dominated by two major players – Apple and Samsung (although there are several others). Hence, while these markets that have a limited number of suppliers are competitive in that they freely and perhaps fiercely compete for the buyer's expenditure, these are not perfectly competitive markets, because they do not have a very large number of suppliers.
In all of the models we develop in this chapter we will assume that the objective of firms is to maximize profit – the difference between revenues and costs.
A perfectly competitive industry is one in which many suppliers, producing an identical product, face many buyers, and no one participant can influence the market.
Profit maximization is the goal of competitive suppliers – they seek to maximize the difference between revenues and costs.
The presence of so many sellers in perfect competition means that each firm recognizes its own small size in relation to the total market, and that its actions have no perceptible impact on the market price for the good or service being traded. Each firm is therefore a price taker—in contrast to a monopolist, who is a price setter.
The same 'smallness' characteristic was assumed when we examined the demands of individuals earlier. Each buyer takes the price as given. He or she is not big enough to be able to influence the price. In contrast, when international airlines purchase or lease aircraft from Boeing or Airbus, they negotiate over the price and other conditions of supply. The market models underlying these types of transactions are examined in Chapter 11.
Hence, when we describe a market as being perfectly competitive we do not mean that other market types are not competitive; all market structure are competitive in the sense that the suppliers wish to make profit, and they produce as efficiently as possible in order to meet that goal.
9.2 Market characteristics
The key attributes of a perfectly competitive market are the following:
1. There must be many firms, each one so small that it cannot influence price or quantity in the industry, and powerless relative to the entire industry.
2. The product must be standardized. Barber shops offer a standard product, but a Lexus differs from a Ford. Barbers tend to be price takers, but Lexus does not charge the same price as Ford, and is a price setter.
3. Buyers are assumed to have full information about the product and its pricing. For example, buyers know that the products of different suppliers really are the same in quality.
4. There are many buyers.
5. There is free entry and exit of firms.
In terms of the demand curve that suppliers face, these market characteristics imply that the demand curve facing the perfectly competitive firm is horizontal, or infinitely elastic, as we defined in Chapter 4. In contrast, the demand curve facing the whole industry is downward sloping. The demand curve facing a firm is represented in Figure 9.1. It implies that the supplier can sell any output he chooses at the going price . He is a small player in the market, and variations in his output have no perceptible impact in the marketplace. But what quantity should he choose, or what quantity will maximize his profit? The profit-maximizing choice is his target, and the MC curve plays a key role in this decision.
9.3 The firm's supply decision
The concept of marginal revenue is key to analyzing the supply decision of an individual firm. We have used marginal analysis at several points to date. In consumer theory, we saw how consumers balance the utility per dollar at the margin in allocating their budget. Marginal revenue is the additional revenue accruing to the firm from the sale of one more unit of output.
Marginal revenue is the additional revenue accruing to the firm resulting from the sale of one more unit of output.
In perfect competition, a firm's marginal revenue (MR) is the price of the good. Since the price is constant for the individual supplier, each additional unit sold at the price P brings in the same additional revenue. Therefore, P=MR. For example, whether a dry cleaning business launders 10 shirts or 100 shirts per day, the price charged to customers is the same. This equality holds in no other market structure, as we shall see in the following chapters.
Supply in the short run
Recall how we defined the short run in the previous chapter: Each firm's plant size is fixed in the short run, so too is the number of firms in an industry. In the long run, each individual firm can change its scale of operation, and at the same time new firms can enter or existing firms can leave the industry.
Perfectly competitive suppliers face the choice of how much to produce at the going market price: That is, the amount that will maximize their profit. We abstract for the moment on how the price in the marketplace is determined. We shall see later in this chapter that it emerges as the value corresponding to the intersection of the supply and demand curves for the whole market – as described in Chapter 3.
The firm's MC curve is critical in defining the optimal amount to supply at any price. In Figure 9.1, MC is the firm's marginal cost curve in the short run. At the price the optimal amount to supply is , the amount determined by the intersection of the MC and the demand. To see why, imagine that the producer chose to supply the quantity . Such an output would leave the opportunity for further profit untapped. By producing one additional unit beyond , the supplier would get in additional revenue and incur an additional cost that is less than in producing this unit. In fact, on every unit between and he can make a profit, because the MR exceeds the associated cost, MC. By the same argument, it makes no sense to increase output beyond , to for example, because the cost of such additional units of output, MC, exceeds the revenue from them. The MC therefore defines an optimal supply response.
Figure 9.1 The competitive firm's optimal output
Here, q0 represents the optimal supply decision when the price is P0. At output q1 the cost of additional units is less than the revenue from such units and therefore it is profitable to increase output beyond q1. Conversely, at q2 the MC of production exceeds the revenue obtained, and so output should be reduced.
Application Box 9.1 The law of one price
If information does not flow then prices in different parts of a market may differ and potential entrants may not know to enter a profitable market.
Consider the fishermen off the coast of Kerala, India in the late 1990s. Their market was studied by Robert Jensen, a development economist. Prior to 1997, fishermen tended to bring their fish to their home market or port. This was cheaper than venturing to other ports, particularly if there was no certainty regarding price. This practice resulted in prices that were high in some local markets and low in others – depending upon the daily catch. Frequently fish was thrown away in low-price markets even though it might have found a favourable price in another village's fish market.
This all changed with the advent of cell phones. Rather than head automatically to their home port, fishermen began to phone several different markets in the hope of finding a good price for their efforts. They began to form agreements with buyers before even bringing their catch to port. Economist Jensen observed a major decline in price variation between the markets that he surveyed. In effect the 'law of one price' came into being for sardines as a result of the introduction of cheap technology and the relatively free flow of information.
While the choice of the output is the best choice for the producer, Figure 9.1 does not tell us anything about profit. For that we need more information on costs. Accordingly, in Figure 9.2 the firm's AVC and ATC curves have been added to Figure 9.1. As explained in the previous chapter, the ATC curve includes both fixed and variable cost components, and the MC curve cuts the AVC and the ATC at their minima.
Figure 9.2 Short-run supply for the competitive firm
A price below P1 does not cover variable costs, so the firm should shut down. Between prices P1 and P3, the producer can cover variable, but not total, costs and therefore should produce in the short run if fixed costs are 'sunk'. In the long run the firm must close if the price does not reach P3. Profits are made if the price exceeds P3. The short-run supply curve is the quantity supplied at each price. It is therefore the MC curve above P1.
First, note that any price below , which corresponds to the minimum of the ATC curve, yields no profit, since it does not enable the producer to cover all of his costs. This price is therefore called the break-even price. Second, any price below , which corresponds to the minimum of the AVC, does not even enable the producer to cover variable costs. What about a price such as , that lies between these? The answer is that, if the supplier has already incurred some fixed costs, he should continue to produce, provided he can cover his variable cost. But in the long run he must cover all of his costs, fixed and variable. Therefore, if the price falls below , he should shut down, even in the short run. This price is therefore called the shut-down price. If a price at least equal to cannot be sustained in the long run, he should leave the industry. But at a price such as he can cover variable costs and therefore should continue to produce in the short run. His optimal output at is defined by the intersection of the line with the MC curve. The firm's short-run supply curve is, therefore, that portion of the MC curve above the minimum of the AVC.
To illustrate this more concretely, consider again the example of our snowboard producer, and imagine that he is producing in a perfectly competitive marketplace. How should he behave in response to different prices? Table 9.1 reproduces the data from Table 8.2.
Table 9.1 Profit maximization in the short run
Labour Output Total Average Average Marginal Total Profit
Revenue \$ Variable Total Cost Cost \$ Cost \$
Cost \$
L Q TR AVC ATC MC TC TR-TC
0 0 3,000
1 15 1,050 66.67 266.67 66.67 4,000 –2,950
2 40 2,800 50.0 125.0 40.0 5,000 –2,200
3 70 4,900 42.86 85.71 33.33 6,000 –1,100
4 110 7,700 36.36 63.64 25.0 7,000 700
5 145 10,150 34.48 55.17 28.57 8,000 2,150
6 175 12,250 34.29 51.43 33.33 9,000 3,250
7 200 14,000 35.0 50.0 40.0 10,000 4,000
8 220 15,400 36.36 50.0 50.0 11,000 4,400
9 235 16,450 38.30 51.06 66.67 12,000 4,450
10 240 16,800 41.67 54.17 200.0 13,000 3,800
Output Price=\$70; Wage=\$1,000; Fixed Cost=\$3,000. The shut-down point occurs at a price of , where the AVC attains a minimum. Hence no production, even in the short run, takes place unless the price exceeds this value. The break-even level of output occurs at a price of , where the ATC attains a minimum.
The shut-down price corresponds to the minimum value of the AVC curve.
The break-even price corresponds to the minimum of the ATC curve.
The firm's short-run supply curve is that portion of the MC curve above the minimum of the AVC.
Suppose that the price is \$70. How many boards should he produce? The answer is defined by the behaviour of the MC curve. For any output less than or equal to 235, the MC is less than the price. For example, at L=9 and Q=235, the MC is \$66.67. At this output level, he makes a profit on the marginal unit produced, because the MC is less than the revenue he gets (\$70) from selling it.
But, at outputs above this, he registers a loss on the marginal units because the MC exceeds the revenue. For example, at L=10 and Q=240, the MC is \$200. Clearly, 235 snowboards is the optimum. To produce more would generate a loss on each additional unit, because the additional cost would exceed the additional revenue. Furthermore, to produce fewer snowboards would mean not availing of the potential for profit on additional boards.
His profit is based on the difference between revenue per unit and cost per unit at this output: (PATC). Since the ATC for the 235 units produced by the nine workers is \$51.06, his profit margin is per board, and total profit is therefore .
Let us establish two other key outputs and prices for the producer. First, the shut-down point is the minimum of his AVC curve. Table 9.1 indicates that the price must be at least \$34.29 for him to be willing to supply any output, since that is the value of the AVC at its minimum. Second, the minimum of his ATC is at \$50. Accordingly, provided the price exceeds \$50, he will cover both variable and fixed costs and make a maximum profit when he chooses an output where P=MC, above . It follows that the short-run supply curve for Black Diamond Snowboards is the segment of the MC curve in Figure 8.4 above the AVC curve.
Given that we have developed the individual firm's supply curve, the next task is to develop the industry supply curve.
Industry supply in the short run
In Chapter 3 it was demonstrated that individual demands can be aggregated into an industry demand by summing them horizontally. The industry supply is obtained in exactly the same manner—by summing the firms' supply quantities across all firms in the industry.
To illustrate, imagine we have many firms, possibly operating at different scales of output and therefore having different short-run MC curves. The MC curves of two of these firms are illustrated in Figure 9.3. The MC of A is below the MC of B; therefore, B likely has a smaller scale of plant than A. Consider first the supply decisions in the price range P1 to P2. At any price between these limits, only firm A will supply output – firm B does not cover its AVC in this price range. Therefore, the joint contribution to industry supply of firms A and B is given by the MC curve of firm A. But once a price of P2 is attained, firm B is now willing to supply. The schedule is the horizontal addition of their supply quantities. Adding the supplies of every firm in the industry in this way yields the industry supply.
Industry supply (short run) in perfect competition is the horizontal sum of all firms' supply curves.
Figure 9.3 Deriving industry supply
The marginal cost curves for firms A and B indicate that at any price below P1 production is unprofitable and supply is therefore zero for both firms. At prices between P1 and P2 firm A is willing to supply, but not firm B. Consequently the market supply comes only from A. At prices above P2 both firms are willing to supply. Therefore the market supply is the horizontal sum of each firm's supply.
Industry equilibrium
Consider next the industry equilibrium. Since the industry supply is the sum of the individual supplies, and the industry demand curve is the sum of individual demands, an equilibrium price and quantity (PE,QE) are defined by the intersection of these industry-level curves, as in Figure 9.4. Here, each firm takes PE as given (it is so small that it cannot influence the going price), and supplies an amount determined by the intersection of this price with its MC curve. The sum of such quantities is therefore QE.
Short-run equilibrium in perfect competition occurs when each firm maximizes profit by producing a quantity where P=MC, provided the price exceeds the minimum of the average variable cost.
Figure 9.4 Market equilibrium
The market supply curve S is the sum of each firm's supply or MC curve above the shut-down price. D is the sum of individual demands. The market equilibrium price and quantity are defined by PE and QE.
9.4 Dynamics: Entry and exit
We have now described the market and firm-level equilibrium in the short run. However, this equilibrium may be only temporary; whether it can be sustained or not depends upon whether profits (or losses) are being incurred, or whether all participant firms are making what are termed normal profits. Such profits are considered an essential part of a firm's operation. They reflect the opportunity cost of the resources used in production. Firms do not operate if they cannot make a minimal, or normal, profit level. Above such profits are economic profits (also called supernormal profits), and these are what entice entry into the industry.
Recall from Chapter 7 that accounting and economic profits are different. The economist includes opportunity costs in determining profit, whereas the accountant considers actual revenues and costs. In the example developed in Section 7.2 the entrepreneur recorded accounting profit, but not economic profit. Suppose now that the numbers were slightly different, and are as defined in Table 9.2: Felicity invests \$250,000 in her business in the form of capital, as before. But she now has gross revenues of \$165,000 and incurs a cost of \$90,000 to buy the clothing wholesale that she then sells retail. She pays herself a salary of \$35,000. If these numbers represent her balance sheet, then she records an accounting profit of \$40,000.
Table 9.2 Economic profits
Sales \$165,000
Materials costs \$90,000
Wage costs \$35,000
Accounting profit \$40,000
Capital invested \$250,000
Implicit return on capital at 4% \$10,000
Additional implicit wage costs \$20,000
Total implicit costs \$30,000
Economic profit \$10,000
Her economic profit calculation must include opportunity costs. The opportunity cost of tying up \$250,000 of capital, if the interest rate is 4%, amounts to \$10,000. In addition, if Felicity could earn \$55,000 in her best alternative job then an additional implicit cost of \$20,000 must be considered. When these two opportunity (or implicit) costs are added to the balance sheet, her profit is reduced to \$10,000. This is her economic profit. If Felicity's economic profit is representative of the retail clothing sector of the economy, then that profitability should attract new entrepreneurs. Our conclusion is that this sector of the economy should experience new entrants and hence an outward shift of the supply curve. In contrast, in the numerical example considered in Section 7.2, Felicity was experiencing losses (negative economic profits), and in the longer term she would have to consider leaving the business. If she and other suppliers exited, then the market supply curve would shift back to the left – representing a reduction in supply.
The critical point in this distinction between accounting and economic cost is that the decision to enter or leave a market in the longer term is based on what the entrepreneur can earn in the wider market place. That is, economic profits rather than accounting profits will determine the equilibrium number of firms in the long term. In terms of our cost curves, we will assume that the full economic costs are included in the various curves that we use. Consequently any profits (or losses) that arise are based upon the full economic costs of the firm's operation.
Economic (supernormal) profits are those profits above normal profits that induce firms to enter an industry.
Let us return to our graphical analysis, and begin by supposing that the market equilibrium described in Figure 9.4 results in profits being made by some firms. Such an outcome is described in Figure 9.5, where the price exceeds the ATC. At the price , a profit-making firm supplies the quantity , as determined by its MC curve. On average, the cost of producing each unit of output, , is defined by the point on the ATC at that output level, point k. Profit per unit is thus given by the value (mk) – the difference between revenue per unit and cost per unit. Total (economic) profit is therefore the area , which is quantity times profit per unit.
Figure 9.5 Short-run profits for the firm
At the price PE, determined by the intersection of market demand and market supply, an individual firm produces the amount QE. The ATC of this output is k and therefore profit per unit is mk. Total profit is therefore PEmkhmk=TRTC.
Figure 9.6 Entry of firms due to economic profits
If economic profits result from the price PE new firms enter the industry. This entry increases the market supply to and the equilibrium price falls to . Entry continues as long as economic profits are present. Eventually the price is driven to a level where only normal profits are made, and entry ceases.
While represents an equilibrium for the firm, it is only a short-run, or temporary, equilibrium for the industry. The assumption of free entry and exit implies that the presence of economic profits will induce new entrepreneurs to enter and start producing. The impact of this dynamic is illustrated in Figure 9.6. An increased number of firms shifts supply rightwards to become , thereby increasing the amount supplied at any price. The impact on price of this supply shift is evident: With an unchanged demand, the equilibrium price must fall.
How far will the price fall, and how many new firms will enter this profitable industry? As long as economic profits exist new firms will enter and the resulting increase in supply will continue to drive the price downwards. But, once the price has been driven down to the minimum of the ATC of a representative firm, there is no longer an incentive for new entrepreneurs to enter. Therefore, the long-run industry equilibrium is where the market price equals the minimum point of a firm's ATC curve. This generates normal profits, and there is no incentive for firms to enter or exit.
A long-run equilibrium in a competitive industry requires a price equal to the minimum point of a firm's ATC. At this point, only normal profits exist, and there is no incentive for firms to enter or exit.
In developing this dynamic, we began with a situation in which economic profits were present. However, we could have equally started from a position of losses. With a market price between the minimum of the AVC and the minimum of the ATC in Figure 9.5, revenues per unit would exceed variable costs but not total costs per unit. When firms cannot cover their ATC in the long run, they will cease production. Such closures must reduce aggregate supply; consequently the market supply curve contracts, rather than expands as it did in Figure 9.6. The reduced supply drives up the price of the good. This process continues as long as firms are making losses. A final industry equilibrium is attained only when the price reaches a level where firms can make a normal profit. Again, this will be at the minimum of the typical firm's ATC.
Accordingly, the long-run equilibrium is the same, regardless of whether we begin from a position in which firms are incurring losses, or where they are making profits.
Application Box 9.2 Entry and exit: Oil rigs
Oil drilling is a competitive market. There are a large number of suppliers, information is ubiquitous, and entry and exit are relatively free.
In the years 2012 and 2013 the price of crude oil was around \$100 US per barrel. Towards the end of 2014 the price of oil began to drop on world markets, and by early 2015 it fluctuated around \$50. The response of drillers in the US was substantial and immediate. The number of active rigs declined dramatically. In terms of our economic model, certain suppliers exited; they moth-balled their rigs and waited for the price of oil to recover.
Another such cycle, even more pronounced, occurred in 2020. With the coronavirus pandemic, the demand for oil dropped and its price plummeted. Again, many firms shut down their rigs and had no choice but to sit out the price decline. A highly informative graphic is presented at tradingeconomics.com/united-states/crude-oil-rigs.
In addition to the decline in traditional oil recovery rigs, the number of operating shale crews declined by even greater amounts. Details at https://www.forbes.com/sites/davidblackmon/2020/05/12/a-grim-earnings-season-for-the-us-shale-business/#6f55a95a1cf2
9.5 Long-run industry supply
When aggregating the firm-level supply curves, as illustrated in Figure 9.3, we did not assume that all firms were identical. In that example, firm A has a cost structure with a lower AVC curve, since its supply curve starts at a lower dollar value. This indicates that firm A may have a larger plant size than firm B – one that puts A closer to the minimum efficient scale region of its long-run ATC curve.
Figure 9.7 Firms with different plant sizes
Firm B cannot compete with Firm A in the long run given that B has a less efficient plant size than firm A. The equilibrium long-run price equals the minimum of the LAC. At this price firm B must move to a more efficient plant size or make losses.
Can firm B survive with his current scale of operation in the long run? Our industry dynamics indicate that it cannot. The reason is that, provided some firms are making economic profits, new entrepreneurs will enter the industry and drive the price down to the minimum of the ATC curve of those firms who are operating with the lowest cost plant size. B-type firms will therefore be forced either to leave the industry or to adjust to the least-cost plant size—corresponding to the lowest point on its long-run ATC curve. Remember that the same technology is available to all firms; they each have the same long-run ATC curve, and may choose different scales of operation in the short run, as illustrated in Figure 9.7. But in the long run they must all produce using the minimum-cost plant size, or else they will be driven from the market.
This behaviour enables us to define a long-run industry supply. The long run involves the entry and exit of firms, and leads to a price corresponding to the minimum of the long-run ATC curve. Therefore, if the long-run equilibrium price corresponds to this minimum, the long-run supply curve of the industry is defined by a particular price value—it is horizontal at the price corresponding to the minimum of the LATC. More or less output is produced as a result of firms entering or leaving the industry, with those present always producing at the same unit cost in a long-run equilibrium.
Industry supply in the long run in perfect competition is horizontal at a price corresponding to the minimum of the representative firm's long-run ATC curve.
Figure 9.8 Long-run dynamics
The LR equilibrium price PE is disturbed by a shift in demand from D1 to D2. With a fixed number of firms, P2 results. Profits accrue at this price and entry occurs. Therefore the SR supply shifts outwards until these profits are eroded and the new equilibrium output is Q2. If, instead, D falls to D3 then firms exit because they make losses, S shifts back until the price is driven up sufficiently to restore normal profits. Different outputs are supplied in the long run at the same price PE, therefore the long-run supply is horizontal at PE.
This industry's long-run supply curve, SL, and a particular short-run supply are illustrated in Figure 9.8. Different points on SL are attained when demand shifts. Suppose that, from an initial equilibrium Q1, defined by the intersection of D1 and S1, demand increases from D1 to D2 because of a growth in income. With a fixed number of firms, the additional demand can be met only at a higher price (P2), where each existing firm produces more using their existing plant size. The economic profits that result induce new operators to produce. This addition to the industry's production capacity shifts the short-run supply outwards and price declines until normal profits are once again being made. The new long-run equilibrium is at Q2, with more firms each producing at the minimum of their long-run ATC curve, PE.
The same dynamic would describe the industry reaction to a decline in demand—price would fall, some firms would exit, and the resulting contraction in supply would force the price back up to the long-run equilibrium level. This is illustrated by a decline in demand from D1 to D3.
Increasing and decreasing cost industries
While a horizontal long-run supply is the norm for perfect competition, in some industries costs increase with the scale of industry output; in others they decrease. This may be because all of the producers use a particular input that itself becomes more or less costly, depending upon the amount supplied.
Figure 9.9 Increasing and decreasing cost industries
When individual-supplier costs rise as the output of the industry increases we have an increasing cost supply curve for the industry in the long run. Conversely, when the costs of individual suppliers fall with the scale of the industry, we have a decreasing cost industry.
Decreasing cost sectors are those that benefit from a decline in the prices of their inputs as the size of their market expands. This is frequently because the suppliers of the inputs themselves can benefit from scale economies as a result of expansion in the market for the final good. A case in point has been the computer market, or the tablet market: As output in these markets has grown, the producers of videocards and random-access memory have benefited from scale economies and thus been able to sell these components at a lower price to the manufacturers of the final goods. An example of an increasing cost market is the market for landings and take-offs at airports. Airports are frequently limited in their ability to expand their size and build additional runways. In such markets, as use grows, planes about to land may have to adopt a circling holding pattern, while those departing encounter clearance delays. Such delays increase the time costs to passengers and the fuel and labour costs to the suppliers. Decreasing and increasing industry costs are reflected in the long-run industry supply curve by a downward-sloping segment or an upward sloping segment, as illustrated in Figure 9.9.
Increasing (decreasing) cost industry is one where costs rise (fall) for each firm because of the scale of industry operation.
9.6 Globalization and technological change
Globalization and technological change have had a profound impact on the way goods and services are produced and brought to market in the modern world. The cost structure of many firms has been reduced by outsourcing to lower-wage economies. Furthermore, the advent of the communications revolution has effectively increased the minimum efficient scale for many industries, as illustrated in Chapter 8 (Figure 8.7). Larger firms are less difficult to manage nowadays, and the LAC curve may not slope upwards until very high output levels are attained. The consequence is that some industries may not have sufficient "production space" to sustain a large number of firms. In order to reap the advantages of scale economies, firms become so large that they can supply a significant part of the market. They are no longer so small as to have no impact on the price.
Outsourcing and easier communications have in many cases simply eliminated many industries in the developed world. Garment making is an example. Some decades ago Quebec was Canada's main garment maker: Brokers dealt with 'cottage-type' garment assemblers outside Montreal and Quebec City. But ultimately the availability of cheaper labour in the developing world combined with efficient communications undercut the local manufacture. Most of Canada's garments are now imported. Other North American and European industries have been impacted in similar ways. Displaced labour has had to reskill, retool, reeducate itself, and either seek alternative employment in the manufacturing sector, or move to the service sector of the economy, or retire.
Globalization has had a third impact on the domestic economy, in so far as it reduces the cost of components. Even industries that continue to operate within national boundaries see a reduction in their cost structure on account of globalization's impact on input costs. This is particularly in evidence in the computing industry, where components are produced in numerous low-wage economies, imported to North America and assembled into computers domestically. Such components are termed intermediate goods.
9.7 Efficient resource allocation
Economists have a particular liking for competitive markets. The reason is not, as is frequently thought, that we love competitive battles; it really concerns resource allocation in the economy at large. In Chapter 5 we explained why markets are frequently an excellent vehicle for transporting the economy's resources to where they are most valued: A perfectly competitive marketplace in which there are no externalities results in resources being used up to the point where the demand and supply prices are equal. If demand is a measure of marginal benefit and supply is a measure of marginal cost, then a perfectly competitive market ensures that this condition will hold in equilibrium. Perfect competition, therefore, results in resources being used efficiently.
Our initial reaction to this perspective may be: If market equilibrium is such that the quantity supplied always equals the quantity demanded, is not every market efficient? The answer is no. As we shall see in the next chapter on monopoly, the monopolist's supply decision does not reflect the marginal cost of resources used in production, and therefore does not result in an efficient allocation in the economy.
Key Terms
Perfect competition: an industry in which many suppliers, producing an identical product, face many buyers, and no one participant can influence the market.
Profit maximization is the goal of competitive suppliers – they seek to maximize the difference between revenues and costs.
Marginal revenue is the additional revenue accruing to the firm resulting from the sale of one more unit of output.
Shut-down price corresponds to the minimum value of the AVC curve.
Break-even price corresponds to the minimum of the ATC curve.
Short-run supply curve for perfect competitor: the portion of the MC curve above the minimum of the AVC.
Industry supply (short run) in perfect competition is the horizontal sum of all firms' supply curves.
Short-run equilibrium in perfect competition occurs when each firm maximizes profit by producing a quantity where P=MC.
Economic (supernormal) profits are those profits above normal profits that induce firms to enter an industry. Economic profits are based on the opportunity cost of the resources used in production.
Long-run equilibrium in a competitive industry requires a price equal to the minimum point of a firm's ATC. At this point, only normal profits exist, and there is no incentive for firms to enter or exit.
Industry supply in the long run in perfect competition is horizontal at a price corresponding to the minimum of the representative firm's long-run ATC curve.
Increasing (decreasing) cost industry is one where costs rise (fall) for each firm because of the scale of industry operation.
Exercises for Chapter 9
EXERCISE 9.1
Wendy's Window Cleaning is a small local operation. Wendy presently cleans the outside windows in her neighbours' houses for \$36 per house. She does ten houses per day. She is incurring total costs of \$420, and of this amount \$100 is fixed. The cost per house is constant.
1. What is the marginal cost associated with cleaning the windows of one house – we know it is constant?
2. At a price of \$36, what is her break-even level of output (number of houses)?
3. If the fixed cost is 'sunk' and she cannot increase her output in the short run, should she shut down?
EXERCISE 9.2
A manufacturer of vacuum cleaners incurs a constant variable cost of production equal to \$80. She can sell the appliances to a wholesaler for \$130. Her annual fixed costs are \$200,000. How many vacuums must she sell in order to cover her total costs?
EXERCISE 9.3
For the vacuum cleaner producer in Exercise 9.2:
1. Draw the MC curve.
2. Next, draw her AFC and her AVC curves.
3. Finally, draw her ATC curve.
4. In order for this cost structure to be compatible with a perfectly competitive industry, what must happen to her MC curve at some output level?
EXERCISE 9.4
Consider the supply curves of two firms in a competitive industry: P=qA and P=2qB.
1. On a diagram, draw these two supply curves, marking their intercepts and slopes numerically (remember that they are really MC curves).
2. Now draw a supply curve that represents the combined supply of these two firms.
EXERCISE 9.5
Amanda's Apple Orchard Productions Limited produces 10,000 kilograms of apples per month. Her total production costs at this output level are \$8,000. Two of her many competitors have larger-scale operations and produce 12,000 and 15,000 kilos at total costs of \$9,500 and \$11,000 respectively. If this industry is competitive, on what segment of the LAC curve are these producers producing?
EXERCISE 9.6
Consider the data in the table below. TC is total cost, TR is total revenue, and Q is output.
Q 0 1 2 3 4 5 6 7 8 9 10
TC 10 18 24 31 39 48 58 69 82 100 120
TR 0 11 22 33 44 55 66 77 88 99 110
1. Add some extra rows to the table and for each level of output calculate the MR, the MC and total profit.
2. Next, compute AFC, AVC, and ATC for each output level, and draw these three cost curves on a diagram.
3. What is the profit-maximizing output?
4. How can you tell that this firm is in a competitive industry?
EXERCISE 9.7
Optional: The market demand and supply curves in a perfectly competitive industry are given by: Qd=30,000–600P and Qs=200P–2000.
1. Draw these functions on a diagram, and calculate the equilibrium price of output in this industry.
2. Now assume that an additional firm is considering entering. This firm has a short-run MC curve defined by MC=10+0.5q, where q is the firm's output. If this firm enters the industry and it knows the equilibrium price in the industry, what output should it produce?
EXERCISE 9.8
Optional: Consider two firms in a perfectly competitive industry. They have the same MC curves and differ only in having higher and lower fixed costs. Suppose the ATC curves are of the form: 400/q+10+(1/4)q and 225/q+10+(1/4)q. The MC for each is a straight line: MC=10+(1/2)q.
1. In the first column of a spreadsheet enter quantity values of 1, 5, 10, 15, 20,..., 50. In the following columns compute the ATC curves for each quantity value.
2. Compute the MC at each output in the next column, and plot all three curves.
3. Compute the break-even price for each firm.
4. Explain why both of these firms cannot continue to produce in the long run in a perfectly competitive market.
09: Perfect competition
A competitive market is one that encompasses a very large number of suppliers, each producing a similar or identical product. Each supplier produces an output that forms a small part of the total market, and the sum of all of these individual outputs represents the production of that sector of the economy. Florists, barber shops, corner stores and dry cleaners all fit this description.
At the other extreme, a market that has just a single supplier is a monopolist. For example, the National Hockey League is the sole supplier of top-quality professional hockey games in North America; Hydro Quebec is a monopoly electricity distributor in Quebec; Via Rail is the only supplier of passenger rail services between Windsor, Ontario and the city of Quebec.
We use the word 'paradigm' in the title to this section: It implies that we will develop a model of supply behaviour for a market in which there are many small suppliers, producing essentially the same product, competing with one-another to meet the demands of consumers.
The structures that we call perfect competition and monopoly are extremes in the market place. Most sectors of the economy lie somewhere between these limiting cases. For example, the market for internet services usually contains several providers in any area – some provide using a fibre cable, others by satellite. The market for smart-phones in North America is dominated by two major players – Apple and Samsung (although there are several others). Hence, while these markets that have a limited number of suppliers are competitive in that they freely and perhaps fiercely compete for the buyer's expenditure, these are not perfectly competitive markets, because they do not have a very large number of suppliers.
In all of the models we develop in this chapter we will assume that the objective of firms is to maximize profit – the difference between revenues and costs.
A perfectly competitive industry is one in which many suppliers, producing an identical product, face many buyers, and no one participant can influence the market.
Profit maximization is the goal of competitive suppliers – they seek to maximize the difference between revenues and costs.
The presence of so many sellers in perfect competition means that each firm recognizes its own small size in relation to the total market, and that its actions have no perceptible impact on the market price for the good or service being traded. Each firm is therefore a price taker—in contrast to a monopolist, who is a price setter.
The same 'smallness' characteristic was assumed when we examined the demands of individuals earlier. Each buyer takes the price as given. He or she is not big enough to be able to influence the price. In contrast, when international airlines purchase or lease aircraft from Boeing or Airbus, they negotiate over the price and other conditions of supply. The market models underlying these types of transactions are examined in Chapter 11.
Hence, when we describe a market as being perfectly competitive we do not mean that other market types are not competitive; all market structure are competitive in the sense that the suppliers wish to make profit, and they produce as efficiently as possible in order to meet that goal. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/09%3A_Perfect_competition/9.01%3A_The_perfect_competition_paradigm.txt |
The key attributes of a perfectly competitive market are the following:
1. There must be many firms, each one so small that it cannot influence price or quantity in the industry, and powerless relative to the entire industry.
2. The product must be standardized. Barber shops offer a standard product, but a Lexus differs from a Ford. Barbers tend to be price takers, but Lexus does not charge the same price as Ford, and is a price setter.
3. Buyers are assumed to have full information about the product and its pricing. For example, buyers know that the products of different suppliers really are the same in quality.
4. There are many buyers.
5. There is free entry and exit of firms.
In terms of the demand curve that suppliers face, these market characteristics imply that the demand curve facing the perfectly competitive firm is horizontal, or infinitely elastic, as we defined in Chapter 4. In contrast, the demand curve facing the whole industry is downward sloping. The demand curve facing a firm is represented in Figure 9.1. It implies that the supplier can sell any output he chooses at the going price . He is a small player in the market, and variations in his output have no perceptible impact in the marketplace. But what quantity should he choose, or what quantity will maximize his profit? The profit-maximizing choice is his target, and the MC curve plays a key role in this decision.
9.03: The firm's supply decision
The concept of marginal revenue is key to analyzing the supply decision of an individual firm. We have used marginal analysis at several points to date. In consumer theory, we saw how consumers balance the utility per dollar at the margin in allocating their budget. Marginal revenue is the additional revenue accruing to the firm from the sale of one more unit of output.
Marginal revenue is the additional revenue accruing to the firm resulting from the sale of one more unit of output.
In perfect competition, a firm's marginal revenue (MR) is the price of the good. Since the price is constant for the individual supplier, each additional unit sold at the price P brings in the same additional revenue. Therefore, P=MR. For example, whether a dry cleaning business launders 10 shirts or 100 shirts per day, the price charged to customers is the same. This equality holds in no other market structure, as we shall see in the following chapters.
Supply in the short run
Recall how we defined the short run in the previous chapter: Each firm's plant size is fixed in the short run, so too is the number of firms in an industry. In the long run, each individual firm can change its scale of operation, and at the same time new firms can enter or existing firms can leave the industry.
Perfectly competitive suppliers face the choice of how much to produce at the going market price: That is, the amount that will maximize their profit. We abstract for the moment on how the price in the marketplace is determined. We shall see later in this chapter that it emerges as the value corresponding to the intersection of the supply and demand curves for the whole market – as described in Chapter 3.
The firm's MC curve is critical in defining the optimal amount to supply at any price. In Figure 9.1, MC is the firm's marginal cost curve in the short run. At the price the optimal amount to supply is , the amount determined by the intersection of the MC and the demand. To see why, imagine that the producer chose to supply the quantity . Such an output would leave the opportunity for further profit untapped. By producing one additional unit beyond , the supplier would get in additional revenue and incur an additional cost that is less than in producing this unit. In fact, on every unit between and he can make a profit, because the MR exceeds the associated cost, MC. By the same argument, it makes no sense to increase output beyond , to for example, because the cost of such additional units of output, MC, exceeds the revenue from them. The MC therefore defines an optimal supply response.
Figure 9.1 The competitive firm's optimal output
Here, q0 represents the optimal supply decision when the price is P0. At output q1 the cost of additional units is less than the revenue from such units and therefore it is profitable to increase output beyond q1. Conversely, at q2 the MC of production exceeds the revenue obtained, and so output should be reduced.
Application Box 9.1 The law of one price
If information does not flow then prices in different parts of a market may differ and potential entrants may not know to enter a profitable market.
Consider the fishermen off the coast of Kerala, India in the late 1990s. Their market was studied by Robert Jensen, a development economist. Prior to 1997, fishermen tended to bring their fish to their home market or port. This was cheaper than venturing to other ports, particularly if there was no certainty regarding price. This practice resulted in prices that were high in some local markets and low in others – depending upon the daily catch. Frequently fish was thrown away in low-price markets even though it might have found a favourable price in another village's fish market.
This all changed with the advent of cell phones. Rather than head automatically to their home port, fishermen began to phone several different markets in the hope of finding a good price for their efforts. They began to form agreements with buyers before even bringing their catch to port. Economist Jensen observed a major decline in price variation between the markets that he surveyed. In effect the 'law of one price' came into being for sardines as a result of the introduction of cheap technology and the relatively free flow of information.
While the choice of the output is the best choice for the producer, Figure 9.1 does not tell us anything about profit. For that we need more information on costs. Accordingly, in Figure 9.2 the firm's AVC and ATC curves have been added to Figure 9.1. As explained in the previous chapter, the ATC curve includes both fixed and variable cost components, and the MC curve cuts the AVC and the ATC at their minima.
Figure 9.2 Short-run supply for the competitive firm
A price below P1 does not cover variable costs, so the firm should shut down. Between prices P1 and P3, the producer can cover variable, but not total, costs and therefore should produce in the short run if fixed costs are 'sunk'. In the long run the firm must close if the price does not reach P3. Profits are made if the price exceeds P3. The short-run supply curve is the quantity supplied at each price. It is therefore the MC curve above P1.
First, note that any price below , which corresponds to the minimum of the ATC curve, yields no profit, since it does not enable the producer to cover all of his costs. This price is therefore called the break-even price. Second, any price below , which corresponds to the minimum of the AVC, does not even enable the producer to cover variable costs. What about a price such as , that lies between these? The answer is that, if the supplier has already incurred some fixed costs, he should continue to produce, provided he can cover his variable cost. But in the long run he must cover all of his costs, fixed and variable. Therefore, if the price falls below , he should shut down, even in the short run. This price is therefore called the shut-down price. If a price at least equal to cannot be sustained in the long run, he should leave the industry. But at a price such as he can cover variable costs and therefore should continue to produce in the short run. His optimal output at is defined by the intersection of the line with the MC curve. The firm's short-run supply curve is, therefore, that portion of the MC curve above the minimum of the AVC.
To illustrate this more concretely, consider again the example of our snowboard producer, and imagine that he is producing in a perfectly competitive marketplace. How should he behave in response to different prices? Table 9.1 reproduces the data from Table 8.2.
Table 9.1 Profit maximization in the short run
Labour Output Total Average Average Marginal Total Profit
Revenue \$ Variable Total Cost Cost \$ Cost \$
Cost \$
L Q TR AVC ATC MC TC TR-TC
0 0 3,000
1 15 1,050 66.67 266.67 66.67 4,000 –2,950
2 40 2,800 50.0 125.0 40.0 5,000 –2,200
3 70 4,900 42.86 85.71 33.33 6,000 –1,100
4 110 7,700 36.36 63.64 25.0 7,000 700
5 145 10,150 34.48 55.17 28.57 8,000 2,150
6 175 12,250 34.29 51.43 33.33 9,000 3,250
7 200 14,000 35.0 50.0 40.0 10,000 4,000
8 220 15,400 36.36 50.0 50.0 11,000 4,400
9 235 16,450 38.30 51.06 66.67 12,000 4,450
10 240 16,800 41.67 54.17 200.0 13,000 3,800
Output Price=\$70; Wage=\$1,000; Fixed Cost=\$3,000. The shut-down point occurs at a price of , where the AVC attains a minimum. Hence no production, even in the short run, takes place unless the price exceeds this value. The break-even level of output occurs at a price of , where the ATC attains a minimum.
The shut-down price corresponds to the minimum value of the AVC curve.
The break-even price corresponds to the minimum of the ATC curve.
The firm's short-run supply curve is that portion of the MC curve above the minimum of the AVC.
Suppose that the price is \$70. How many boards should he produce? The answer is defined by the behaviour of the MC curve. For any output less than or equal to 235, the MC is less than the price. For example, at L=9 and Q=235, the MC is \$66.67. At this output level, he makes a profit on the marginal unit produced, because the MC is less than the revenue he gets (\$70) from selling it.
But, at outputs above this, he registers a loss on the marginal units because the MC exceeds the revenue. For example, at L=10 and Q=240, the MC is \$200. Clearly, 235 snowboards is the optimum. To produce more would generate a loss on each additional unit, because the additional cost would exceed the additional revenue. Furthermore, to produce fewer snowboards would mean not availing of the potential for profit on additional boards.
His profit is based on the difference between revenue per unit and cost per unit at this output: (PATC). Since the ATC for the 235 units produced by the nine workers is \$51.06, his profit margin is per board, and total profit is therefore .
Let us establish two other key outputs and prices for the producer. First, the shut-down point is the minimum of his AVC curve. Table 9.1 indicates that the price must be at least \$34.29 for him to be willing to supply any output, since that is the value of the AVC at its minimum. Second, the minimum of his ATC is at \$50. Accordingly, provided the price exceeds \$50, he will cover both variable and fixed costs and make a maximum profit when he chooses an output where P=MC, above . It follows that the short-run supply curve for Black Diamond Snowboards is the segment of the MC curve in Figure 8.4 above the AVC curve.
Given that we have developed the individual firm's supply curve, the next task is to develop the industry supply curve.
Industry supply in the short run
In Chapter 3 it was demonstrated that individual demands can be aggregated into an industry demand by summing them horizontally. The industry supply is obtained in exactly the same manner—by summing the firms' supply quantities across all firms in the industry.
To illustrate, imagine we have many firms, possibly operating at different scales of output and therefore having different short-run MC curves. The MC curves of two of these firms are illustrated in Figure 9.3. The MC of A is below the MC of B; therefore, B likely has a smaller scale of plant than A. Consider first the supply decisions in the price range P1 to P2. At any price between these limits, only firm A will supply output – firm B does not cover its AVC in this price range. Therefore, the joint contribution to industry supply of firms A and B is given by the MC curve of firm A. But once a price of P2 is attained, firm B is now willing to supply. The schedule is the horizontal addition of their supply quantities. Adding the supplies of every firm in the industry in this way yields the industry supply.
Industry supply (short run) in perfect competition is the horizontal sum of all firms' supply curves.
Figure 9.3 Deriving industry supply
The marginal cost curves for firms A and B indicate that at any price below P1 production is unprofitable and supply is therefore zero for both firms. At prices between P1 and P2 firm A is willing to supply, but not firm B. Consequently the market supply comes only from A. At prices above P2 both firms are willing to supply. Therefore the market supply is the horizontal sum of each firm's supply.
Industry equilibrium
Consider next the industry equilibrium. Since the industry supply is the sum of the individual supplies, and the industry demand curve is the sum of individual demands, an equilibrium price and quantity (PE,QE) are defined by the intersection of these industry-level curves, as in Figure 9.4. Here, each firm takes PE as given (it is so small that it cannot influence the going price), and supplies an amount determined by the intersection of this price with its MC curve. The sum of such quantities is therefore QE.
Short-run equilibrium in perfect competition occurs when each firm maximizes profit by producing a quantity where P=MC, provided the price exceeds the minimum of the average variable cost.
Figure 9.4 Market equilibrium
The market supply curve S is the sum of each firm's supply or MC curve above the shut-down price. D is the sum of individual demands. The market equilibrium price and quantity are defined by PE and QE. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/09%3A_Perfect_competition/9.02%3A_Market_characteristics.txt |
The concept of marginal revenue is key to analyzing the supply decision of an individual firm. We have used marginal analysis at several points to date. In consumer theory, we saw how consumers balance the utility per dollar at the margin in allocating their budget. Marginal revenue is the additional revenue accruing to the firm from the sale of one more unit of output.
Marginal revenue is the additional revenue accruing to the firm resulting from the sale of one more unit of output.
In perfect competition, a firm's marginal revenue (MR) is the price of the good. Since the price is constant for the individual supplier, each additional unit sold at the price P brings in the same additional revenue. Therefore, P=MR. For example, whether a dry cleaning business launders 10 shirts or 100 shirts per day, the price charged to customers is the same. This equality holds in no other market structure, as we shall see in the following chapters.
Supply in the short run
Recall how we defined the short run in the previous chapter: Each firm's plant size is fixed in the short run, so too is the number of firms in an industry. In the long run, each individual firm can change its scale of operation, and at the same time new firms can enter or existing firms can leave the industry.
Perfectly competitive suppliers face the choice of how much to produce at the going market price: That is, the amount that will maximize their profit. We abstract for the moment on how the price in the marketplace is determined. We shall see later in this chapter that it emerges as the value corresponding to the intersection of the supply and demand curves for the whole market – as described in Chapter 3.
The firm's MC curve is critical in defining the optimal amount to supply at any price. In Figure 9.1, MC is the firm's marginal cost curve in the short run. At the price the optimal amount to supply is , the amount determined by the intersection of the MC and the demand. To see why, imagine that the producer chose to supply the quantity . Such an output would leave the opportunity for further profit untapped. By producing one additional unit beyond , the supplier would get in additional revenue and incur an additional cost that is less than in producing this unit. In fact, on every unit between and he can make a profit, because the MR exceeds the associated cost, MC. By the same argument, it makes no sense to increase output beyond , to for example, because the cost of such additional units of output, MC, exceeds the revenue from them. The MC therefore defines an optimal supply response.
Figure 9.1 The competitive firm's optimal output
Here, q0 represents the optimal supply decision when the price is P0. At output q1 the cost of additional units is less than the revenue from such units and therefore it is profitable to increase output beyond q1. Conversely, at q2 the MC of production exceeds the revenue obtained, and so output should be reduced.
Application Box 9.1 The law of one price
If information does not flow then prices in different parts of a market may differ and potential entrants may not know to enter a profitable market.
Consider the fishermen off the coast of Kerala, India in the late 1990s. Their market was studied by Robert Jensen, a development economist. Prior to 1997, fishermen tended to bring their fish to their home market or port. This was cheaper than venturing to other ports, particularly if there was no certainty regarding price. This practice resulted in prices that were high in some local markets and low in others – depending upon the daily catch. Frequently fish was thrown away in low-price markets even though it might have found a favourable price in another village's fish market.
This all changed with the advent of cell phones. Rather than head automatically to their home port, fishermen began to phone several different markets in the hope of finding a good price for their efforts. They began to form agreements with buyers before even bringing their catch to port. Economist Jensen observed a major decline in price variation between the markets that he surveyed. In effect the 'law of one price' came into being for sardines as a result of the introduction of cheap technology and the relatively free flow of information.
While the choice of the output is the best choice for the producer, Figure 9.1 does not tell us anything about profit. For that we need more information on costs. Accordingly, in Figure 9.2 the firm's AVC and ATC curves have been added to Figure 9.1. As explained in the previous chapter, the ATC curve includes both fixed and variable cost components, and the MC curve cuts the AVC and the ATC at their minima.
Figure 9.2 Short-run supply for the competitive firm
A price below P1 does not cover variable costs, so the firm should shut down. Between prices P1 and P3, the producer can cover variable, but not total, costs and therefore should produce in the short run if fixed costs are 'sunk'. In the long run the firm must close if the price does not reach P3. Profits are made if the price exceeds P3. The short-run supply curve is the quantity supplied at each price. It is therefore the MC curve above P1.
First, note that any price below , which corresponds to the minimum of the ATC curve, yields no profit, since it does not enable the producer to cover all of his costs. This price is therefore called the break-even price. Second, any price below , which corresponds to the minimum of the AVC, does not even enable the producer to cover variable costs. What about a price such as , that lies between these? The answer is that, if the supplier has already incurred some fixed costs, he should continue to produce, provided he can cover his variable cost. But in the long run he must cover all of his costs, fixed and variable. Therefore, if the price falls below , he should shut down, even in the short run. This price is therefore called the shut-down price. If a price at least equal to cannot be sustained in the long run, he should leave the industry. But at a price such as he can cover variable costs and therefore should continue to produce in the short run. His optimal output at is defined by the intersection of the line with the MC curve. The firm's short-run supply curve is, therefore, that portion of the MC curve above the minimum of the AVC.
To illustrate this more concretely, consider again the example of our snowboard producer, and imagine that he is producing in a perfectly competitive marketplace. How should he behave in response to different prices? Table 9.1 reproduces the data from Table 8.2.
Table 9.1 Profit maximization in the short run
Labour Output Total Average Average Marginal Total Profit
Revenue \$ Variable Total Cost Cost \$ Cost \$
Cost \$
L Q TR AVC ATC MC TC TR-TC
0 0 3,000
1 15 1,050 66.67 266.67 66.67 4,000 –2,950
2 40 2,800 50.0 125.0 40.0 5,000 –2,200
3 70 4,900 42.86 85.71 33.33 6,000 –1,100
4 110 7,700 36.36 63.64 25.0 7,000 700
5 145 10,150 34.48 55.17 28.57 8,000 2,150
6 175 12,250 34.29 51.43 33.33 9,000 3,250
7 200 14,000 35.0 50.0 40.0 10,000 4,000
8 220 15,400 36.36 50.0 50.0 11,000 4,400
9 235 16,450 38.30 51.06 66.67 12,000 4,450
10 240 16,800 41.67 54.17 200.0 13,000 3,800
Output Price=\$70; Wage=\$1,000; Fixed Cost=\$3,000. The shut-down point occurs at a price of , where the AVC attains a minimum. Hence no production, even in the short run, takes place unless the price exceeds this value. The break-even level of output occurs at a price of , where the ATC attains a minimum.
The shut-down price corresponds to the minimum value of the AVC curve.
The break-even price corresponds to the minimum of the ATC curve.
The firm's short-run supply curve is that portion of the MC curve above the minimum of the AVC.
Suppose that the price is \$70. How many boards should he produce? The answer is defined by the behaviour of the MC curve. For any output less than or equal to 235, the MC is less than the price. For example, at L=9 and Q=235, the MC is \$66.67. At this output level, he makes a profit on the marginal unit produced, because the MC is less than the revenue he gets (\$70) from selling it.
But, at outputs above this, he registers a loss on the marginal units because the MC exceeds the revenue. For example, at L=10 and Q=240, the MC is \$200. Clearly, 235 snowboards is the optimum. To produce more would generate a loss on each additional unit, because the additional cost would exceed the additional revenue. Furthermore, to produce fewer snowboards would mean not availing of the potential for profit on additional boards.
His profit is based on the difference between revenue per unit and cost per unit at this output: (PATC). Since the ATC for the 235 units produced by the nine workers is \$51.06, his profit margin is per board, and total profit is therefore .
Let us establish two other key outputs and prices for the producer. First, the shut-down point is the minimum of his AVC curve. Table 9.1 indicates that the price must be at least \$34.29 for him to be willing to supply any output, since that is the value of the AVC at its minimum. Second, the minimum of his ATC is at \$50. Accordingly, provided the price exceeds \$50, he will cover both variable and fixed costs and make a maximum profit when he chooses an output where P=MC, above . It follows that the short-run supply curve for Black Diamond Snowboards is the segment of the MC curve in Figure 8.4 above the AVC curve.
Given that we have developed the individual firm's supply curve, the next task is to develop the industry supply curve.
Industry supply in the short run
In Chapter 3 it was demonstrated that individual demands can be aggregated into an industry demand by summing them horizontally. The industry supply is obtained in exactly the same manner—by summing the firms' supply quantities across all firms in the industry.
To illustrate, imagine we have many firms, possibly operating at different scales of output and therefore having different short-run MC curves. The MC curves of two of these firms are illustrated in Figure 9.3. The MC of A is below the MC of B; therefore, B likely has a smaller scale of plant than A. Consider first the supply decisions in the price range P1 to P2. At any price between these limits, only firm A will supply output – firm B does not cover its AVC in this price range. Therefore, the joint contribution to industry supply of firms A and B is given by the MC curve of firm A. But once a price of P2 is attained, firm B is now willing to supply. The schedule is the horizontal addition of their supply quantities. Adding the supplies of every firm in the industry in this way yields the industry supply.
Industry supply (short run) in perfect competition is the horizontal sum of all firms' supply curves.
Figure 9.3 Deriving industry supply
The marginal cost curves for firms A and B indicate that at any price below P1 production is unprofitable and supply is therefore zero for both firms. At prices between P1 and P2 firm A is willing to supply, but not firm B. Consequently the market supply comes only from A. At prices above P2 both firms are willing to supply. Therefore the market supply is the horizontal sum of each firm's supply.
Industry equilibrium
Consider next the industry equilibrium. Since the industry supply is the sum of the individual supplies, and the industry demand curve is the sum of individual demands, an equilibrium price and quantity (PE,QE) are defined by the intersection of these industry-level curves, as in Figure 9.4. Here, each firm takes PE as given (it is so small that it cannot influence the going price), and supplies an amount determined by the intersection of this price with its MC curve. The sum of such quantities is therefore QE.
Short-run equilibrium in perfect competition occurs when each firm maximizes profit by producing a quantity where P=MC, provided the price exceeds the minimum of the average variable cost.
Figure 9.4 Market equilibrium
The market supply curve S is the sum of each firm's supply or MC curve above the shut-down price. D is the sum of individual demands. The market equilibrium price and quantity are defined by PE and QE. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/09%3A_Perfect_competition/9.03%3A_The_firm's_supply_decision.txt |
We have now described the market and firm-level equilibrium in the short run. However, this equilibrium may be only temporary; whether it can be sustained or not depends upon whether profits (or losses) are being incurred, or whether all participant firms are making what are termed normal profits. Such profits are considered an essential part of a firm's operation. They reflect the opportunity cost of the resources used in production. Firms do not operate if they cannot make a minimal, or normal, profit level. Above such profits are economic profits (also called supernormal profits), and these are what entice entry into the industry.
Recall from Chapter 7 that accounting and economic profits are different. The economist includes opportunity costs in determining profit, whereas the accountant considers actual revenues and costs. In the example developed in Section 7.2 the entrepreneur recorded accounting profit, but not economic profit. Suppose now that the numbers were slightly different, and are as defined in Table 9.2: Felicity invests \$250,000 in her business in the form of capital, as before. But she now has gross revenues of \$165,000 and incurs a cost of \$90,000 to buy the clothing wholesale that she then sells retail. She pays herself a salary of \$35,000. If these numbers represent her balance sheet, then she records an accounting profit of \$40,000.
Table 9.2 Economic profits
Sales \$165,000
Materials costs \$90,000
Wage costs \$35,000
Accounting profit \$40,000
Capital invested \$250,000
Implicit return on capital at 4% \$10,000
Additional implicit wage costs \$20,000
Total implicit costs \$30,000
Economic profit \$10,000
Her economic profit calculation must include opportunity costs. The opportunity cost of tying up \$250,000 of capital, if the interest rate is 4%, amounts to \$10,000. In addition, if Felicity could earn \$55,000 in her best alternative job then an additional implicit cost of \$20,000 must be considered. When these two opportunity (or implicit) costs are added to the balance sheet, her profit is reduced to \$10,000. This is her economic profit. If Felicity's economic profit is representative of the retail clothing sector of the economy, then that profitability should attract new entrepreneurs. Our conclusion is that this sector of the economy should experience new entrants and hence an outward shift of the supply curve. In contrast, in the numerical example considered in Section 7.2, Felicity was experiencing losses (negative economic profits), and in the longer term she would have to consider leaving the business. If she and other suppliers exited, then the market supply curve would shift back to the left – representing a reduction in supply.
The critical point in this distinction between accounting and economic cost is that the decision to enter or leave a market in the longer term is based on what the entrepreneur can earn in the wider market place. That is, economic profits rather than accounting profits will determine the equilibrium number of firms in the long term. In terms of our cost curves, we will assume that the full economic costs are included in the various curves that we use. Consequently any profits (or losses) that arise are based upon the full economic costs of the firm's operation.
Economic (supernormal) profits are those profits above normal profits that induce firms to enter an industry.
Let us return to our graphical analysis, and begin by supposing that the market equilibrium described in Figure 9.4 results in profits being made by some firms. Such an outcome is described in Figure 9.5, where the price exceeds the ATC. At the price , a profit-making firm supplies the quantity , as determined by its MC curve. On average, the cost of producing each unit of output, , is defined by the point on the ATC at that output level, point k. Profit per unit is thus given by the value (mk) – the difference between revenue per unit and cost per unit. Total (economic) profit is therefore the area , which is quantity times profit per unit.
Figure 9.5 Short-run profits for the firm
At the price PE, determined by the intersection of market demand and market supply, an individual firm produces the amount QE. The ATC of this output is k and therefore profit per unit is mk. Total profit is therefore PEmkhmk=TRTC.
Figure 9.6 Entry of firms due to economic profits
If economic profits result from the price PE new firms enter the industry. This entry increases the market supply to and the equilibrium price falls to . Entry continues as long as economic profits are present. Eventually the price is driven to a level where only normal profits are made, and entry ceases.
While represents an equilibrium for the firm, it is only a short-run, or temporary, equilibrium for the industry. The assumption of free entry and exit implies that the presence of economic profits will induce new entrepreneurs to enter and start producing. The impact of this dynamic is illustrated in Figure 9.6. An increased number of firms shifts supply rightwards to become , thereby increasing the amount supplied at any price. The impact on price of this supply shift is evident: With an unchanged demand, the equilibrium price must fall.
How far will the price fall, and how many new firms will enter this profitable industry? As long as economic profits exist new firms will enter and the resulting increase in supply will continue to drive the price downwards. But, once the price has been driven down to the minimum of the ATC of a representative firm, there is no longer an incentive for new entrepreneurs to enter. Therefore, the long-run industry equilibrium is where the market price equals the minimum point of a firm's ATC curve. This generates normal profits, and there is no incentive for firms to enter or exit.
A long-run equilibrium in a competitive industry requires a price equal to the minimum point of a firm's ATC. At this point, only normal profits exist, and there is no incentive for firms to enter or exit.
In developing this dynamic, we began with a situation in which economic profits were present. However, we could have equally started from a position of losses. With a market price between the minimum of the AVC and the minimum of the ATC in Figure 9.5, revenues per unit would exceed variable costs but not total costs per unit. When firms cannot cover their ATC in the long run, they will cease production. Such closures must reduce aggregate supply; consequently the market supply curve contracts, rather than expands as it did in Figure 9.6. The reduced supply drives up the price of the good. This process continues as long as firms are making losses. A final industry equilibrium is attained only when the price reaches a level where firms can make a normal profit. Again, this will be at the minimum of the typical firm's ATC.
Accordingly, the long-run equilibrium is the same, regardless of whether we begin from a position in which firms are incurring losses, or where they are making profits.
Application Box 9.2 Entry and exit: Oil rigs
Oil drilling is a competitive market. There are a large number of suppliers, information is ubiquitous, and entry and exit are relatively free.
In the years 2012 and 2013 the price of crude oil was around \$100 US per barrel. Towards the end of 2014 the price of oil began to drop on world markets, and by early 2015 it fluctuated around \$50. The response of drillers in the US was substantial and immediate. The number of active rigs declined dramatically. In terms of our economic model, certain suppliers exited; they moth-balled their rigs and waited for the price of oil to recover.
Another such cycle, even more pronounced, occurred in 2020. With the coronavirus pandemic, the demand for oil dropped and its price plummeted. Again, many firms shut down their rigs and had no choice but to sit out the price decline. A highly informative graphic is presented at https://tradingeconomics.com/united-states/crude-oil-rigs.
In addition to the decline in traditional oil recovery rigs, the number of operating shale crews declined by even greater amounts. Details at https://www.forbes.com/sites/davidblackmon/2020/05/12/a-grim-earnings-season-for-the-us-shale-business/#6f55a95a1cf2 | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/09%3A_Perfect_competition/9.04%3A_Dynamics-_Entry_and_exit.txt |
When aggregating the firm-level supply curves, as illustrated in Figure 9.3, we did not assume that all firms were identical. In that example, firm A has a cost structure with a lower AVC curve, since its supply curve starts at a lower dollar value. This indicates that firm A may have a larger plant size than firm B – one that puts A closer to the minimum efficient scale region of its long-run ATC curve.
Figure 9.7 Firms with different plant sizes
Firm B cannot compete with Firm A in the long run given that B has a less efficient plant size than firm A. The equilibrium long-run price equals the minimum of the LAC. At this price firm B must move to a more efficient plant size or make losses.
Can firm B survive with his current scale of operation in the long run? Our industry dynamics indicate that it cannot. The reason is that, provided some firms are making economic profits, new entrepreneurs will enter the industry and drive the price down to the minimum of the ATC curve of those firms who are operating with the lowest cost plant size. B-type firms will therefore be forced either to leave the industry or to adjust to the least-cost plant size—corresponding to the lowest point on its long-run ATC curve. Remember that the same technology is available to all firms; they each have the same long-run ATC curve, and may choose different scales of operation in the short run, as illustrated in Figure 9.7. But in the long run they must all produce using the minimum-cost plant size, or else they will be driven from the market.
This behaviour enables us to define a long-run industry supply. The long run involves the entry and exit of firms, and leads to a price corresponding to the minimum of the long-run ATC curve. Therefore, if the long-run equilibrium price corresponds to this minimum, the long-run supply curve of the industry is defined by a particular price value—it is horizontal at the price corresponding to the minimum of the LATC. More or less output is produced as a result of firms entering or leaving the industry, with those present always producing at the same unit cost in a long-run equilibrium.
Industry supply in the long run in perfect competition is horizontal at a price corresponding to the minimum of the representative firm's long-run ATC curve.
Figure 9.8 Long-run dynamics
The LR equilibrium price PE is disturbed by a shift in demand from D1 to D2. With a fixed number of firms, P2 results. Profits accrue at this price and entry occurs. Therefore the SR supply shifts outwards until these profits are eroded and the new equilibrium output is Q2. If, instead, D falls to D3 then firms exit because they make losses, S shifts back until the price is driven up sufficiently to restore normal profits. Different outputs are supplied in the long run at the same price PE, therefore the long-run supply is horizontal at PE.
This industry's long-run supply curve, SL, and a particular short-run supply are illustrated in Figure 9.8. Different points on SL are attained when demand shifts. Suppose that, from an initial equilibrium Q1, defined by the intersection of D1 and S1, demand increases from D1 to D2 because of a growth in income. With a fixed number of firms, the additional demand can be met only at a higher price (P2), where each existing firm produces more using their existing plant size. The economic profits that result induce new operators to produce. This addition to the industry's production capacity shifts the short-run supply outwards and price declines until normal profits are once again being made. The new long-run equilibrium is at Q2, with more firms each producing at the minimum of their long-run ATC curve, PE.
The same dynamic would describe the industry reaction to a decline in demand—price would fall, some firms would exit, and the resulting contraction in supply would force the price back up to the long-run equilibrium level. This is illustrated by a decline in demand from D1 to D3.
Increasing and decreasing cost industries
While a horizontal long-run supply is the norm for perfect competition, in some industries costs increase with the scale of industry output; in others they decrease. This may be because all of the producers use a particular input that itself becomes more or less costly, depending upon the amount supplied.
Figure 9.9 Increasing and decreasing cost industries
When individual-supplier costs rise as the output of the industry increases we have an increasing cost supply curve for the industry in the long run. Conversely, when the costs of individual suppliers fall with the scale of the industry, we have a decreasing cost industry.
Decreasing cost sectors are those that benefit from a decline in the prices of their inputs as the size of their market expands. This is frequently because the suppliers of the inputs themselves can benefit from scale economies as a result of expansion in the market for the final good. A case in point has been the computer market, or the tablet market: As output in these markets has grown, the producers of videocards and random-access memory have benefited from scale economies and thus been able to sell these components at a lower price to the manufacturers of the final goods. An example of an increasing cost market is the market for landings and take-offs at airports. Airports are frequently limited in their ability to expand their size and build additional runways. In such markets, as use grows, planes about to land may have to adopt a circling holding pattern, while those departing encounter clearance delays. Such delays increase the time costs to passengers and the fuel and labour costs to the suppliers. Decreasing and increasing industry costs are reflected in the long-run industry supply curve by a downward-sloping segment or an upward sloping segment, as illustrated in Figure 9.9.
Increasing (decreasing) cost industry is one where costs rise (fall) for each firm because of the scale of industry operation. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/09%3A_Perfect_competition/9.05%3A_Long-run_industry_supply.txt |
Globalization and technological change have had a profound impact on the way goods and services are produced and brought to market in the modern world. The cost structure of many firms has been reduced by outsourcing to lower-wage economies. Furthermore, the advent of the communications revolution has effectively increased the minimum efficient scale for many industries, as illustrated in Chapter 8 (Figure 8.7). Larger firms are less difficult to manage nowadays, and the LAC curve may not slope upwards until very high output levels are attained. The consequence is that some industries may not have sufficient "production space" to sustain a large number of firms. In order to reap the advantages of scale economies, firms become so large that they can supply a significant part of the market. They are no longer so small as to have no impact on the price.
Outsourcing and easier communications have in many cases simply eliminated many industries in the developed world. Garment making is an example. Some decades ago Quebec was Canada's main garment maker: Brokers dealt with 'cottage-type' garment assemblers outside Montreal and Quebec City. But ultimately the availability of cheaper labour in the developing world combined with efficient communications undercut the local manufacture. Most of Canada's garments are now imported. Other North American and European industries have been impacted in similar ways. Displaced labour has had to reskill, retool, reeducate itself, and either seek alternative employment in the manufacturing sector, or move to the service sector of the economy, or retire.
Globalization has had a third impact on the domestic economy, in so far as it reduces the cost of components. Even industries that continue to operate within national boundaries see a reduction in their cost structure on account of globalization's impact on input costs. This is particularly in evidence in the computing industry, where components are produced in numerous low-wage economies, imported to North America and assembled into computers domestically. Such components are termed intermediate goods.
9.07: Efficient resource allocation
Economists have a particular liking for competitive markets. The reason is not, as is frequently thought, that we love competitive battles; it really concerns resource allocation in the economy at large. In Chapter 5 we explained why markets are frequently an excellent vehicle for transporting the economy's resources to where they are most valued: A perfectly competitive marketplace in which there are no externalities results in resources being used up to the point where the demand and supply prices are equal. If demand is a measure of marginal benefit and supply is a measure of marginal cost, then a perfectly competitive market ensures that this condition will hold in equilibrium. Perfect competition, therefore, results in resources being used efficiently.
Our initial reaction to this perspective may be: If market equilibrium is such that the quantity supplied always equals the quantity demanded, is not every market efficient? The answer is no. As we shall see in the next chapter on monopoly, the monopolist's supply decision does not reflect the marginal cost of resources used in production, and therefore does not result in an efficient allocation in the economy.
9.08: Key Terms
Perfect competition: an industry in which many suppliers, producing an identical product, face many buyers, and no one participant can influence the market.
Profit maximization is the goal of competitive suppliers – they seek to maximize the difference between revenues and costs.
Marginal revenue is the additional revenue accruing to the firm resulting from the sale of one more unit of output.
Shut-down price corresponds to the minimum value of the AVC curve.
Break-even price corresponds to the minimum of the ATC curve.
Short-run supply curve for perfect competitor: the portion of the MC curve above the minimum of the AVC.
Industry supply (short run) in perfect competition is the horizontal sum of all firms' supply curves.
Short-run equilibrium in perfect competition occurs when each firm maximizes profit by producing a quantity where P=MC.
Economic (supernormal) profits are those profits above normal profits that induce firms to enter an industry. Economic profits are based on the opportunity cost of the resources used in production.
Long-run equilibrium in a competitive industry requires a price equal to the minimum point of a firm's ATC. At this point, only normal profits exist, and there is no incentive for firms to enter or exit.
Industry supply in the long run in perfect competition is horizontal at a price corresponding to the minimum of the representative firm's long-run ATC curve.
Increasing (decreasing) cost industry is one where costs rise (fall) for each firm because of the scale of industry operation. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/09%3A_Perfect_competition/9.06%3A_Globalization_and_technological_change.txt |
EXERCISE 9.1
Wendy's Window Cleaning is a small local operation. Wendy presently cleans the outside windows in her neighbours' houses for \$36 per house. She does ten houses per day. She is incurring total costs of \$420, and of this amount \$100 is fixed. The cost per house is constant.
1. What is the marginal cost associated with cleaning the windows of one house – we know it is constant?
2. At a price of \$36, what is her break-even level of output (number of houses)?
3. If the fixed cost is 'sunk' and she cannot increase her output in the short run, should she shut down?
EXERCISE 9.2
A manufacturer of vacuum cleaners incurs a constant variable cost of production equal to \$80. She can sell the appliances to a wholesaler for \$130. Her annual fixed costs are \$200,000. How many vacuums must she sell in order to cover her total costs?
EXERCISE 9.3
For the vacuum cleaner producer in Exercise 9.2:
1. Draw the MC curve.
2. Next, draw her AFC and her AVC curves.
3. Finally, draw her ATC curve.
4. In order for this cost structure to be compatible with a perfectly competitive industry, what must happen to her MC curve at some output level?
EXERCISE 9.4
Consider the supply curves of two firms in a competitive industry: P=qA and P=2qB.
1. On a diagram, draw these two supply curves, marking their intercepts and slopes numerically (remember that they are really MC curves).
2. Now draw a supply curve that represents the combined supply of these two firms.
EXERCISE 9.5
Amanda's Apple Orchard Productions Limited produces 10,000 kilograms of apples per month. Her total production costs at this output level are \$8,000. Two of her many competitors have larger-scale operations and produce 12,000 and 15,000 kilos at total costs of \$9,500 and \$11,000 respectively. If this industry is competitive, on what segment of the LAC curve are these producers producing?
EXERCISE 9.6
Consider the data in the table below. TC is total cost, TR is total revenue, and Q is output.
Q 0 1 2 3 4 5 6 7 8 9 10
TC 10 18 24 31 39 48 58 69 82 100 120
TR 0 11 22 33 44 55 66 77 88 99 110
1. Add some extra rows to the table and for each level of output calculate the MR, the MC and total profit.
2. Next, compute AFC, AVC, and ATC for each output level, and draw these three cost curves on a diagram.
3. What is the profit-maximizing output?
4. How can you tell that this firm is in a competitive industry?
EXERCISE 9.7
Optional: The market demand and supply curves in a perfectly competitive industry are given by: Qd=30,000–600P and Qs=200P–2000.
1. Draw these functions on a diagram, and calculate the equilibrium price of output in this industry.
2. Now assume that an additional firm is considering entering. This firm has a short-run MC curve defined by MC=10+0.5q, where q is the firm's output. If this firm enters the industry and it knows the equilibrium price in the industry, what output should it produce?
EXERCISE 9.8
Optional: Consider two firms in a perfectly competitive industry. They have the same MC curves and differ only in having higher and lower fixed costs. Suppose the ATC curves are of the form: 400/q+10+(1/4)q and 225/q+10+(1/4)q. The MC for each is a straight line: MC=10+(1/2)q.
1. In the first column of a spreadsheet enter quantity values of 1, 5, 10, 15, 20,..., 50. In the following columns compute the ATC curves for each quantity value.
2. Compute the MC at each output in the next column, and plot all three curves.
3. Compute the break-even price for each firm.
4. Explain why both of these firms cannot continue to produce in the long run in a perfectly competitive market. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/09%3A_Perfect_competition/9.09%3A_Exercises_for_Chapter_9.txt |
Chapter 10: Monopoly
In this chapter we will explore:
10.1
Why monopolies exist
10.2
How monopolists maximize profits
10.3
Long-run behaviour
10.4
Monopoly and market efficiency
10.5
Price discrimination
10.6
Cartels
10.7
Invention, innovation and rent seeking
10.1 Monopolies
In analyzing perfect competition we emphasized the difference between the industry and the individual supplier. The individual supplier is an atomistic unit with no market power. In contrast, a monopolist has a great deal of market power, for the simple reason that a monopolist is the sole supplier of a particular product and so really is the industry. The word monopoly, comes from the Greek words monos, meaning one, and polein meaning to sell. When there is just a single seller, our analysis need not distinguish between the industry and the individual firm. They are the same on the supply side.
Furthermore, the distinction between long run and short run is blurred, because a monopoly that continues to survive as a monopoly obviously sees no entry or exit. This is not to say that monopolized sectors of the economy do not evolve, they do. Sometimes they die, sometimes they evolve in a different role. For example, when digital cameras entered the market place in the eighties the Polaroid Land camera (which printed film straight out of the camera) 'died' because the demand side of the market lost interest. The Blackberry 'smart' phone had a virtual monopoly on this product into the new millennium until Apple and Nokia entered the market.
A monopolist is the sole supplier of an industry's output, and therefore the industry and the firm are one and the same.
Monopolies can exist and exert their dominance in the market place for several reasons; scale economies, national policy, successful prevention of entry, research and development combined with patent protection.
Natural monopolies
Traditionally, monopolies were viewed as being 'natural' in some sectors of the economy. This means that scale economies define some industries' production and cost structures up to very high output levels, and that the whole market might be supplied at least cost by a single firm.
Consider the situation depicted in Figure 10.1. The long-run ATC curve declines indefinitely. There is no output level where average costs begin to increase. Imagine now having several firms, each producing with a plant size corresponding to the short-run average cost curve , or alternatively a single larger firm using a plant size denoted by . The small firms in this case cannot compete with the larger firm because the larger firm has lower production costs and can undercut the smaller firms, and supply the complete market in the process. Such a scenario is termed a natural monopoly.
Figure 10.1 A 'natural' monopolist
When LR average costs continue to decline at very high output, one large firm may be able to supply the industry at a lower unit cost than several smaller firms. With a plant size corresponding to ATC2, a single supplier can supply the whole market, whereas several smaller firms, each with plan size corresponding to ATC1, cannot compete with the larger firm on account of differential unit costs.
Natural monopoly: one where the ATC of producing any output declines with the scale of operation.
Electricity distribution in some of Canada's provinces is in the hands of a single supplier – Hydro Quebec or Hydro One in Ontario, for example. These distributors are natural monopolies in the sense described above: Unit distribution costs decline with size. In contrast, electricity production is not 'naturally' a monopoly. Other suppliers were once thought of as 'natural' monopolies also, but are no longer. Bell Canada was considered to be a natural monopoly in the era of land lines: It would not make economic sense to run several sets of phone lines to every residence. But that was before the arrival of cell phones, broadband and satellites. Canada Post was also thought to be a natural monopoly, until the advent of FEDEX, UPS and other couriers proved otherwise. Invention can compete away a 'natural' monopoly.
In reality there are very few pure monopolies. Facebook, Microsoft, Amazon, Apple, Netflix and Google may be extraordinarily dominant in their markets, but they are not the only suppliers of the services or products that they offer. There exist other products that are similar.
National and Provincial Policy
Government policy can foster monopolies. Some governments are, or once were, proud to have a 'national carrier' in the airline industry – Air Canada in Canada or British Airways in the UK. The mail service was viewed as a symbol of nationhood in Canada and the US: Canada Post and the US Postal system are national emblems that have historic significance. They were vehicles for integrating the provinces or states at various points in the federal lives of these countries.
In the modern era, most of Canada's provinces have decided to create a provincial monopoly crown corporation for the sale of cannabis. But competition abounds in the form of an illegal market.
The down side of such nationalist policies is that they can be costly to the taxpayer. Industries that are not subject to competition can become fat and uncompetitive: Managers have insufficient incentives to curtail costs; unions realize the government is committed to sustain the monopoly and push for higher wages than under a more competitive structure, and innovation may be less likely to occur.
Maintaining barriers to entry
Monopolies can continue to survive if they are successful in preventing the entry of new firms and products. Patents and copyrights are one vehicle for preserving the sole-supplier role, and are certainly necessary to encourage firms to undertake the research and development (R&D) for new products.
Many corporations produce products that require a large up-front investment; this might be in the form of research and development, or the construction of costly production facilities. For example, Boeing or Airbus incurs billions of dollars in developing new aircraft; pharmaceuticals may have to invest a billion dollars to develop a new drug. However, once such an investment is complete, the cost of producing each unit of output may be relatively low. This is particularly true in pharmaceuticals. Such a phenomenon is displayed in Figure 10.2. In this case the average cost for a small number of units produced is high, but once the fixed cost is spread over an ever larger output, the average cost declines rapidly, and in the limit approaches the marginal cost. These production structures are common in today's global economy, and they give rise to markets characterized either by a single supplier or a small number of suppliers.
Figure 10.2 Fixed cost and constant marginal cost
With a fixed cost of producing the first unit of output equal to F and a constant marginal cost thereafter, the long-run average total cost, LATC, declines indefinitely and becomes asymptotic to the marginal cost curve.
This figure is useful in understanding the role of patents. Suppose that Pharma A spends one billion dollars in developing a new drug and has constant unit production costs thereafter, while Pharma B avoids research and development and simply imitates Pharma A's product. Clearly Pharma B would have a LATC equal to its LMC, and would be able to undercut the initial developer of the drug. Such an outcome would discourage investment in new products and the economy at large would suffer as a consequence. Economies would be worse off if protection is not provided to the developers of new products because, if such protection is not offered, potential developers will not have the incentive to incur the up-front investment required.
While copyright and patent protection is legal, predatory pricing is an illegal form of entry barrier, and we explore it more fully in Chapter 14. An example would be where an existing firm that sells nationally may deliberately undercut the price of a small local entrant to the industry. Airlines with a national scope are frequently accused of posting low fares on flights in regional markets that a new carrier is trying to enter.
Political lobbying is another means of maintaining monopolistic power. For example, the Canadian Wheat Board had fought successfully for decades to prevent independent farmers from marketing wheat. This Board lost its monopoly status in August 2012, when the government of the day decided it was not beneficial to consumers or farmers in general. Numerous 'supply management' policies are in operation all across Canada. Agriculture is protected by production quotas. All maple syrup in Quebec must be marketed through a single monopoly supplier.
Critical networks also form a type of barrier, though not always a monopoly. Microsoft's Office package has an almost monopoly status in word processing and spreadsheet analysis for the reason that so many individuals and corporations use it. The fact that we know a business colleague will be able to edit our documents if written in Word, provides us with an incentive to use Word, even if we might prefer Wordperfect as a vehicle for composing documents. We develop the concept of strategic entry prevention further in Chapter 11.
10.2 Profit maximizing behaviour
We established in the previous chapter that, in deciding upon a profit-maximizing output, any firm should produce up to the point where the additional cost equals the additional revenue from a unit of output. What distinguishes the supply decision for a monopolist from the supply decision of the perfect competitor is that the monopolist faces a downward sloping demand. A monopolist is the sole supplier and therefore must meet the full market demand. This means that if more output is produced, the price must fall. We will illustrate the choice of a profit maximizing output using first a marginal-cost/marginal-revenue approach; then a supply/demand approach.
Marginal revenue and marginal cost
Table 10.1 displays price and quantity values for a demand curve in columns 1 and 2. Column 3 contains the sales revenue generated at each output. It is the product of price and quantity. Since the price denotes the revenue per unit, it is sometimes referred to as average revenue. The total revenue (TR) reaches a maximum at \$32, where 4 units of output are produced. A greater output necessitates a lower price on every unit sold, and in this case revenue falls if the fifth unit is brought to the market. Even though the fifth unit sells for a positive price, the price on the other 4 units is now lower and the net effect is to reduce total revenue. This pattern reflects what we examined in Chapter 4: As price is lowered from the highest possible value of \$14 (where 1 unit is demanded) and the corresponding quantity increases, revenue rises, peaks, and ultimately falls as output increases. In Chapter 4 we explained that this maximum revenue point occurs where the price elasticity is unity (-1), at the midpoint of a linear demand curve.
Table 10.1 A profit maximizing monopolist
Quantity Price Total Marginal Marginal Total Profit
(Q) (P) revenue (TR) revenue (MR) cost (MC) cost (TC)
0 16
1 14 14 14 2 2 12
2 12 24 10 3 5 19
3 10 30 6 4 9 21
4 8 32 2 5 14 18
5 6 30 -2 6 20 10
6 4 24 -6 7 27 -3
7 2 14 -10 8 35 -21
Figure 10.3 Total revenue and marginal revenue
When the quantity sold increases total revenue/expenditure initially increases also. At a certain point, further sales require a price that not only increases quantity, but reduces revenue on units already being sold to such a degree that TR declines – where the demand elasticity equals –1 (the mid point of a linear demand curve). Here the midpoint occurs at Q=4. Where the TR is a maximum the MR=0.
Related to the total revenue function is the marginal revenue function. It is the addition to total revenue due to the sale of one more unit of the commodity.
Marginal revenue is the change in total revenue due to selling one more unit of the good.
Average revenue is the price per unit sold.
The MR in this example is defined in the fourth column of Table 10.1. When the quantity sold increases from 1 unit to 2 units total revenue increases from \$14 to \$24. Therefore the marginal revenue associated with the second unit of output is \$10. When a third unit is sold TR increases to \$30 and therefore the MR of the third unit is \$6. As output increases the MR declines and eventually becomes negative – at the point where the TR is a maximum: If TR begins to decline then the additional revenue is by definition negative.
The MR function is plotted in Figure 10.4. It becomes negative when output increases from 4 to 5 units.
Figure 10.4 Monopolist's profit maximizing output
It is optimal for the monopolist to increase output as long as MR exceeds MC. In this case MR>MC for units 1, 2 and 3. But for the fourth unit MC>MR and therefore the monopolist would reduce total profit by producing it. He should produce only 3 units of output.
The optimal output
This producer has a marginal cost structure given in the fifth column of the table, and this too is plotted in Figure 10.4. Our profit maximizing rule from Chapter 8 states that it is optimal to produce a greater output as long as the additional revenue exceeds the additional cost of production on the next unit of output. In perfectly competitive markets the additional revenue is given by the fixed price for the individual producer, whereas for the monopolist the additional revenue is the marginal revenue. Consequently as long as MR exceeds MC for the next unit a greater output is profitable, but once MC exceeds MR the production of additional units should cease.
From Table 10.1 and Figure 10.4 it is clear that the optimal output is at 3 units. The third unit itself yields a profit of 2\$, the difference between MR (\$6) and MC (\$4). A fourth unit however would reduce profit by \$3, because the MR (\$2) is less than the MC (\$5). What price should the producer charge? The price, as always, is given by the demand function. At a quantity sold of 3 units, the corresponding price is \$10, yielding total revenue of \$30.
Profit is the difference between total revenue and total cost. In Chapter 8 we computed total cost as the average cost times the number of units produced. It can also be computed as the sum of costs associated with each unit produced: The first unit costs \$2, the second \$3 and the third \$4. The total cost of producing 3 units is the sum of these dollar values: . The profit-maximizing output therefore yields a profit of \$21 ().
Supply and demand
When illustrating market behaviour it is convenient to describe behaviour by simple linear supply and demand functions that are continuous, rather than the 'step' functions used in the preceding example. As explained in Chapter 5, in using continuous curves to represent a market we implicitly assume that a unit of output can be broken into subunits. In the example above we assumed that sales always involve one whole unit of the product being sold. In fact many goods can be sold in fractional units: Gasoline can be sold in fractions of a litre; fruits and vegetables can be sold in fractions of a kilogram, and so forth. Table 10.2 below furnishes the data for our analysis.
Table 10.2 Discrete quantities
Price Quantity Total Total Profit
demanded revenue cost
12 0 0 0 0
11 2 22 1 21
10 4 40 4 36
9 6 54 9 45
8 8 64 16 48
7 10 70 25 45
6 12 72 36 36
5 14 70 49 21
4 16 64 64 0
3 18 54 81 -27
2 20 40 100 -60
1 22 22 121 -99
0 24 0 144 -144
The first two columns define the demand curve. Total revenue is the product of price and quantity and given in column 3. The cost data are given in column 4, and profit – the difference between total revenue and total cost is in the final column. Profit is maximized where the difference between revenue and cost is greatest; in this case where the output is 8 units. At lower or higher outputs profit is less. Figure 10.5 contains the curves defining total revenue (TR), total cost (TC) and profit. These functions can be obtained by mapping all of the revenue-quantity combinations, the cost-quantity combinations, and the profit-quantity combinations as a series of points, and joining these points to form the smooth functions displayed. The vertical axis is measured in dollars, the horizontal axis in units of output. Graphically, profit is maximized where the dollar difference between TR and TC is greatest; that is at the output where the vertical distance between the two curves is greatest. This difference, which is also defined by the profit curve, occurs at a value of 8 units, corresponding to the outcome in Table 10.2.
Figure 10.5 Total revenue, total cost & profit
At any quantity less than this output, profit would rise with additional output. This is because, from a less-than-optimal output, the additional revenue from increased sales exceeds the increased cost associated with producing those units: Stated differently, the marginal revenue would exceed the marginal cost. Conversely, outputs greater than the optimum result in a MR less than the associated MC. Accordingly, since outputs where MR>MC are too low, and outputs where MR<MC are too high, the optimum must be where the MR=MC. Hence, the equality between MR and MC is implied in this diagram at the output where the difference between TR and TC is greatest.
Note finally that total revenue is maximized where the TR curve reaches a peak. In this example that occurs at a value of 12 units of output. This is to be anticipated, as we learned in Chapter 4, because the midpoint of the demand schedule in Table 10.2 occurs at that value.
Figure 10.6 Market demand, the MR curve, and the monopolist's AC and MC curves
Figure 10.6 displays the demand curve for the market, the MR curve, and the monopolist's MC and AC curves. Consider first the marginal revenue curve. In contrast to the previous example, where only whole or integer units could be sold, in this example units can be sold in fractional amounts, and the MR curve must reflect this. To determine the position of the MR curve, note that with a straight-line demand curve total revenue is a maximum at the midpoint of the demand curve. Any increase in output results in reduced revenue: Stated differently, the marginal revenue becomes negative at that output. Up to that output the MR is positive, as illustrated in Figure 10.3. Accordingly, the MR curve must intersect the quantity axis midway between zero and the horizontal-axis intercept of the demand curve. Geometrically, since the MR intersects the quantity axis half way to the horizontal intercept of the demand curve, it must have a slope that is twice the slope of the demand curve.
By observing the data in columns 1 and 2 of the table, the demand curve intercepts are , and from above discussion the MR curve has intercepts . The AC is obtained by dividing TC by output in Table 10.2, and the MC can be also calculated as the change in total cost divided by the change in output from Table 10.2. The result of these calculations is displayed in Figure 10.6.
The profit maximizing output is 8 units, where MC=MR. The price at which 8 units can be sold is read from the demand curve1, or the first column in Table 10.2. It is \$8. And, as expected, this price-quantity combination maximizes profit. Table 10.2 indicates that profit is maximized at \$48, at q=8.
Demand elasticity and marginal revenue
We have shown above that the MR curve cuts the horizontal axis at a quantity where the elasticity of demand is unity. We know from Chapter 4 that demand is elastic at points on the demand curve above this unit-elastic point. Furthermore, since the intersection of MR and MC must be at a positive dollar value (MC cannot be negative), then it must be the case that the profit maximizing price for a monopolist always lies on the elastic segment of the demand curve.
A general graphical representation
In Figure 10.7 we generalize the graphical representation of the monopoly profit maximizing output by allowing the MC and ATC curves to be nonlinear. The optimal output is at , where MR=MC, and the price sustains that output. With the average cost known, profit per unit is AB, and therefore total profit is this margin multiplied by the number of units sold, .
Total profit is therefore
Note that the monopolist may not always make a profit. Losses could result in Figure 10.7 if average costs were to rise so that the ATC were everywhere above the demand curve, or if the demand curve shifted down to being everywhere below the ATC curve. In the longer term the monopolist would have to either reduce costs or perhaps stimulate demand through advertising if she wanted to continue in operation.
Figure 10.7 The monopoly equilibrium
The profit maximizing output is QE, where MC=MR. This output can be sold at a price PE. The cost per unit of QE is read from the ATC curve, and equals B. Per unit profit is therefore AB and total profit is PEABCE.
10.3 Long-run choices
Consider next the impact of a shift in demand upon the profit maximizing choice of this firm. A rightward shift in demand in Figure 10.7 also yields a new MR curve. The firm therefore chooses a new level of output, using the same profit maximizing rule: Set MC=MR. This output will be greater than the previous output, but again the price must be on an elastic portion of the new demand curve. If operating with the same plant size, the MC and ATC curves do not change and the new profit per unit is again read from the ATC curve.
By this stage the curious student will have asked: "What happens to plant size in the long run?" For example, is the monopolist in Figure 10.7 using the most appropriate plant size in the first place? Even if she is, should the monopolist consider adopting an expanded plant size in response to the shift in demand?
The answer is: In the long run the monopolist is free to choose whatever plant size is best. Her initial plant size might have been optimal for the demand she faced, but if it was, it is unlikely to be optimal for the larger scale of production associated with the demand shift. Accordingly, with the new demand curve, she must consider how much profit she could make using different plant sizes.
Figure 10.8 The monopolist's choice of plant size
With constant returns to scale and constant prices per unit of labour and capital, a doubling of output involves exactly a doubling of costs. Thus, per unit costs, or average costs, are constant in the LR. Hence LAC=LMC, and each is constant.
To illustrate one possibility, we will think of this firm as having constant returns to scale at all output ranges, as displayed in Figure 10.8. (Our reasoning carries through if the LAC slopes downwards; the graph just becomes a little more complex.) The key characteristic of constant returns to scale is that a doubling of inputs leads to a doubling of output. Therefore, if the per-unit cost of inputs is fixed, a doubling of inputs (and therefore output) leads exactly to a doubling of costs. This implies that, when the firm varies its plant size and its labour use, the cost of producing each additional unit must be constant. The long-run marginal cost LMC is therefore constant and equals the ATC in the long run.
Figure 10.9 describes the market for this good. The optimal output and price are determined in the usual manner: Set MC=MR. If the monopolist has plant size corresponding to ATC1, the optimal output is Q1 and should be sold at the price P1.The key issue now is: Given the demand conditions, could the monopolist make more profit by choosing a plant size that differs from the one corresponding to ATC1?
Figure 10.9 Plant size in the long run
With demand conditions defined by D and MR, the optimal plant size is one corresponding to the point where MR=MC in the long run. Therefore Q2 is the optimal output and the optimal plant size corresponds to ATC2. If the current plant is defined by ATC1, then optimal SR production is Q1.
In this instance the answer is a clear 'yes'. Her LMC curve is horizontal and so, by increasing output from Q1 to Q2 she earns a profit on each additional unit in that range, because the MR curve lies above the LMC curve. In order to produce the output level Q2 at least cost she must choose a plant size corresponding to AC2.
10.4 Output inefficiency
A characteristic of perfect competition is that it secures an efficient allocation of resources when there are no externalities in the market: Resources are used up to the point where their marginal cost equals their marginal value – as measured by the price that consumers are willing to pay. But a monopoly structure does not yield this output. Consider Figure 10.10.
Figure 10.10 Monopoly output inefficiency
A monopolist maximizes profit at QM. Here the value of marginal output exceeds cost. If output expands to Q× a gain arises equal to the area ABF. This is the deadweight loss associated with the output QM rather than Q×. If the monopolist's long-run MC is equivalent to a competitive industry's supply curve, then the deadweight loss is the cost of having a monopoly rather than a perfectly competitive market.
The monopolist's profit-maximizing output is where MC equals MR. This output is inefficient for the reason that we developed in Chapter 5: If output is increased beyond the additional benefit exceeds the additional cost of producing it. The additional benefit is measured by the willingness of buyers to pay – the market demand curve. The additional cost is the long-run MC curve under the assumption of constant returns to scale. Using the terminology from Chapter 5, there is a deadweight loss equal to the area ABF. This is termed allocative inefficiency.
Allocative inefficiency arises when resources are not appropriately allocated and result in deadweight losses .
Perfect competition versus monopoly
The area ABF can also be considered as the efficiency loss associated with having a monopoly rather than a perfectly competitive market structure. In perfect competition the supply curve is horizontal. This is achieved by having firms enter and exit when more or less must be produced. Accordingly, if the perfectly competitive industry's supply curve approximates the monopolist's long-run marginal cost curve2, we can say that if the monopoly were turned into a competitive industry, output would increase from to . The deadweight loss is one measure of the superiority of the perfectly competitive structure over the monopoly structure.
Note that this critique of monopoly is not initially focused upon profit. While monopoly profits are what frequently irk the public, we have focused upon resource allocation inefficiencies. But in a real sense the two are related: Monopoly inefficiencies arise through output being restricted, and it is this output reduction – achieved by maintaining a higher than competitive price – that gives rise to those profits. Nonetheless, there is more than just a shift in purchasing power from the buyer to the seller. Deadweight losses arise because output is at a level lower than the point where the MC equals the value placed on the good; thus the economy is sacrificing the possibility of creating additional surplus.
Given that monopoly has this undesirable inefficiency, what measures should be taken, if any, to counter the inefficiency? We will see what Canada's Competition Act has to say in Chapter 14 and also examine what other measures are available to control monopolies.
10.5 Price discrimination
A common characteristic in the pricing of many goods is that different individuals pay different prices for goods or services that are essentially the same. Examples abound: Seniors get a reduced rate for coffee in Burger King; hair salons charge women more than they charge men; bank charges are frequently waived for juniors. Price discrimination involves charging different prices to different consumers in order to increase profit.
Price discrimination involves charging different prices to different consumers in order to increase profit.
A strict definition of discrimination involves different prices for identical products. We all know of a school friend who has been willing to take the midnight flight to make it home at school break at a price he can afford. In contrast, the business executive prefers the seven a.m. flight to arrive for a nine a.m. business meeting in the same city at several times the price. These are very mild forms of price discrimination, since a midnight flight (or a midday flight) is not a perfect substitute for an early morning flight. Price discrimination is practiced because buyers are willing to pay different amounts for a good or service, and the supplier may have a means of profiting from this. Consider the following example.
Family Flicks is the local movie theatre. It has two distinct groups of customers – those of prime age form one group; youth and seniors form the other. Family Flicks has done its market research and determined that each group accounts for 50 percent of the total market of 100 potential viewers per screening. It has also established that the prime-age group members are willing to pay \$12 to see a movie, while the seniors and youth are willing to pay just \$5. How should the tickets be priced?
Family Flicks has no variable costs, only fixed costs. It must pay a \$100 royalty to the movie maker each time it shows the current movie, and must pay a cashier and usher \$20 each. Total costs are therefore \$140, regardless of how many people show up – short-run MC is zero. On the pricing front, as illustrated in Table 10.3 below, if Family Flicks charges \$12 per ticket it will attract 50 viewers, generate \$600 in revenue and therefore make a profit of \$460.
Table 10.3 Price discrimination
P=\$5 P=\$12 Twin price
No. of customers 100 50
Total revenue \$500 \$600 \$850
Total costs \$140 \$140 \$140
Profit \$360 \$460 \$710
In contrast, if it charges \$5 it can fill the theatre, because each of the prime-age individuals is willing to pay more than \$5, but the seniors and youth are now offered a price they too are willing to pay. However, the total revenue is now only \$500 (), and profits are reduced to \$360. It therefore decides to charge the high price and leave the theatre half-empty, because this strategy maximizes its profit.
Suppose finally that the theatre is able to segregate its customers. It can ask the young and senior customers for identification upon entry, and in this way charge them a lower price, while still maintaining the higher price to the prime-age customers. If it can execute such a plan Family Flicks can now generate \$850 in revenue – \$600 from the prime-age group and \$250 from the youth and seniors groups. Profit soars to \$710.
There are two important conditions for this scheme to work:
1. The seller must be able to segregate the market at a reasonable cost. In the movie case this is achieved by asking for identification.
2. The second condition is that resale must be impossible or impractical. For example, we rule out the opportunity for young buyers to resell their tickets to the prime-age individuals. Sellers have many ways of achieving this – they can require immediate entry to the movie theatre upon ticket purchase, they can stamp the customer's hand, they can demand the showing of ID with the ticket when entering the theatre area.
Frequently we think of sellers who offer price reductions to specific groups as being generous. For example, hotels may levy only a nominal fee for the presence of a child, once the parents have paid a suitable rate for the room or suite in which a family stays. The hotel knows that if it charges too much for the child, it may lose the whole family as a paying unit. The coffee shop offering cheap coffee to seniors is interested in getting a price that will cover its variable cost and so contribute to its profit. It is unlikely to be motivated by philanthropy, or to be concerned with the financial circumstances of seniors.
Figure 10.11 Price discrimination at the movies
At P=12, 50 prime-age individuals demand movie tickets. At P=5, 50 more seniors and youths demand tickets. Since the MC is zero the efficient output is where the demand curve takes a zero value – where all 100 customers purchase tickets. Thus, any scheme that results in all 100 individuals buying ticket is efficient. Efficient output is at point C.
Price discrimination has a further interesting feature that is illustrated in Figure 10.11: It frequently reduces the deadweight loss associated with a monopoly seller!
In our Family Flicks example, the profit maximizing monopolist that did not, or could not, price discriminate left 50 customers unsupplied who were willing to pay \$5 for a good that had a zero MC. This is a deadweight loss of \$250 because 50 seniors and youth valued a commodity at \$5 that had a zero MC. Their demand was not met because, in the absence of an ability to discriminate between consumer groups, Family Flicks made more profit by satisfying the demand of the prime-age group alone. But in this example, by segregating its customers, the firm's profit maximization behaviour resulted in the DWL being eliminated, because it supplied the product to those additional 50 individuals. In this instance price discrimination improves welfare, because more of a good is supplied in a situation where market valuation exceeds marginal cost.
In the preceding example we simplified the demand side of the market by assuming that every individual in a given group was willing to pay the same price – either \$12 or \$5. More realistically each group can be defined by a downward-sloping demand curve, reflecting the variety of prices that buyers in a given market segment are willing to pay. It is valuable to extend the analysis to include this reality. For example, a supplier may face different demands from her domestic and foreign buyers, and if she can segment these markets she can price discriminate effectively.
Consider Figure 10.12 where two segmented demands are displayed, DA and DB, with their associated marginal revenue curves, MRA and MRB. We will assume that marginal costs are constant for the moment. It should be clear by this point that the profit maximizing solution for the monopoly supplier is to supply an amount to each market where the MC equals the MR in each market: Since the buyers in one market cannot resell to buyers in the other, the monopolist considers these as two different markets and therefore maximizes profit by applying the standard rule. She will maximize profit in market A by supplying the quantity QA and in market B by supplying QB. The prices at which these quantities can be sold are PA and PB. These prices, unsurprisingly, are different – the objective of segmenting markets is to increase profit by treating the markets as distinct.
An example of this type of price discrimination is where pharmaceutical companies sell drugs to less developed economies at a lower price than to developed economies. The low price is sufficient to cover marginal cost and is therefore profitable - provided the high price market covers the fixed costs.
Figure 10.12 Pricing in segregated markets
With two separate markets defined by DA and DB, and their associated MR curves MRA and MRB, a profit maximizing strategy is to produce where MC=MRA=MRB, and discriminate between the two markets by charging prices PA and PB.
The preceding examples involved two separable groups of customers and are very real. This kind of group segregation is sometimes called third degree price discrimination. But it may be possible to segregate customers into several groups rather than just two. In the limit, if we could charge a different price to every consumer in a market, or for every unit sold, the revenue accruing to the monopolist would be the area under the demand curve up to the output sold. Though primarily of theoretical interest, this is illustrated in Figure 10.13. It is termed perfect price discrimination, and sometimes first degree price discrimination. Such discrimination is not so unrealistic: A tax accountant may charge different customers a different price for providing the same service; home renovators may try to charge as much as any client appears willing to pay.
Figure 10.13 Perfect price discrimination
A monopolist who can sell each unit at a different price maximizes profit by producing Q×. With each consumer paying a different price the demand curve becomes the MR curve. The result is that the monopoly DWL is eliminated because the efficient output is produced, and the monopolist appropriates all the consumer surplus. Total revenue for the perfect price discriminator is OABQ×.
Second degree price discrimination is based on a different concept of buyer identifiability. In the cases we have developed above, the seller is able to distinguish the buyers by observing a vital characteristic that signals their type. It is also possible that, while individuals might have defining traits which influence their demands, such traits might not be detectable by the supplier. Nonetheless, it is frequently possible for the supplier to offer different pricing options (corresponding to different uses of a product) that buyers would choose from, with the result that her profit would be greater than under a uniform price with no variation in the use of the service. Different cell phone 'plans', or different internet plans that users can choose from are examples of this second-degree discrimination.
10.6 Cartels: Acting like a monopolist
A cartel is a group of suppliers that colludes to operate like a monopolist. The cartel formed by the members of the Organization of Oil Exporting Countries (OPEC) is an example of a cartel that was successful in achieving its objectives for a long period. This cartel first flexed its muscles in 1973, by increasing the world price of oil from \$3 per barrel to \$10 per barrel. The result was to transfer billions of dollars from the energy-importing nations in Europe and North America to OPEC members – the demand for oil is relatively inelastic, hence an increase in price increases total expenditures.
A cartel is a group of suppliers that colludes to operate like a monopolist.
A second renowned cartel is managed by De Beers, which controls a large part of the world's diamond supply. In Canada, agricultural marketing boards are a means of restricting supply legally. Such cartels may have thousands of members. By limiting entry, through requiring a production 'quota', the incumbents can charge a higher price than if entry to the industry were free.
To illustrate the dynamics of cartels consider Figure 10.14. Several producers, with given production capacities, come together and agree to restrict output with a view to increasing price and therefore profit. This may be done with the agreement of the government, or it may be done secretively, and possibly against the law. Each firm has a MC curve, and the industry supply is defined as the sum of these marginal cost curves, as illustrated in Figure 9.3. The resulting cartel is effectively one in which there is a single supplier with many different plants – a multi-plant monopolist. To maximize profits this organization will choose an output level where the MR equals the MC. In contrast, if these firms act competitively the output chosen will be . The competitive output yields no supernormal profit, whereas the monopoly/cartel output does.
Figure 10.14 Cartelizing a competitive industry
A cartel is formed when individual suppliers come together and act like a monopolist in order to increase profit. If MC is the joint supply curve of the cartel, profits are maximized at the output Qm, where MC=MR. In contrast, if these firms operate competitively output increases to Qc.
The cartel results in a deadweight loss equal to the area ABF, just as in the standard monopoly model.
Cartel instability
Some cartels are unstable in the long run. In the first instance, the degree of instability depends on the authority that the governing body of the cartel can exercise over its members, and upon the degree of information it has on the operations of its members. If a cartel is simply an arrangement among producers to limit output, each individual member of the cartel has an incentive to increase its output, because the monopoly price that the cartel attempts to sustain exceeds the cost of producing a marginal unit of output. In Figure 10.14 each firm has a MC of output equal to \$F when the group collectively produces the output . Yet any firm that brings output to market, beyond its agreed production limit, at the price will make a profit of AF on that additional output – provided the other members of the cartel agree to restrict their output. Since each firm faces the same incentive to increase output, it is difficult to restrain all members from doing so.
Individual members are more likely to abide by the cartel rules if the organization can sanction them for breaking the supply-restriction agreement. Alternatively, if the actions of individual members are not observable by the organization, then the incentive to break ranks may be too strong for the cartel to sustain its monopoly power.
We will see in Chapter 14 that Canada's Competition Act forbids the formation of cartels, as it forbids many other anti-competitive practices. At the same time, our governments frequently are the driving force in the formation of domestic cartels.
In the second instance, cartels may be undermined eventually by the emergence of new products and new technologies. OPEC has lost much of its power in the modern era because of technological developments in oil recovery. Canada's 'tar sands' yield oil, as a result of technological developments that enabled producers to separate the oil from the earth it is mixed with. Fracking technologies are another means of extracting oil that is discovered in small pockets and encased in rock. The supply coming from these new technologies has limited the ability of the old OPEC cartel to increase prices through supply restriction.
Application Box 10.1 The taxi cartel
The new sharing economy has brought competition to some traditional cartels. City taxis are an example of such a formation: Traditionally, entry has been restricted to drivers who hold a permit (medallion), and fares are higher as a consequence of the resulting reduced supply. A secondary market then develops for these medallions, in which the city may offer new medallions through auction, or existing owners may exit and sell their medallions. Restricted entry has characterized most of Canada's major cities. Depending on the strictness of the entry process, medallions are worth correspondingly more. By 2012, medallions were selling in New York and Boston for a price in the neighborhood of one million dollars.
But ride-sharing start-up companies changed all of that. As Western examples, Uber and Lyft developed smart-phone apps that link demanders for rides with drivers, who may, or may not be, part of the traditional taxi companies. Such start-ups have succeeded in taking a significant part of the taxi business away from the traditional operators. As a result, the price of taxi medallions on the open market has plunged. From trading in the range of \$1m. in New York in 2012, medallions are being offered in 2019 at about one fifth of that price. In Toronto, some medallions were traded in the range of \$300,000 in 2012, but are on offer in 2019 for prices in the range of \$30,000.
Not surprisingly, the traditional taxi companies charge that ride-hailing operators are violating the accepted rules governing the taxi business, and have launched legal suits against them and against local governments, and lobbied governments to keep them out of their cities.
In the new 'sharing economy', of which ride hailing companies are an example, participants operate with less traditional capital, and the communications revolution has been critical to their success. Home owners can use an online site to rent a spare bedroom in their house to visitors to their city (Airbnb), and thus compete with hotels. The main capital in this business is in the form of the information technology that links potential buyers to potential sellers.
Information on medallion prices in Canada can be found by, for example, searching at http://www.kijiji.ca
10.7 Invention, innovation and rent seeking
Invention and innovation are critical aspects of the modern economy. In some sectors of the economy, firms that cannot invent or innovate are liable to die. Invention is a genuine discovery, whereas innovation is the introduction of a new product or process.
Invention is the discovery of a new product or process through research.
Product innovation refers to new or better goods or services.
Process innovation refers to new or better production or supply.
To this point we have said little that is good about monopolies. However, the economist Joseph Schumpeter argued that, while monopoly leads to resource misallocation in the economy, this cost might be offset by the greater tendency for monopoly firms to invent and innovate. This is because such firms have more profit and therefore more resources with which to fund R&D and may therefore be more innovative than competitive firms. If this were true then, taking a long-run dynamic view of the marketplace, monopolies could have lower costs and more advanced products than competitive firms and thus benefit the consumer.
While this argument has some logical appeal, it falls short on several counts. First, even if large firms carry out more research than competitive firms, there is no guarantee that the ensuing benefits carry over to the consumer. Second, the results of such research may be used to prevent entry into the industry in question. Firms may register their inventions and gain use protection before a competitor can come up with the same or a similar invention. Apple and Samsung each own tens of thousands of patents. Third, the empirical evidence on the location of most R&D is inconclusive: A sector with several large firms, rather than one with a single or very many firms, may be best. For example, if Apple did not have Samsung as a competitor, or vice versa, would the pace of innovation be as strong?
Fourth, much research has a 'public good' aspect to it. Research carried out at universities and government-funded laboratories is sometimes referred to as basic research: It explores the principles underlying chemistry, social relations, engineering forces, microbiology, etc., and has multiple applications in the commercial world. If disseminated, this research is like a public good – its fruits can be used in many different applications, and its use in one area does not preclude its use in others. Consequently, rather than protecting monopolies on the promise of more R&D, a superior government policy might be to invest directly in research and make the fruits of the research publicly available.
Modern economies have patent laws, which grant inventors a legal monopoly on use for a fixed period of time – perhaps fifteen years. By preventing imitation, patent laws raise the incentive to conduct R&D but do not establish a monopoly in the long run. Over the life of a patent the inventor charges a higher price than would exist if his invention were not protected; this both yields greater profits and provides the research incentive. When the patent expires, competition from other producers leads to higher output and lower prices for the product. Generic drugs are a good example of this phenomenon.
Patent laws grant inventors a legal monopoly on use for a fixed period of time.
The power of globalization once again is very relevant in patents. Not all countries have patent laws that are as strong as those in North America and Europe. The BRIC economies (Brazil, Russia, India and China) form an emerging power block. But their legal systems and enforcement systems are less well-developed than in Europe or North America. The absence of a strong and transparent legal structure inhibits research and development, because their fruits may be appropriated by competitors.
Rent seeking
Citizens are frequently appalled when they read of lobbying activities in their nation's capital. Every capital city in the world has an army of lobbyists, seeking to influence legislators and regulators. Such individuals are in the business of rent seeking, whose goal is to direct profit to particular groups, and protect that profit from the forces of competition. In Virginia and Kentucky we find that state taxes on cigarettes are the lowest in the US – because the tobacco leaf is grown in these states, and the tobacco industry makes major contributions to the campaigns of some political representatives.
Rent-seeking carries a resource cost: Imagine that we could outlaw the lobbying business and put these lobbyists to work producing goods and services in the economy instead. Their purpose is to maintain as much quasi-monopoly power in the hands of their clients as possible, and to ensure that the fruits of this effort go to those same clients. If this practice could be curtailed then the time and resources involved could be redirected to other productive ends.
Rent seeking is an activity that uses productive resources to redistribute rather than create output and value.
Industries in which rent seeking is most prevalent tend to be those in which the potential for economic profits is greatest – monopolies or near-monopolies. These, therefore, are the industries that allocate resources to the preservation of their protected status. We do not observe laundromat owners or shoe-repair businesses lobbying in Ottawa.
Conclusion
We have now examined two extreme types of market structure – perfect competition and monopoly. While many sectors of the economy operate in a way that is close to the competitive paradigm, very few are pure monopolies in that they have no close substitute products. Even firms like Microsoft, or De Beers, that supply a huge percentage of the world market for their product would deny that they are monopolies and would argue that they are subject to strong competitive pressures from smaller or 'fringe' producers. As a result we must look upon the monopoly paradigm as a useful way of analyzing markets, rather than being an exact description of the world. Accordingly, our next task is to examine how sectors with a few, several or multiple suppliers act when pursuing the objective of profit maximization. Many different market structures define the real economy, and we will concentrate on a limited number of the more important structures in the next chapter.
Key Terms
Monopolist: is the sole supplier of an industry's output, and therefore the industry and the firm are one and the same.
Natural monopoly: one where the ATC of producing any output declines with the scale of operation.
Marginal revenue is the change in total revenue due to selling one more unit of the good.
Average revenue is the price per unit sold.
Allocative inefficiency arises when resources are not appropriately allocated and result in deadweight losses.
Price discrimination involves charging different prices to different consumers in order to increase profit.
A cartel is a group of suppliers that colludes to operate like a monopolist.
Rent seeking is an activity that uses productive resources to redistribute rather than create output and value.
Invention is the discovery of a new product or process through research.
Product innovation refers to new or better products or services.
Process innovation refers to new or better production or supply.
Patent laws grant inventors a legal monopoly on use for a fixed period of time.
Exercises for Chapter 10
EXERCISE 10.1
Consider a monopolist with demand curve defined by P=100–2Q. The MR curve is MR=100–4Q and the marginal cost is MC=10+Q. The demand intercepts are , the MR intercepts are .
1. Develop a diagram that illustrates this market, using either graph paper or an Excel spreadsheet, for values of output .
2. Identify visually the profit-maximizing price and output combination.
3. Optional: Compute the profit maximizing price and output combination.
EXERCISE 10.2
Consider a monopolist who wants to maximize revenue rather than profit. She has the demand curve P=72–Q, with marginal revenue MR=72–2Q, and MC=12. The demand intercepts are , the MR intercepts are .
1. Graph the three functions, using either graph paper or an Excel spreadsheet.
2. Calculate the price she should charge in order to maximize revenue. [Hint: Where the MR=0.]
3. Compute the total revenue she will obtain using this strategy.
EXERCISE 10.3
Suppose that the monopoly in Exercise 10.2 has a large number of plants. Consider what could happen if each of these plants became a separate firm, and acted competitively. In this perfectly competitive world you can assume that the MC curve of the monopolist becomes the industry supply curve.
1. Illustrate graphically the output that would be produced in the industry?
2. What price would be charged in the marketplace?
3. Optional: Compute the gain to the economy in dollar terms as a result of the DWL being eliminated [Hint: It resembles the area ABF in Figure 10.14].
EXERCISE 10.4
In the text example in Table 10.1, compute the profit that the monopolist would make if he were able to price discriminate, by selling each unit at the demand price in the market.
EXERCISE 10.5
A monopolist is able to discriminate perfectly among his consumers – by charging a different price to each one. The market demand curve facing him is given by P=72–Q. His marginal cost is given by MC=24 and marginal revenue is MR=72–2Q.
1. In a diagram, illustrate the profit-maximizing equilibrium, where discrimination is not practiced. The demand intercepts are , the MR intercepts are .
2. Illustrate the equilibrium output if he discriminates perfectly.
3. Optional: If he has no fixed cost beyond the marginal production cost of \$24 per unit, calculate his profit in each pricing scenario.
EXERCISE 10.6
A monopolist faces two distinct markets A and B for her product, and she is able to insure that resale is not possible. The demand curves in these markets are given by PA=20–(1/4)QA and PB=14–(1/4)QB. The marginal cost is constant: MC=4. There are no fixed costs.
1. Graph these two markets and illustrate the profit maximizing price and quantity in each market. [You will need to insert the MR curves to determine the optimal output.] The demand intercepts in A are , and in B are .
2. In which market will the monopolist charge a higher price?
EXERCISE 10.7
A concert organizer is preparing for the arrival of the Grateful Living band in his small town. He knows he has two types of concert goers: One group of 40 people, each willing to spend \$60 on the concert, and another group of 70 people, each willing to spend \$40. His total costs are purely fixed at \$3,500.
1. Draw the market demand curve faced by this monopolist.
2. Draw the MR and MC curves.
3. With two-price discrimination what will be the monopolist's profit?
4. If he must charge a single price for all tickets can he make a profit?
EXERCISE 10.8
Optional: A monopolist faces a demand curve P=64–2Q and MR=64–4Q. His marginal cost is MC=16.
1. Graph the three functions and compute the profit maximizing output and price.
2. Compute the efficient level of output (where MC=demand), and compute the DWL associated with producing the profit maximizing output rather than the efficient output.
10: Monopoly
In analyzing perfect competition we emphasized the difference between the industry and the individual supplier. The individual supplier is an atomistic unit with no market power. In contrast, a monopolist has a great deal of market power, for the simple reason that a monopolist is the sole supplier of a particular product and so really is the industry. The word monopoly, comes from the Greek words monos, meaning one, and polein meaning to sell. When there is just a single seller, our analysis need not distinguish between the industry and the individual firm. They are the same on the supply side.
Furthermore, the distinction between long run and short run is blurred, because a monopoly that continues to survive as a monopoly obviously sees no entry or exit. This is not to say that monopolized sectors of the economy do not evolve, they do. Sometimes they die, sometimes they evolve in a different role. For example, when digital cameras entered the market place in the eighties the Polaroid Land camera (which printed film straight out of the camera) 'died' because the demand side of the market lost interest. The Blackberry 'smart' phone had a virtual monopoly on this product into the new millennium until Apple and Nokia entered the market.
A monopolist is the sole supplier of an industry's output, and therefore the industry and the firm are one and the same.
Monopolies can exist and exert their dominance in the market place for several reasons; scale economies, national policy, successful prevention of entry, research and development combined with patent protection.
Natural monopolies
Traditionally, monopolies were viewed as being 'natural' in some sectors of the economy. This means that scale economies define some industries' production and cost structures up to very high output levels, and that the whole market might be supplied at least cost by a single firm.
Consider the situation depicted in Figure 10.1. The long-run ATC curve declines indefinitely. There is no output level where average costs begin to increase. Imagine now having several firms, each producing with a plant size corresponding to the short-run average cost curve , or alternatively a single larger firm using a plant size denoted by . The small firms in this case cannot compete with the larger firm because the larger firm has lower production costs and can undercut the smaller firms, and supply the complete market in the process. Such a scenario is termed a natural monopoly.
Figure 10.1 A 'natural' monopolist
When LR average costs continue to decline at very high output, one large firm may be able to supply the industry at a lower unit cost than several smaller firms. With a plant size corresponding to ATC2, a single supplier can supply the whole market, whereas several smaller firms, each with plan size corresponding to ATC1, cannot compete with the larger firm on account of differential unit costs.
Natural monopoly: one where the ATC of producing any output declines with the scale of operation.
Electricity distribution in some of Canada's provinces is in the hands of a single supplier – Hydro Quebec or Hydro One in Ontario, for example. These distributors are natural monopolies in the sense described above: Unit distribution costs decline with size. In contrast, electricity production is not 'naturally' a monopoly. Other suppliers were once thought of as 'natural' monopolies also, but are no longer. Bell Canada was considered to be a natural monopoly in the era of land lines: It would not make economic sense to run several sets of phone lines to every residence. But that was before the arrival of cell phones, broadband and satellites. Canada Post was also thought to be a natural monopoly, until the advent of FEDEX, UPS and other couriers proved otherwise. Invention can compete away a 'natural' monopoly.
In reality there are very few pure monopolies. Facebook, Microsoft, Amazon, Apple, Netflix and Google may be extraordinarily dominant in their markets, but they are not the only suppliers of the services or products that they offer. There exist other products that are similar.
National and Provincial Policy
Government policy can foster monopolies. Some governments are, or once were, proud to have a 'national carrier' in the airline industry – Air Canada in Canada or British Airways in the UK. The mail service was viewed as a symbol of nationhood in Canada and the US: Canada Post and the US Postal system are national emblems that have historic significance. They were vehicles for integrating the provinces or states at various points in the federal lives of these countries.
In the modern era, most of Canada's provinces have decided to create a provincial monopoly crown corporation for the sale of cannabis. But competition abounds in the form of an illegal market.
The down side of such nationalist policies is that they can be costly to the taxpayer. Industries that are not subject to competition can become fat and uncompetitive: Managers have insufficient incentives to curtail costs; unions realize the government is committed to sustain the monopoly and push for higher wages than under a more competitive structure, and innovation may be less likely to occur.
Maintaining barriers to entry
Monopolies can continue to survive if they are successful in preventing the entry of new firms and products. Patents and copyrights are one vehicle for preserving the sole-supplier role, and are certainly necessary to encourage firms to undertake the research and development (R&D) for new products.
Many corporations produce products that require a large up-front investment; this might be in the form of research and development, or the construction of costly production facilities. For example, Boeing or Airbus incurs billions of dollars in developing new aircraft; pharmaceuticals may have to invest a billion dollars to develop a new drug. However, once such an investment is complete, the cost of producing each unit of output may be relatively low. This is particularly true in pharmaceuticals. Such a phenomenon is displayed in Figure 10.2. In this case the average cost for a small number of units produced is high, but once the fixed cost is spread over an ever larger output, the average cost declines rapidly, and in the limit approaches the marginal cost. These production structures are common in today's global economy, and they give rise to markets characterized either by a single supplier or a small number of suppliers.
Figure 10.2 Fixed cost and constant marginal cost
With a fixed cost of producing the first unit of output equal to F and a constant marginal cost thereafter, the long-run average total cost, LATC, declines indefinitely and becomes asymptotic to the marginal cost curve.
This figure is useful in understanding the role of patents. Suppose that Pharma A spends one billion dollars in developing a new drug and has constant unit production costs thereafter, while Pharma B avoids research and development and simply imitates Pharma A's product. Clearly Pharma B would have a LATC equal to its LMC, and would be able to undercut the initial developer of the drug. Such an outcome would discourage investment in new products and the economy at large would suffer as a consequence. Economies would be worse off if protection is not provided to the developers of new products because, if such protection is not offered, potential developers will not have the incentive to incur the up-front investment required.
While copyright and patent protection is legal, predatory pricing is an illegal form of entry barrier, and we explore it more fully in Chapter 14. An example would be where an existing firm that sells nationally may deliberately undercut the price of a small local entrant to the industry. Airlines with a national scope are frequently accused of posting low fares on flights in regional markets that a new carrier is trying to enter.
Political lobbying is another means of maintaining monopolistic power. For example, the Canadian Wheat Board had fought successfully for decades to prevent independent farmers from marketing wheat. This Board lost its monopoly status in August 2012, when the government of the day decided it was not beneficial to consumers or farmers in general. Numerous 'supply management' policies are in operation all across Canada. Agriculture is protected by production quotas. All maple syrup in Quebec must be marketed through a single monopoly supplier.
Critical networks also form a type of barrier, though not always a monopoly. Microsoft's Office package has an almost monopoly status in word processing and spreadsheet analysis for the reason that so many individuals and corporations use it. The fact that we know a business colleague will be able to edit our documents if written in Word, provides us with an incentive to use Word, even if we might prefer Wordperfect as a vehicle for composing documents. We develop the concept of strategic entry prevention further in Chapter 11. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/10%3A_Monopoly/10.01%3A_Monopolies.txt |
We established in the previous chapter that, in deciding upon a profit-maximizing output, any firm should produce up to the point where the additional cost equals the additional revenue from a unit of output. What distinguishes the supply decision for a monopolist from the supply decision of the perfect competitor is that the monopolist faces a downward sloping demand. A monopolist is the sole supplier and therefore must meet the full market demand. This means that if more output is produced, the price must fall. We will illustrate the choice of a profit maximizing output using first a marginal-cost/marginal-revenue approach; then a supply/demand approach.
Marginal revenue and marginal cost
Table 10.1 displays price and quantity values for a demand curve in columns 1 and 2. Column 3 contains the sales revenue generated at each output. It is the product of price and quantity. Since the price denotes the revenue per unit, it is sometimes referred to as average revenue. The total revenue (TR) reaches a maximum at \$32, where 4 units of output are produced. A greater output necessitates a lower price on every unit sold, and in this case revenue falls if the fifth unit is brought to the market. Even though the fifth unit sells for a positive price, the price on the other 4 units is now lower and the net effect is to reduce total revenue. This pattern reflects what we examined in Chapter 4: As price is lowered from the highest possible value of \$14 (where 1 unit is demanded) and the corresponding quantity increases, revenue rises, peaks, and ultimately falls as output increases. In Chapter 4 we explained that this maximum revenue point occurs where the price elasticity is unity (-1), at the midpoint of a linear demand curve.
Table 10.1 A profit maximizing monopolist
Quantity Price Total Marginal Marginal Total Profit
(Q) (P) revenue (TR) revenue (MR) cost (MC) cost (TC)
0 16
1 14 14 14 2 2 12
2 12 24 10 3 5 19
3 10 30 6 4 9 21
4 8 32 2 5 14 18
5 6 30 -2 6 20 10
6 4 24 -6 7 27 -3
7 2 14 -10 8 35 -21
Figure 10.3 Total revenue and marginal revenue
When the quantity sold increases total revenue/expenditure initially increases also. At a certain point, further sales require a price that not only increases quantity, but reduces revenue on units already being sold to such a degree that TR declines – where the demand elasticity equals –1 (the mid point of a linear demand curve). Here the midpoint occurs at Q=4. Where the TR is a maximum the MR=0.
Related to the total revenue function is the marginal revenue function. It is the addition to total revenue due to the sale of one more unit of the commodity.
Marginal revenue is the change in total revenue due to selling one more unit of the good.
Average revenue is the price per unit sold.
The MR in this example is defined in the fourth column of Table 10.1. When the quantity sold increases from 1 unit to 2 units total revenue increases from \$14 to \$24. Therefore the marginal revenue associated with the second unit of output is \$10. When a third unit is sold TR increases to \$30 and therefore the MR of the third unit is \$6. As output increases the MR declines and eventually becomes negative – at the point where the TR is a maximum: If TR begins to decline then the additional revenue is by definition negative.
The MR function is plotted in Figure 10.4. It becomes negative when output increases from 4 to 5 units.
Figure 10.4 Monopolist's profit maximizing output
It is optimal for the monopolist to increase output as long as MR exceeds MC. In this case MR>MC for units 1, 2 and 3. But for the fourth unit MC>MR and therefore the monopolist would reduce total profit by producing it. He should produce only 3 units of output.
The optimal output
This producer has a marginal cost structure given in the fifth column of the table, and this too is plotted in Figure 10.4. Our profit maximizing rule from Chapter 8 states that it is optimal to produce a greater output as long as the additional revenue exceeds the additional cost of production on the next unit of output. In perfectly competitive markets the additional revenue is given by the fixed price for the individual producer, whereas for the monopolist the additional revenue is the marginal revenue. Consequently as long as MR exceeds MC for the next unit a greater output is profitable, but once MC exceeds MR the production of additional units should cease.
From Table 10.1 and Figure 10.4 it is clear that the optimal output is at 3 units. The third unit itself yields a profit of 2\$, the difference between MR (\$6) and MC (\$4). A fourth unit however would reduce profit by \$3, because the MR (\$2) is less than the MC (\$5). What price should the producer charge? The price, as always, is given by the demand function. At a quantity sold of 3 units, the corresponding price is \$10, yielding total revenue of \$30.
Profit is the difference between total revenue and total cost. In Chapter 8 we computed total cost as the average cost times the number of units produced. It can also be computed as the sum of costs associated with each unit produced: The first unit costs \$2, the second \$3 and the third \$4. The total cost of producing 3 units is the sum of these dollar values: . The profit-maximizing output therefore yields a profit of \$21 ().
Supply and demand
When illustrating market behaviour it is convenient to describe behaviour by simple linear supply and demand functions that are continuous, rather than the 'step' functions used in the preceding example. As explained in Chapter 5, in using continuous curves to represent a market we implicitly assume that a unit of output can be broken into subunits. In the example above we assumed that sales always involve one whole unit of the product being sold. In fact many goods can be sold in fractional units: Gasoline can be sold in fractions of a litre; fruits and vegetables can be sold in fractions of a kilogram, and so forth. Table 10.2 below furnishes the data for our analysis.
Table 10.2 Discrete quantities
Price Quantity Total Total Profit
demanded revenue cost
12 0 0 0 0
11 2 22 1 21
10 4 40 4 36
9 6 54 9 45
8 8 64 16 48
7 10 70 25 45
6 12 72 36 36
5 14 70 49 21
4 16 64 64 0
3 18 54 81 -27
2 20 40 100 -60
1 22 22 121 -99
0 24 0 144 -144
The first two columns define the demand curve. Total revenue is the product of price and quantity and given in column 3. The cost data are given in column 4, and profit – the difference between total revenue and total cost is in the final column. Profit is maximized where the difference between revenue and cost is greatest; in this case where the output is 8 units. At lower or higher outputs profit is less. Figure 10.5 contains the curves defining total revenue (TR), total cost (TC) and profit. These functions can be obtained by mapping all of the revenue-quantity combinations, the cost-quantity combinations, and the profit-quantity combinations as a series of points, and joining these points to form the smooth functions displayed. The vertical axis is measured in dollars, the horizontal axis in units of output. Graphically, profit is maximized where the dollar difference between TR and TC is greatest; that is at the output where the vertical distance between the two curves is greatest. This difference, which is also defined by the profit curve, occurs at a value of 8 units, corresponding to the outcome in Table 10.2.
Figure 10.5 Total revenue, total cost & profit
At any quantity less than this output, profit would rise with additional output. This is because, from a less-than-optimal output, the additional revenue from increased sales exceeds the increased cost associated with producing those units: Stated differently, the marginal revenue would exceed the marginal cost. Conversely, outputs greater than the optimum result in a MR less than the associated MC. Accordingly, since outputs where MR>MC are too low, and outputs where MR<MC are too high, the optimum must be where the MR=MC. Hence, the equality between MR and MC is implied in this diagram at the output where the difference between TR and TC is greatest.
Note finally that total revenue is maximized where the TR curve reaches a peak. In this example that occurs at a value of 12 units of output. This is to be anticipated, as we learned in Chapter 4, because the midpoint of the demand schedule in Table 10.2 occurs at that value.
Figure 10.6 Market demand, the MR curve, and the monopolist's AC and MC curves
Figure 10.6 displays the demand curve for the market, the MR curve, and the monopolist's MC and AC curves. Consider first the marginal revenue curve. In contrast to the previous example, where only whole or integer units could be sold, in this example units can be sold in fractional amounts, and the MR curve must reflect this. To determine the position of the MR curve, note that with a straight-line demand curve total revenue is a maximum at the midpoint of the demand curve. Any increase in output results in reduced revenue: Stated differently, the marginal revenue becomes negative at that output. Up to that output the MR is positive, as illustrated in Figure 10.3. Accordingly, the MR curve must intersect the quantity axis midway between zero and the horizontal-axis intercept of the demand curve. Geometrically, since the MR intersects the quantity axis half way to the horizontal intercept of the demand curve, it must have a slope that is twice the slope of the demand curve.
By observing the data in columns 1 and 2 of the table, the demand curve intercepts are , and from above discussion the MR curve has intercepts . The AC is obtained by dividing TC by output in Table 10.2, and the MC can be also calculated as the change in total cost divided by the change in output from Table 10.2. The result of these calculations is displayed in Figure 10.6.
The profit maximizing output is 8 units, where MC=MR. The price at which 8 units can be sold is read from the demand curve1, or the first column in Table 10.2. It is \$8. And, as expected, this price-quantity combination maximizes profit. Table 10.2 indicates that profit is maximized at \$48, at q=8.
Demand elasticity and marginal revenue
We have shown above that the MR curve cuts the horizontal axis at a quantity where the elasticity of demand is unity. We know from Chapter 4 that demand is elastic at points on the demand curve above this unit-elastic point. Furthermore, since the intersection of MR and MC must be at a positive dollar value (MC cannot be negative), then it must be the case that the profit maximizing price for a monopolist always lies on the elastic segment of the demand curve.
A general graphical representation
In Figure 10.7 we generalize the graphical representation of the monopoly profit maximizing output by allowing the MC and ATC curves to be nonlinear. The optimal output is at , where MR=MC, and the price sustains that output. With the average cost known, profit per unit is AB, and therefore total profit is this margin multiplied by the number of units sold, .
Total profit is therefore
Note that the monopolist may not always make a profit. Losses could result in Figure 10.7 if average costs were to rise so that the ATC were everywhere above the demand curve, or if the demand curve shifted down to being everywhere below the ATC curve. In the longer term the monopolist would have to either reduce costs or perhaps stimulate demand through advertising if she wanted to continue in operation.
Figure 10.7 The monopoly equilibrium
The profit maximizing output is QE, where MC=MR. This output can be sold at a price PE. The cost per unit of QE is read from the ATC curve, and equals B. Per unit profit is therefore AB and total profit is PEABCE. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/10%3A_Monopoly/10.02%3A_Profit_maximizing_behaviour.txt |
Consider next the impact of a shift in demand upon the profit maximizing choice of this firm. A rightward shift in demand in Figure 10.7 also yields a new MR curve. The firm therefore chooses a new level of output, using the same profit maximizing rule: Set MC=MR. This output will be greater than the previous output, but again the price must be on an elastic portion of the new demand curve. If operating with the same plant size, the MC and ATC curves do not change and the new profit per unit is again read from the ATC curve.
By this stage the curious student will have asked: "What happens to plant size in the long run?" For example, is the monopolist in Figure 10.7 using the most appropriate plant size in the first place? Even if she is, should the monopolist consider adopting an expanded plant size in response to the shift in demand?
The answer is: In the long run the monopolist is free to choose whatever plant size is best. Her initial plant size might have been optimal for the demand she faced, but if it was, it is unlikely to be optimal for the larger scale of production associated with the demand shift. Accordingly, with the new demand curve, she must consider how much profit she could make using different plant sizes.
Figure 10.8 The monopolist's choice of plant size
With constant returns to scale and constant prices per unit of labour and capital, a doubling of output involves exactly a doubling of costs. Thus, per unit costs, or average costs, are constant in the LR. Hence LAC=LMC, and each is constant.
To illustrate one possibility, we will think of this firm as having constant returns to scale at all output ranges, as displayed in Figure 10.8. (Our reasoning carries through if the LAC slopes downwards; the graph just becomes a little more complex.) The key characteristic of constant returns to scale is that a doubling of inputs leads to a doubling of output. Therefore, if the per-unit cost of inputs is fixed, a doubling of inputs (and therefore output) leads exactly to a doubling of costs. This implies that, when the firm varies its plant size and its labour use, the cost of producing each additional unit must be constant. The long-run marginal cost LMC is therefore constant and equals the ATC in the long run.
Figure 10.9 describes the market for this good. The optimal output and price are determined in the usual manner: Set MC=MR. If the monopolist has plant size corresponding to ATC1, the optimal output is Q1 and should be sold at the price P1.The key issue now is: Given the demand conditions, could the monopolist make more profit by choosing a plant size that differs from the one corresponding to ATC1?
Figure 10.9 Plant size in the long run
With demand conditions defined by D and MR, the optimal plant size is one corresponding to the point where MR=MC in the long run. Therefore Q2 is the optimal output and the optimal plant size corresponds to ATC2. If the current plant is defined by ATC1, then optimal SR production is Q1.
In this instance the answer is a clear 'yes'. Her LMC curve is horizontal and so, by increasing output from Q1 to Q2 she earns a profit on each additional unit in that range, because the MR curve lies above the LMC curve. In order to produce the output level Q2 at least cost she must choose a plant size corresponding to AC2.
10.04: Output inefficiency
A characteristic of perfect competition is that it secures an efficient allocation of resources when there are no externalities in the market: Resources are used up to the point where their marginal cost equals their marginal value – as measured by the price that consumers are willing to pay. But a monopoly structure does not yield this output. Consider Figure 10.10.
Figure 10.10 Monopoly output inefficiency
A monopolist maximizes profit at QM. Here the value of marginal output exceeds cost. If output expands to Q× a gain arises equal to the area ABF. This is the deadweight loss associated with the output QM rather than Q×. If the monopolist's long-run MC is equivalent to a competitive industry's supply curve, then the deadweight loss is the cost of having a monopoly rather than a perfectly competitive market.
The monopolist's profit-maximizing output is where MC equals MR. This output is inefficient for the reason that we developed in Chapter 5: If output is increased beyond the additional benefit exceeds the additional cost of producing it. The additional benefit is measured by the willingness of buyers to pay – the market demand curve. The additional cost is the long-run MC curve under the assumption of constant returns to scale. Using the terminology from Chapter 5, there is a deadweight loss equal to the area ABF. This is termed allocative inefficiency.
Allocative inefficiency arises when resources are not appropriately allocated and result in deadweight losses .
Perfect competition versus monopoly
The area ABF can also be considered as the efficiency loss associated with having a monopoly rather than a perfectly competitive market structure. In perfect competition the supply curve is horizontal. This is achieved by having firms enter and exit when more or less must be produced. Accordingly, if the perfectly competitive industry's supply curve approximates the monopolist's long-run marginal cost curve2, we can say that if the monopoly were turned into a competitive industry, output would increase from to . The deadweight loss is one measure of the superiority of the perfectly competitive structure over the monopoly structure.
Note that this critique of monopoly is not initially focused upon profit. While monopoly profits are what frequently irk the public, we have focused upon resource allocation inefficiencies. But in a real sense the two are related: Monopoly inefficiencies arise through output being restricted, and it is this output reduction – achieved by maintaining a higher than competitive price – that gives rise to those profits. Nonetheless, there is more than just a shift in purchasing power from the buyer to the seller. Deadweight losses arise because output is at a level lower than the point where the MC equals the value placed on the good; thus the economy is sacrificing the possibility of creating additional surplus.
Given that monopoly has this undesirable inefficiency, what measures should be taken, if any, to counter the inefficiency? We will see what Canada's Competition Act has to say in Chapter 14 and also examine what other measures are available to control monopolies. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/10%3A_Monopoly/10.03%3A_Long-run_choices.txt |
A common characteristic in the pricing of many goods is that different individuals pay different prices for goods or services that are essentially the same. Examples abound: Seniors get a reduced rate for coffee in Burger King; hair salons charge women more than they charge men; bank charges are frequently waived for juniors. Price discrimination involves charging different prices to different consumers in order to increase profit.
Price discrimination involves charging different prices to different consumers in order to increase profit.
A strict definition of discrimination involves different prices for identical products. We all know of a school friend who has been willing to take the midnight flight to make it home at school break at a price he can afford. In contrast, the business executive prefers the seven a.m. flight to arrive for a nine a.m. business meeting in the same city at several times the price. These are very mild forms of price discrimination, since a midnight flight (or a midday flight) is not a perfect substitute for an early morning flight. Price discrimination is practiced because buyers are willing to pay different amounts for a good or service, and the supplier may have a means of profiting from this. Consider the following example.
Family Flicks is the local movie theatre. It has two distinct groups of customers – those of prime age form one group; youth and seniors form the other. Family Flicks has done its market research and determined that each group accounts for 50 percent of the total market of 100 potential viewers per screening. It has also established that the prime-age group members are willing to pay \$12 to see a movie, while the seniors and youth are willing to pay just \$5. How should the tickets be priced?
Family Flicks has no variable costs, only fixed costs. It must pay a \$100 royalty to the movie maker each time it shows the current movie, and must pay a cashier and usher \$20 each. Total costs are therefore \$140, regardless of how many people show up – short-run MC is zero. On the pricing front, as illustrated in Table 10.3 below, if Family Flicks charges \$12 per ticket it will attract 50 viewers, generate \$600 in revenue and therefore make a profit of \$460.
Table 10.3 Price discrimination
P=\$5 P=\$12 Twin price
No. of customers 100 50
Total revenue \$500 \$600 \$850
Total costs \$140 \$140 \$140
Profit \$360 \$460 \$710
In contrast, if it charges \$5 it can fill the theatre, because each of the prime-age individuals is willing to pay more than \$5, but the seniors and youth are now offered a price they too are willing to pay. However, the total revenue is now only \$500 (), and profits are reduced to \$360. It therefore decides to charge the high price and leave the theatre half-empty, because this strategy maximizes its profit.
Suppose finally that the theatre is able to segregate its customers. It can ask the young and senior customers for identification upon entry, and in this way charge them a lower price, while still maintaining the higher price to the prime-age customers. If it can execute such a plan Family Flicks can now generate \$850 in revenue – \$600 from the prime-age group and \$250 from the youth and seniors groups. Profit soars to \$710.
There are two important conditions for this scheme to work:
1. The seller must be able to segregate the market at a reasonable cost. In the movie case this is achieved by asking for identification.
2. The second condition is that resale must be impossible or impractical. For example, we rule out the opportunity for young buyers to resell their tickets to the prime-age individuals. Sellers have many ways of achieving this – they can require immediate entry to the movie theatre upon ticket purchase, they can stamp the customer's hand, they can demand the showing of ID with the ticket when entering the theatre area.
Frequently we think of sellers who offer price reductions to specific groups as being generous. For example, hotels may levy only a nominal fee for the presence of a child, once the parents have paid a suitable rate for the room or suite in which a family stays. The hotel knows that if it charges too much for the child, it may lose the whole family as a paying unit. The coffee shop offering cheap coffee to seniors is interested in getting a price that will cover its variable cost and so contribute to its profit. It is unlikely to be motivated by philanthropy, or to be concerned with the financial circumstances of seniors.
Figure 10.11 Price discrimination at the movies
At P=12, 50 prime-age individuals demand movie tickets. At P=5, 50 more seniors and youths demand tickets. Since the MC is zero the efficient output is where the demand curve takes a zero value – where all 100 customers purchase tickets. Thus, any scheme that results in all 100 individuals buying ticket is efficient. Efficient output is at point C.
Price discrimination has a further interesting feature that is illustrated in Figure 10.11: It frequently reduces the deadweight loss associated with a monopoly seller!
In our Family Flicks example, the profit maximizing monopolist that did not, or could not, price discriminate left 50 customers unsupplied who were willing to pay \$5 for a good that had a zero MC. This is a deadweight loss of \$250 because 50 seniors and youth valued a commodity at \$5 that had a zero MC. Their demand was not met because, in the absence of an ability to discriminate between consumer groups, Family Flicks made more profit by satisfying the demand of the prime-age group alone. But in this example, by segregating its customers, the firm's profit maximization behaviour resulted in the DWL being eliminated, because it supplied the product to those additional 50 individuals. In this instance price discrimination improves welfare, because more of a good is supplied in a situation where market valuation exceeds marginal cost.
In the preceding example we simplified the demand side of the market by assuming that every individual in a given group was willing to pay the same price – either \$12 or \$5. More realistically each group can be defined by a downward-sloping demand curve, reflecting the variety of prices that buyers in a given market segment are willing to pay. It is valuable to extend the analysis to include this reality. For example, a supplier may face different demands from her domestic and foreign buyers, and if she can segment these markets she can price discriminate effectively.
Consider Figure 10.12 where two segmented demands are displayed, DA and DB, with their associated marginal revenue curves, MRA and MRB. We will assume that marginal costs are constant for the moment. It should be clear by this point that the profit maximizing solution for the monopoly supplier is to supply an amount to each market where the MC equals the MR in each market: Since the buyers in one market cannot resell to buyers in the other, the monopolist considers these as two different markets and therefore maximizes profit by applying the standard rule. She will maximize profit in market A by supplying the quantity QA and in market B by supplying QB. The prices at which these quantities can be sold are PA and PB. These prices, unsurprisingly, are different – the objective of segmenting markets is to increase profit by treating the markets as distinct.
An example of this type of price discrimination is where pharmaceutical companies sell drugs to less developed economies at a lower price than to developed economies. The low price is sufficient to cover marginal cost and is therefore profitable - provided the high price market covers the fixed costs.
Figure 10.12 Pricing in segregated markets
With two separate markets defined by DA and DB, and their associated MR curves MRA and MRB, a profit maximizing strategy is to produce where MC=MRA=MRB, and discriminate between the two markets by charging prices PA and PB.
The preceding examples involved two separable groups of customers and are very real. This kind of group segregation is sometimes called third degree price discrimination. But it may be possible to segregate customers into several groups rather than just two. In the limit, if we could charge a different price to every consumer in a market, or for every unit sold, the revenue accruing to the monopolist would be the area under the demand curve up to the output sold. Though primarily of theoretical interest, this is illustrated in Figure 10.13. It is termed perfect price discrimination, and sometimes first degree price discrimination. Such discrimination is not so unrealistic: A tax accountant may charge different customers a different price for providing the same service; home renovators may try to charge as much as any client appears willing to pay.
Figure 10.13 Perfect price discrimination
A monopolist who can sell each unit at a different price maximizes profit by producing Q×. With each consumer paying a different price the demand curve becomes the MR curve. The result is that the monopoly DWL is eliminated because the efficient output is produced, and the monopolist appropriates all the consumer surplus. Total revenue for the perfect price discriminator is OABQ×.
Second degree price discrimination is based on a different concept of buyer identifiability. In the cases we have developed above, the seller is able to distinguish the buyers by observing a vital characteristic that signals their type. It is also possible that, while individuals might have defining traits which influence their demands, such traits might not be detectable by the supplier. Nonetheless, it is frequently possible for the supplier to offer different pricing options (corresponding to different uses of a product) that buyers would choose from, with the result that her profit would be greater than under a uniform price with no variation in the use of the service. Different cell phone 'plans', or different internet plans that users can choose from are examples of this second-degree discrimination. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/10%3A_Monopoly/10.05%3A_Price_discrimination.txt |
A cartel is a group of suppliers that colludes to operate like a monopolist. The cartel formed by the members of the Organization of Oil Exporting Countries (OPEC) is an example of a cartel that was successful in achieving its objectives for a long period. This cartel first flexed its muscles in 1973, by increasing the world price of oil from \$3 per barrel to \$10 per barrel. The result was to transfer billions of dollars from the energy-importing nations in Europe and North America to OPEC members – the demand for oil is relatively inelastic, hence an increase in price increases total expenditures.
A cartel is a group of suppliers that colludes to operate like a monopolist.
A second renowned cartel is managed by De Beers, which controls a large part of the world's diamond supply. In Canada, agricultural marketing boards are a means of restricting supply legally. Such cartels may have thousands of members. By limiting entry, through requiring a production 'quota', the incumbents can charge a higher price than if entry to the industry were free.
To illustrate the dynamics of cartels consider Figure 10.14. Several producers, with given production capacities, come together and agree to restrict output with a view to increasing price and therefore profit. This may be done with the agreement of the government, or it may be done secretively, and possibly against the law. Each firm has a MC curve, and the industry supply is defined as the sum of these marginal cost curves, as illustrated in Figure 9.3. The resulting cartel is effectively one in which there is a single supplier with many different plants – a multi-plant monopolist. To maximize profits this organization will choose an output level where the MR equals the MC. In contrast, if these firms act competitively the output chosen will be . The competitive output yields no supernormal profit, whereas the monopoly/cartel output does.
Figure 10.14 Cartelizing a competitive industry
A cartel is formed when individual suppliers come together and act like a monopolist in order to increase profit. If MC is the joint supply curve of the cartel, profits are maximized at the output Qm, where MC=MR. In contrast, if these firms operate competitively output increases to Qc.
The cartel results in a deadweight loss equal to the area ABF, just as in the standard monopoly model.
Cartel instability
Some cartels are unstable in the long run. In the first instance, the degree of instability depends on the authority that the governing body of the cartel can exercise over its members, and upon the degree of information it has on the operations of its members. If a cartel is simply an arrangement among producers to limit output, each individual member of the cartel has an incentive to increase its output, because the monopoly price that the cartel attempts to sustain exceeds the cost of producing a marginal unit of output. In Figure 10.14 each firm has a MC of output equal to \$F when the group collectively produces the output . Yet any firm that brings output to market, beyond its agreed production limit, at the price will make a profit of AF on that additional output – provided the other members of the cartel agree to restrict their output. Since each firm faces the same incentive to increase output, it is difficult to restrain all members from doing so.
Individual members are more likely to abide by the cartel rules if the organization can sanction them for breaking the supply-restriction agreement. Alternatively, if the actions of individual members are not observable by the organization, then the incentive to break ranks may be too strong for the cartel to sustain its monopoly power.
We will see in Chapter 14 that Canada's Competition Act forbids the formation of cartels, as it forbids many other anti-competitive practices. At the same time, our governments frequently are the driving force in the formation of domestic cartels.
In the second instance, cartels may be undermined eventually by the emergence of new products and new technologies. OPEC has lost much of its power in the modern era because of technological developments in oil recovery. Canada's 'tar sands' yield oil, as a result of technological developments that enabled producers to separate the oil from the earth it is mixed with. Fracking technologies are another means of extracting oil that is discovered in small pockets and encased in rock. The supply coming from these new technologies has limited the ability of the old OPEC cartel to increase prices through supply restriction.
Application Box 10.1 The taxi cartel
The new sharing economy has brought competition to some traditional cartels. City taxis are an example of such a formation: Traditionally, entry has been restricted to drivers who hold a permit (medallion), and fares are higher as a consequence of the resulting reduced supply. A secondary market then develops for these medallions, in which the city may offer new medallions through auction, or existing owners may exit and sell their medallions. Restricted entry has characterized most of Canada's major cities. Depending on the strictness of the entry process, medallions are worth correspondingly more. By 2012, medallions were selling in New York and Boston for a price in the neighborhood of one million dollars.
But ride-sharing start-up companies changed all of that. As Western examples, Uber and Lyft developed smart-phone apps that link demanders for rides with drivers, who may, or may not be, part of the traditional taxi companies. Such start-ups have succeeded in taking a significant part of the taxi business away from the traditional operators. As a result, the price of taxi medallions on the open market has plunged. From trading in the range of \$1m. in New York in 2012, medallions are being offered in 2019 at about one fifth of that price. In Toronto, some medallions were traded in the range of \$300,000 in 2012, but are on offer in 2019 for prices in the range of \$30,000.
Not surprisingly, the traditional taxi companies charge that ride-hailing operators are violating the accepted rules governing the taxi business, and have launched legal suits against them and against local governments, and lobbied governments to keep them out of their cities.
In the new 'sharing economy', of which ride hailing companies are an example, participants operate with less traditional capital, and the communications revolution has been critical to their success. Home owners can use an online site to rent a spare bedroom in their house to visitors to their city (Airbnb), and thus compete with hotels. The main capital in this business is in the form of the information technology that links potential buyers to potential sellers.
Information on medallion prices in Canada can be found by, for example, searching at http://www.kijiji.ca | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/10%3A_Monopoly/10.06%3A_Cartels-_Acting_like_a_monopolist.txt |
Invention and innovation are critical aspects of the modern economy. In some sectors of the economy, firms that cannot invent or innovate are liable to die. Invention is a genuine discovery, whereas innovation is the introduction of a new product or process.
Invention is the discovery of a new product or process through research.
Product innovation refers to new or better goods or services.
Process innovation refers to new or better production or supply.
To this point we have said little that is good about monopolies. However, the economist Joseph Schumpeter argued that, while monopoly leads to resource misallocation in the economy, this cost might be offset by the greater tendency for monopoly firms to invent and innovate. This is because such firms have more profit and therefore more resources with which to fund R&D and may therefore be more innovative than competitive firms. If this were true then, taking a long-run dynamic view of the marketplace, monopolies could have lower costs and more advanced products than competitive firms and thus benefit the consumer.
While this argument has some logical appeal, it falls short on several counts. First, even if large firms carry out more research than competitive firms, there is no guarantee that the ensuing benefits carry over to the consumer. Second, the results of such research may be used to prevent entry into the industry in question. Firms may register their inventions and gain use protection before a competitor can come up with the same or a similar invention. Apple and Samsung each own tens of thousands of patents. Third, the empirical evidence on the location of most R&D is inconclusive: A sector with several large firms, rather than one with a single or very many firms, may be best. For example, if Apple did not have Samsung as a competitor, or vice versa, would the pace of innovation be as strong?
Fourth, much research has a 'public good' aspect to it. Research carried out at universities and government-funded laboratories is sometimes referred to as basic research: It explores the principles underlying chemistry, social relations, engineering forces, microbiology, etc., and has multiple applications in the commercial world. If disseminated, this research is like a public good – its fruits can be used in many different applications, and its use in one area does not preclude its use in others. Consequently, rather than protecting monopolies on the promise of more R&D, a superior government policy might be to invest directly in research and make the fruits of the research publicly available.
Modern economies have patent laws, which grant inventors a legal monopoly on use for a fixed period of time – perhaps fifteen years. By preventing imitation, patent laws raise the incentive to conduct R&D but do not establish a monopoly in the long run. Over the life of a patent the inventor charges a higher price than would exist if his invention were not protected; this both yields greater profits and provides the research incentive. When the patent expires, competition from other producers leads to higher output and lower prices for the product. Generic drugs are a good example of this phenomenon.
Patent laws grant inventors a legal monopoly on use for a fixed period of time.
The power of globalization once again is very relevant in patents. Not all countries have patent laws that are as strong as those in North America and Europe. The BRIC economies (Brazil, Russia, India and China) form an emerging power block. But their legal systems and enforcement systems are less well-developed than in Europe or North America. The absence of a strong and transparent legal structure inhibits research and development, because their fruits may be appropriated by competitors.
Rent seeking
Citizens are frequently appalled when they read of lobbying activities in their nation's capital. Every capital city in the world has an army of lobbyists, seeking to influence legislators and regulators. Such individuals are in the business of rent seeking, whose goal is to direct profit to particular groups, and protect that profit from the forces of competition. In Virginia and Kentucky we find that state taxes on cigarettes are the lowest in the US – because the tobacco leaf is grown in these states, and the tobacco industry makes major contributions to the campaigns of some political representatives.
Rent-seeking carries a resource cost: Imagine that we could outlaw the lobbying business and put these lobbyists to work producing goods and services in the economy instead. Their purpose is to maintain as much quasi-monopoly power in the hands of their clients as possible, and to ensure that the fruits of this effort go to those same clients. If this practice could be curtailed then the time and resources involved could be redirected to other productive ends.
Rent seeking is an activity that uses productive resources to redistribute rather than create output and value.
Industries in which rent seeking is most prevalent tend to be those in which the potential for economic profits is greatest – monopolies or near-monopolies. These, therefore, are the industries that allocate resources to the preservation of their protected status. We do not observe laundromat owners or shoe-repair businesses lobbying in Ottawa. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/10%3A_Monopoly/10.07%3A_Invention_innovation_and_rent_seeking.txt |
We have now examined two extreme types of market structure – perfect competition and monopoly. While many sectors of the economy operate in a way that is close to the competitive paradigm, very few are pure monopolies in that they have no close substitute products. Even firms like Microsoft, or De Beers, that supply a huge percentage of the world market for their product would deny that they are monopolies and would argue that they are subject to strong competitive pressures from smaller or 'fringe' producers. As a result we must look upon the monopoly paradigm as a useful way of analyzing markets, rather than being an exact description of the world. Accordingly, our next task is to examine how sectors with a few, several or multiple suppliers act when pursuing the objective of profit maximization. Many different market structures define the real economy, and we will concentrate on a limited number of the more important structures in the next chapter.
10.09: Key Terms
Monopolist: is the sole supplier of an industry's output, and therefore the industry and the firm are one and the same.
Natural monopoly: one where the ATC of producing any output declines with the scale of operation.
Marginal revenue is the change in total revenue due to selling one more unit of the good.
Average revenue is the price per unit sold.
Allocative inefficiency arises when resources are not appropriately allocated and result in deadweight losses.
Price discrimination involves charging different prices to different consumers in order to increase profit.
A cartel is a group of suppliers that colludes to operate like a monopolist.
Rent seeking is an activity that uses productive resources to redistribute rather than create output and value.
Invention is the discovery of a new product or process through research.
Product innovation refers to new or better products or services.
Process innovation refers to new or better production or supply.
Patent laws grant inventors a legal monopoly on use for a fixed period of time.
10.10: Exercises for Chapter 10
EXERCISE 10.1
Consider a monopolist with demand curve defined by P=100–2Q. The MR curve is MR=100–4Q and the marginal cost is MC=10+Q. The demand intercepts are , the MR intercepts are .
1. Develop a diagram that illustrates this market, using either graph paper or an Excel spreadsheet, for values of output .
2. Identify visually the profit-maximizing price and output combination.
3. Optional: Compute the profit maximizing price and output combination.
EXERCISE 10.2
Consider a monopolist who wants to maximize revenue rather than profit. She has the demand curve P=72–Q, with marginal revenue MR=72–2Q, and MC=12. The demand intercepts are , the MR intercepts are .
1. Graph the three functions, using either graph paper or an Excel spreadsheet.
2. Calculate the price she should charge in order to maximize revenue. [Hint: Where the MR=0.]
3. Compute the total revenue she will obtain using this strategy.
EXERCISE 10.3
Suppose that the monopoly in Exercise 10.2 has a large number of plants. Consider what could happen if each of these plants became a separate firm, and acted competitively. In this perfectly competitive world you can assume that the MC curve of the monopolist becomes the industry supply curve.
1. Illustrate graphically the output that would be produced in the industry?
2. What price would be charged in the marketplace?
3. Optional: Compute the gain to the economy in dollar terms as a result of the DWL being eliminated [Hint: It resembles the area ABF in Figure 10.14].
EXERCISE 10.4
In the text example in Table 10.1, compute the profit that the monopolist would make if he were able to price discriminate, by selling each unit at the demand price in the market.
EXERCISE 10.5
A monopolist is able to discriminate perfectly among his consumers – by charging a different price to each one. The market demand curve facing him is given by P=72–Q. His marginal cost is given by MC=24 and marginal revenue is MR=72–2Q.
1. In a diagram, illustrate the profit-maximizing equilibrium, where discrimination is not practiced. The demand intercepts are , the MR intercepts are .
2. Illustrate the equilibrium output if he discriminates perfectly.
3. Optional: If he has no fixed cost beyond the marginal production cost of \$24 per unit, calculate his profit in each pricing scenario.
EXERCISE 10.6
A monopolist faces two distinct markets A and B for her product, and she is able to insure that resale is not possible. The demand curves in these markets are given by PA=20–(1/4)QA and PB=14–(1/4)QB. The marginal cost is constant: MC=4. There are no fixed costs.
1. Graph these two markets and illustrate the profit maximizing price and quantity in each market. [You will need to insert the MR curves to determine the optimal output.] The demand intercepts in A are , and in B are .
2. In which market will the monopolist charge a higher price?
EXERCISE 10.7
A concert organizer is preparing for the arrival of the Grateful Living band in his small town. He knows he has two types of concert goers: One group of 40 people, each willing to spend \$60 on the concert, and another group of 70 people, each willing to spend \$40. His total costs are purely fixed at \$3,500.
1. Draw the market demand curve faced by this monopolist.
2. Draw the MR and MC curves.
3. With two-price discrimination what will be the monopolist's profit?
4. If he must charge a single price for all tickets can he make a profit?
EXERCISE 10.8
Optional: A monopolist faces a demand curve P=64–2Q and MR=64–4Q. His marginal cost is MC=16.
1. Graph the three functions and compute the profit maximizing output and price.
2. Compute the efficient level of output (where MC=demand), and compute the DWL associated with producing the profit maximizing output rather than the efficient output. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/10%3A_Monopoly/10.08%3A_Conclusion.txt |
Chapter 11: Imperfect competition
In this chapter we will explore:
11.1
The principle ideas
11.2
Imperfect competitors
11.3
Imperfect competitors: measures of structure and market power
11.4
Imperfect competition: monopolistic competition
11.5
Imperfect competition: economies of scope and platforms
11.6
Strategic behaviour: oligopoly and games
11.7
Strategic behaviour: duopoly and Cournot games
11.8
Strategic behaviour: entry, exit and potential competition
11.9
Matching markets: design
11.1 The principle ideas
The preceding chapters have explored extreme forms of supply: The monopolist is the sole supplier and possesses as much market power as possible. In contrast, the perfect competitor is small and has no market power whatsoever. He simply accepts the price for his product that is determined in the market by the forces of supply and demand. These are very useful paradigms to explore, but the real world for the most part lies between these extremes. We observe that there are a handful of dominant brewers in Canada who supply more than three quarters of the market, and they are accompanied by numerous micro brewers that form the fringe of the brewing business. We have a small number of air carriers and one of them controls half of the national market. The communications market has just three major suppliers; the Canadian Football League has nine teams and there are just a handful of major hardware/builders' suppliers stores nationally. At the other end of the spectrum we have countless restaurants and fitness centres, but they do not supply exactly the same product to the marketplaces for 'food' or 'health', and so these markets are not perfectly competitive, despite the enormous number of participants.
In this chapter we will explore three broad topics: First is the relationship between firm behaviour and firm size relative to the whole sector. This comes broadly under the heading of imperfect competition and covers a variety of market forms. Second, we will explore the principle modern ideas in strategic behavior. In a sense all decisions in microeconomics have an element of strategy to them - economic agents aim to attain certain goals and they adopt specific maximizing strategies to attain them. But in this chapter we explore a more specific concept of strategic behavior - one that focuses upon direct interactions between a small number of players in the market place. Third, we explore the principle characteristics of what are termed matching' markets. These are markets where transactions take place without money and involve matching heterogeneous suppliers with heterogeneous buyers.
11.2 Imperfect competitors
Imperfect competitors can be defined by the number of firms in their sector, or the share of total sales going to a small number of suppliers. They can also be defined in terms of the characteristics of the demand curves they all face. A perfect competitor faces a perfectly elastic demand at the existing market price, and this is the only market structure to have this characteristic. In all other market structures suppliers effectively face a downward-sloping demand. This means that they have some influence on the price of the good, and also that if they change the price they charge, they can expect demand to reflect this in a predictable manner. So, in theory, we can classify all market structures apart from perfect competition as being imperfectly competitive. In practice we use the term to denote firms that fall between the extremes of perfect competition and monopoly.
Imperfectly competitive firms face a downward-sloping demand curve, and their output price reflects the quantity sold.
The demand curve for the firm and industry coincide for the monopolist, but not for other imperfectly competitive firms. It is convenient to categorize the producing sectors of the economy as either having a relatively small number of participants, or having a large number. The former market structures are called oligopolistic, and the latter are called monopolistically competitive. The word oligopoly comes from the Greek word oligos meaning few, and polein meaning to sell.
Oligopoly defines a market with a small number of suppliers.
Monopolistic competition defines a market with many sellers of products that have similar characteristics. Monopolistically competitive firms can exert only a small influence on the whole market.
The home appliance industry is an oligopoly. The prices of KitchenAid appliances depend not only on their own output and sales, but also on the prices of Whirlpool, Maytag and Bosch. If a firm has just two main producers it is called a duopoly. Canadian National and Canadian Pacific are the only two major rail freight carriers in Canada; they thus form a duopoly. In contrast, the local Italian restaurant is a monopolistic competitor. Its output is a package of distinctive menu choices, personal service, and convenience for local customers. It can charge a different price than the out-of-neighbourhood restaurant, but if its prices are too high local diners may travel elsewhere for their food experience, or switch to a different cuisine locally. Many markets are defined by producers who supply similar but not identical products. Canada's universities all provide degrees, but they differ one from another in their programs, their balance of in-class and on-line courses, their student activities, whether they are science based or liberal arts based, whether they have cooperative programs or not, and so forth. While universities are not in the business of making profit, they certainly wish to attract students, and one way of doing this is to differentiate themselves from other institutions. The profit-oriented world of commerce likewise seeks to increase its market share by distinguishing its product line.
Duopoly defines a market or sector with just two firms.
These distinctions are not completely airtight. For example, if a sole domestic producer is subject to international competition it cannot act in the way we described in the previous chapter – it has potential, or actual, competition. Bombardier may be Canada's sole rail car manufacturer, but it is not a monopolist, even in Canada. It could best be described as being part of an international oligopoly in rail-car manufacture. Likewise, it is frequently difficult to delineate the boundary of a given market. For example, is Canada Post a monopoly in mail delivery, or an oligopolist in hard-copy communication? We can never fully remove these ambiguities.
The role of cost structures
A critical determinant of market structure is the way in which demand and cost interact to determine the likely number of market participants in a given sector or market. Structure also evolves over the long run: Time is required for entry and exit.
Figure 11.1 shows the demand curve D for the output of an industry in the long run. Suppose, initially, that all firms and potential entrants face the long-run average cost curve LATC1. At the price P1, free entry and exit means that each firm produces q1. With the demand curve D, industry output is Q1. The number of firms in the industry is N1 (=Q1/q1). If q1, the minimum average cost output on LATC1, is small relative to D, then N1 is large. This outcome might be perfect competition (N virtually infinite), or monopolistic competition (N large) with slightly differentiated products produced by each firm.
Figure 11.1 Demand, costs and market structure
With a cost structure defined by LATC1 this market has space for many firms – perfect or monopolistic competition, each producing approximately q1. If costs correspond to LATC2, where scale economies are substantial, there may be space for just one producer. The intermediate case, LATC3, can give rise to oligopoly, with each firm producing more than q1 but less than a monopolist. These curves encounter their MES at very different output levels.
Instead, suppose that the production structure in the industry is such that the long-run average cost curve is LATC2. Here, scale economies are vast, relative to the market size. At the lowest point on this cost curve, output is large relative to the demand curve D. If this one firm were to act like a monopolist it would produce an output where MR=MC in the long run and set a price such that the chosen output is sold. Given the scale economies, there may be no scope for another firm to enter this market, because such a firm would have to produce a very high output to compete with the existing producer. This situation is what we previously called a "natural" monopolist.
Finally, the cost structure might involve curves of the type LATC3, which would give rise to the possibility of several producers, rather than one or very many. This results in oligopoly.
It is clear that one crucial determinant of market structure is minimum efficient scale relative to the size of the total market as shown by the demand curve. The larger the minimum efficient scale relative to market size, the smaller is the number of producers in the industry.
11.3 Imperfect competitors: measures of structure and market power
Sectors of the economy do not fit neatly into the limited number of categories described above. The best we can say in most cases is that they resemble more closely one type of market than another. Consider the example of Canada's brewing sector: It has two large brewers in Molson-Coors and Labatt, a couple of intermediate sized firms such as Sleeman, and an uncountable number of small boutique brew pubs. While such a large number of brewers satisfy one requirement for perfect competition, it would not be true to say that the biggest brewers wield no market power; and this is the most critical element in defining market structure.
By the same token, we could not define this market as a duopoly: Even though there are just two major participants, there are countless others who, together, are important.
One way of defining what a particular structure most closely resembles is to examine the percentage of sales in the market that is attributable to a small number of firms. For example: What share is attributable to the largest three or four firms? The larger the share, the more concentrated the market power. Such a statistic is called a concentration ratio. The N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.
The N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.
Table 11.1 Concentration in Canadian food processing 2011
Sector % of shipments
Sugar 98
Breakfast cereal 96
Canning 60
Meat processing 23
Source: "Four Firm Concentration Ratios (CR4s) for selected food processing sectors," adapted from Statistics Canada publication Measuring industry concentration in Canada's food processing sectors, Agriculture and Rural Working Paper series no. 70, Catalogue 21-601, http://www.statcan.gc.ca/pub/21-601-m/21-601-m2004070-eng.pdf.
Table 11.1 contains information on the 4-firm concentration ratio for several sectors of the Canadian economy. It indicates that, at one extreme, sectors such as breakfast cereals and sugars have a high degree of concentration, whereas meat processing has much less. A high degree of concentration suggests market power, and possibly economies of scale.
11.4 Imperfect competition: monopolistic competition
Monopolistic competition presumes a large number of quite small producers or suppliers, each of whom may have a slightly differentiated product. The competition element of this name signifies that there are many participants, while the monopoly component signifies that each supplier faces a downward-sloping demand. In concrete terms, your local coffee shop that serves "fair trade" coffee has a product that differs slightly from that of neighbouring shops that sell the traditional product. They coexist in the same sector, and probably charge different prices: The fair trade supplier likely charges a higher price, but knows nonetheless that too large a difference between her price and the prices of her competitors will see some of her clientele migrate to those lower-priced establishments. That is to say, she faces a downward-sloping demand curve.
The competition part of the name also indicates that there is free entry and exit. There are no barriers to entry. As a consequence, we know at the outset that only normal profits will exist in a long-run equilibrium. Economic profits will be competed away by entry, just as losses will erode due to exit.
As a general rule then, each firm can influence its market share to some extent by changing its price. Its demand curve is not horizontal because different firms' products are only limited substitutes. A lower price level may draw some new customers away from competitors, but convenience or taste will prevent most patrons from deserting their local businesses. In concrete terms: A pasta special at the local Italian restaurant that reduces the price below the corresponding price at the competing local Thai restaurant will indeed draw clients away from the latter, but the foods are sufficiently different that only some customers will leave the Thai restaurant. The differentiated menus mean that many customers will continue to pay the higher price.
A differentiated product is one that differs slightly from other products in the same market.
Given that there are very many firms, the theory also envisages limits to scale economies. Firms are small and, with many competitors, individual firms do not compete strategically with particular rivals. Because the various products offered are slightly differentiated, we avoid graphics with a market demand, because this would imply that a uniform product is being considered. At the same time the market is a well-defined concept—it might be composed of all those restaurants within a reasonable distance, for example, even though each one is slightly different from the others. The market share of each firm depends on the price that it charges and on the number of competing firms. For a given number of suppliers, a shift in industry demand also shifts the demand facing each firm. Likewise, the presence of more firms in the industry reduces the demand facing each one.
Equilibrium is illustrated in Figure 11.2. Here D0 is the initial demand facing a representative firm, and MR0 is the corresponding marginal revenue curve. Profit is maximized where MC=MR, and the price P0 is obtained from the demand curve corresponding to the output q0. Total profit is the product of output times the difference between price and average cost, which equals .
Figure 11.2 Equilibrium for a monopolistic competitor
Profits exist at the initial equilibrium (q0,P0). Hence, new firms enter and reduce the share of the total market faced by each firm, thereby shifting back their demand curve. A final equilibrium is reached where economic profits are eliminated: At AC=PE and MR=MC.
With free entry, such profits attract new firms. The increased number of firms reduces the share of the market that any one firm can claim. That is, the firm's demand curve shifts inwards when entry occurs. As long as (economic) profits exist, this process continues. For entry to cease, average cost must equal price. A final equilibrium is illustrated by the combination , where the demand has shifted inward to D.
At this long-run equilibrium, two conditions must hold: First, the optimal pricing rule must be satisfied—that is MC=MR; second it must be the case that only normal profits are made at the final equilibrium. Economic profits are competed away as a result of free entry. Graphically this implies that ATC must equal price at the output where MC=MR. In turn this implies that the ATC is tangent to the demand curve where P=ATC. While this could be proven mathematically, it is easy to intuit why this tangency must exist: If ATC merely intersected the demand curve at the output where MC=MR, we could find some other output where the demand price would be above ATC, suggesting that profits could be made at such an output. Clearly that could not represent an equilibrium.
The monopolistically competitive equilibrium in the long run requires the firm's demand curve to be tangent to the ATC curve at the output where MR=MC.
11.5 Imperfect competition: economies of scope and platforms
The communications revolution has impacted market structure in modern economies profoundly: it has facilitated economies of scope, meaning that firms may yield more collective profit if merged than if operating independently.
Economies of Scope
Imagine an aspiring entrepreneur who envisages a revolution of the traditional taxi sector of the economy. He decides to develop a smartphone application that will match independent income-seeking vehicle owners (drivers) with individuals seeking transport (passengers) from point A to point B. We know how this adventure evolves. In one case it takes the form of the corporation Uber, in another the corporation Lyft, and others worldwide.
These corporations have grown in leaps and bounds and have taken business from the conventional taxi corporations. As of 2019 they cannot turn a profit, yet the stock market continues to bet upon future success: investors believe that when these corporations evolve into fully integrated multi-product suppliers, both costs will decline and demand will increase for each component of the business. In the case of transportation companies, they aim to become a 'one-stop-shop' for mobility services. Uber is not only a ride-hailing service, it also transports meals through its Uber-eats platform, and is developing the electric scooter and electric bike markets in addition. In some local markets it is linked to public transport services. All of this is being achieved through a single smartphone application. The objective is to simplify movement for persons, by providing multiple options on a variety of transport modes, accessed through a single portal.
This phenomenon is described in Figure 11.3. The subscripts A and I represent market conditions when the service supplier is operating Alone or in an Integrated corporation. The initial equilibrium is defined by the A demand and cost conditions. The profit maximizing output occurs when , leading to a price and a quantity . Each unit of the good yields a profit margin of .
Figure 11.3 Summa's ride hailing service
Demand for a particular product increases when the autonomous supplier (A) merges with another firm to become an integrated firm (I), because customers switch to firms that offer several different services from the same platform: the demand curve shifts outward, from DA to DI. With integration, the fixed costs fall and average costs fall, even with marginal costs constant. Output and profit increase, and concentration in the marketplace rises.
This firm now merges with another transportation corporation - perhaps a food delivery service, perhaps an electric bike service. Since each firm has a similar type of fixed cost, these costs can be reduced by the merger. In technical terms, the merged firms, or merged operations, share a common hardware-cum-software platform. Each firm will therefore incur lower average costs, even if marginal costs remain unchanged: the AC curve declines to . In addition to the decline in average costs, each firm sees an increase in its customer base, because transportation service buyers find it preferable to choose their mode of transport through a single portal rather than through several different modes of access. This is represented by an outward shift in the demand curve for vehicle rides to .
The new profit maximizing equilibrium occurs at Total profit necessarily increases both because average costs have fallen and the number of buyers willing to buy at any price has risen. The analytics in this figure also describe the benefits accruing to the other firm or firms in the merger.
A platform describes a technology that is common to more than one product in a multi-product organization.
We conclude from this analysis that, if scope economies are substantial, it may be difficult for stand-alone firms specializing in just one component of the transportation services sector to remain profitable. It may also be impossible to define a conventional equilibrium in this kind of marketplace. This is because some conglomerate firms may have different component producers in their suite of firms. For example, Lyft may not have a food delivery service, but it may have a limousine or bus service. What is critical for an equilibrium is that firms of a particular type, whether they are part of a conglomerate or not, be able to compete with corresponding firms. This means that their cost structure must be similar.
As a further example: Amazon initially was primarily an on-line book seller. But it expanded to include the sale of other products. And once it became a 'market for everything' the demand side of the market exploded in parallel with the product line, because it becomes easy to shop for 'anything' or even different objects on a single site. Only Walmart, in North America, comes close to being able to compete with Amazon.
11.6 Strategic behaviour: Oligopoly and games
Under perfect competition or monopolistic competition, there are so many firms in the industry that each one can ignore the immediate effect of its own actions on particular rivals. However, in an oligopolistic industry each firm must consider how its actions affect the decisions of its relatively few competitors. Each firm must guess how its rivals will react. Before discussing what constitutes an intelligent guess, we investigate whether they are likely to collude or compete. Collusion is a means of reducing competition with a view to increasing profit.
Collusion is an explicit or implicit agreement to avoid competition with a view to increasing profit.
A particular form of collusion occurs when firms co-operate to form a cartel, as we saw in the last chapter. Collusion is more difficult if there are many firms in the industry, if the product is not standardized, or if demand and cost conditions are changing rapidly. In the absence of collusion, each firm's demand curve depends upon how competitors react: If Air Canada contemplates offering customers a seat sale on a particular route, how will West Jet react? Will it, too, make the same offer to buyers? If Air Canada thinks about West Jet's likely reaction, will it go ahead with the contemplated promotion? A conjecture is a belief that one firm forms about the strategic reaction of another competing firm.
A conjecture is a belief that one firm forms about the strategic reaction of another competing firm.
Good poker players will attempt to anticipate their opponents' moves or reactions. Oligopolists are like poker players, in that they try to anticipate their rivals' moves. To study interdependent decision making, we use game theory. A game is a situation in which contestants plan strategically to maximize their payoffs, taking account of rivals' behaviour.
A game is a situation in which contestants plan strategically to maximize their payoffs, taking account of rivals' behaviour.
The players in the game try to maximize their own payoffs. In an oligopoly, the firms are the players and their payoffs are their profits. Each player must choose a strategy, which is a plan describing how a player moves or acts in different situations.
A strategy is a game plan describing how a player acts, or moves, in each possible situation.
Equilibrium outcomes
How do we arrive at an equilibrium in these games? Let us begin by defining a commonly used concept of equilibrium. A Nash equilibrium is one in which each player chooses the best strategy, given the strategies chosen by the other players, and there is no incentive to move or change choice.
A Nash equilibrium is one in which each player chooses the best strategy, given the strategies chosen by the other player, and there is no incentive for any player to move.
In such an equilibrium, no player wants to change strategy, since the other players' strategies were already figured into determining each player's own best strategy. This concept and theory are attributable to the Princeton mathematician John Nash, who was popularized by the Hollywood movie version of his life, A Beautiful Mind.
In most games, each player's best strategy depends on the strategies chosen by their opponents. Occasionally, a player's best strategy is independent of those chosen by rivals. Such a strategy is called a dominant strategy.
A dominant strategy is a player's best strategy, independent of the strategies adopted by rivals.
We now illustrate these concepts with the help of two different games. These games differ in their outcomes and strategies. Table 11.2 contains the domestic happiness game1. Will and Kate are attempting to live in harmony, and their happiness depends upon each of them carrying out domestic chores such as shopping, cleaning and cooking. The first element in each pair defines Will's outcome, the second Kate's outcome. If both contribute to domestic life they each receive a happiness or utility level of 5 units. If one contributes and the other does not the happiness levels are 2 for the contributor and 6 for the non-contributor, or 'free-rider'. If neither contributes happiness levels are 3 each. When each follows the same strategy the payoffs are on the diagonal, when they follow different strategies the payoffs are on the off-diagonal. Since the elements of the table define the payoffs resulting from various choices, this type of matrix is called a payoff matrix.
A payoff matrix defines the rewards to each player resulting from particular choices.
So how is the game likely to unfold? In response to Will's choice of a contribute strategy, Kate's utility maximizing choice involves lazing: She gets 6 units by not contributing as opposed to 5 by contributing. Instead, if Will decides to be lazy what is in Kate's best interest? Clearly it is to be lazy also because that strategy yields 3 units of happiness compared to 2 units if she contributes. In sum, Kate's best strategy is to be lazy, regardless of Will's behaviour. So the strategy of not contributing is a dominant strategy, in this particular game.
Will also has a dominant strategy – identical to Kate's. This is not surprising since the payoffs are symmetric in the table. Hence, since each has a dominant strategy of not contributing the Nash equilibrium is in the bottom right cell, where each receives a payoff of 3 units. Interestingly, this equilibrium is not the one that yields maximum combined happiness.
Table 11.2 A game with dominant strategies
Kate's choice
Contribute Laze
Will's choice Contribute 5,5 2,6
Laze 6,2 3,3
The first element in each cell denotes the payoff or utility to Will; the second element the utility to Kate.
The reason that the equilibrium yields less utility for each player in this game is that the game is competitive: Each player tends to their own interest and seeks the best outcome conditional on the choice of the other player. This is evident from the (5,5) combination. From this position Kate would do better to defect to the Laze strategy, because her utility would increase2.
To summarize: This game has a unique equilibrium and each player has a dominant strategy. But let us change the payoffs just slightly to the values in Table 11.3. The off-diagonal elements have changed. The contributor now gets no utility as a result of his or her contributions: Even though the household is a better place, he or she may be so annoyed with the other person that no utility flows to the contributor.
Table 11.3 A game without dominant strategies
Kate's choice
Contribute Laze
Will's choice Contribute 5,5 0,4
Laze 4,0 3,3
The first element in each cell denotes the payoff or utility to Will; the second element the utility to Kate.
What are the optimal choices here? Starting again from Will choosing to contribute, what is Kate's best strategy? It is to contribute: She gets 5 units from contributing and 4 from lazing, hence she is better contributing. But what is her best strategy if Will decides to laze? It is to laze, because that yields her 3 units as opposed to 0 by contributing. This set of payoffs therefore contains no dominant strategy for either player.
As a result of there being no dominant strategy, there arises the possibility of more than one equilibrium outcome. In fact there are two equilibria in this game now: If the players find themselves both contributing and obtaining a utility level of (5,5) it would not be sensible for either one to defect to a laze option. For example, if Kate decided to laze she would obtain a payoff of 4 utils rather than the 5 she enjoys at the (5,5) equilibrium. By the same reasoning, if they find themselves at the (laze, laze) combination there is no incentive to move to a contribute strategy.
Once again, it is to be emphasized that the twin equilibria emerge in a competitive environment. If this game involved cooperation or collusion the players should be able to reach the (5,5) equilibrium rather than the (3,3) equilibrium. But in the competitive environment we cannot say ex ante which equilibrium will be attained.
Repeated games
This game illustrates the tension between collusion and competition. While we have developed the game in the context of the household, it can equally be interpreted in the context of a profit maximizing game between two market competitors. Suppose the numbers define profit levels rather than utility as in Table 11.4. The 'contribute' option can be interpreted as 'cooperate' or 'collude', as we described for a cartel in the previous chapter. They collude by agreeing to restrict output, sell that restricted output at a higher price, and in turn make a greater total profit which they split between themselves. The combined best profit outcome (5,5) arises when each firm restricts its output.
Table 11.4 Collusion possibilities
Firm K's profit
Low output High output
Firm W's profit Low output 5,5 2,6
High output 6,2 3,3
The first element in each cell denotes the profit to Firm W; the second element the profit to Firm K.
But again there arises an incentive to defect: If Firm W agrees to maintain a high price and restrict output, then Firm K has an incentive to renege and increase output, hoping to improve its profit through the willingness of Firm W to restrict output. Since the game is symmetric, each firm has an incentive to renege. Each firm has a dominant strategy – high output, and there is a unique equilibrium (3,3).
Obviously there arises the question of whether these firms can find an operating mechanism that would ensure they each generate a profit of 5 units rather than 3 units, while remaining purely self-interested. This question brings us to the realm of repeated games. For example, suppose that firms make strategic choices each quarter of the year. If firm K had 'cheated' on the collusive strategy it had agreed with firm W in the previous quarter, what would happen in the following quarter? Would firms devise a strategy so that cheating would not be in the interest of either one, or would the competitive game just disintegrate into an unpredictable pattern? These are interesting questions and have provoked a great deal of thought among game theorists. But they are beyond our scope at the present time.
A repeated game is one that is repeated in successive time periods and where the knowledge that the game will be repeated influences the choices and outcomes in earlier periods.
We now examine what might happen in one-shot games of the type we have been examining, but in the context of many possible choices. In particular, instead of assuming that each firm can choose a high or low output, how would the outcome of the game be determined if each firm can choose an output that can lie anywhere between a high and low output? In terms of the demand curve for the market, this means that the firms can choose some output and price that is consistent with demand conditions: There may be an infinite number of choices. This framing of a game enables us to explore new concepts in strategic behavior.
11.7 Strategic behaviour: Duopoly and Cournot games
The duopoly model that we frequently use in economics to analyze competition between a small number of competitors is fashioned after the ideas of French economist Augustin Cournot. Consequently it has come to be known as the Cournot duopoly model. While the maximizing behaviour that is incorporated in this model can apply to a situation with several firms rather than two, we will develop the model with two firms. This differs slightly from the preceding section, where each firm has simply a choice between a high or low output.
The critical element of the Cournot approach is that the firms each determine their optimal strategy – one that maximizes profit – by reacting optimally to their opponent's strategy, which in this case involves their choice of output.
Cournot behaviour involves each firm reacting optimally in their choice of output to their competitors' output decisions.
A central element here is the reaction function of each firm, which defines the optimal output choice conditional upon their opponent's choice.
Reaction functions define the optimal choice of output conditional upon a rival's output choice.
We can develop an optimal strategy with the help of Figure 11.4. D is the market demand, and two firms supply this market. If B supplies a zero output, then A would face the whole demand, and would maximize profit where MC=MR. Let this output be defined by . We transfer this output combination to Figure 11.5, where the output of each firm is on one of the axes—A on the vertical axis and B on the horizontal. This particular combination of zero output for B and for A is represented on the vertical axis as the point .
Figure 11.4 Duopoly behaviour
When one firm, B, chooses a specific output, e.g. , then A's residual demand is the difference between the market demand and . A's profit is maximized at – where . This is an optimal reaction by A to B's choice. For all possible choices by B, A can form a similar optimal response. The combination of these responses forms A's reaction function.
Instead, suppose that B produces a quantity in Figure 11.4. This reduces the demand curve facing A correspondingly from D to , which we call A's residual demand. When subject to such a choice by B, firm A maximizes profit by producing where , where is the marginal revenue corresponding to the residual demand . The optimum for A is now , and this pair of outputs is represented by the combination in Figure 11.5.
Figure 11.5 Reaction functions and equilibrium
The reaction function for A (RA) defines the optimal output response for A to any output choice by B. The reaction function for B is defined similarly. The equilibrium occurs at the intersection of RA and RB. Any other combination will induce one firm to change its output, and therefore could not be an equilibrium.
Firm A forms a similar optimal response for every possible output level that B could choose, and these responses define A's reaction function. The reaction function illustrated for A in Figure 11.5 is thus the locus of all optimal response outputs on the part of A. The downward-sloping function makes sense: The more B produces, the smaller is the residual market for A, and therefore the less A will produce.
But A is just one of the players in the game. If B acts in the same optimizing fashion, B too can formulate a series of optimal reactions to A's output choices. The combination of such choices would yield a reaction function for B. This is plotted as in Figure 11.5.
An equilibrium is defined by the intersection of the two reaction functions, in this case by the point E. At this output level each firm is making an optimal decision, conditional upon the choice of its opponent. Consequently, neither firm has an incentive to change its output; therefore it can be called the Nash equilibrium.
Any other combination of outputs on either reaction function would lead one of the players to change its output choice, and therefore could not constitute an equilibrium. To see this, suppose that B produces an output greater than ; how will A react? A's reaction function indicates that it should choose a quantity to supply less than . If so, how will B respond in turn to that optimal choice? It responds with a quantity read from its reaction function, and this will be less than the amount chosen at the previous stage. By tracing out such a sequence of reactions it is clear that the output of each firm will move to the equilibrium .
Application Box 11.1 Cournot: Fixed costs and brand
Why do we observe so many industries on the national, and even international, stages with only a handful of firms? For example, Intel produces more than half of the world's computer chips, and AMD produces a significant part of the remainder. Why are there only two major commercial aircraft producers in world aviation – Boeing and Airbus? Why are there only a handful of major North American suppliers in pharmaceuticals, automobile tires, soda pop, internet search engines and wireless telecommunications?
The answer lies primarily in the nature of modern product development. Product development (fixed) costs, coupled with a relatively small marginal cost of production, leads to markets where there is enough space for only a few players. The development cost for a new cell phone, or a new aircraft, or a new computer-operating system may run into billions, while the cost of producing each unit may in fact be constant. The enormous development cost associated with many products explains not only why there may be a small number of firms in the domestic market for the product, but also why the number of firms in some sectors is small worldwide.
The Cournot model yields an outcome that lies between monopoly (or collusion/cartel) and competitive market models. It does not necessarily assume that the firms are identical in terms of their cost structure, although the lower-cost producer will end up with a larger share of the market.
The next question that arises is whether this duopoly market will be sustained as a duopoly, or if entry may take place. In particular, if economic profits accrue to the participants will such profits be competed away by the arrival of new producers, or might there be barriers of either a 'natural' or 'constructed' type that operate against new entrants?
11.8 Strategic behaviour: Entry, exit & potential competition
At this point we inquire about the potential entry and impact of new firms – firms who might enter the industry if conditions were sufficiently enticing, meaning the presence of economic profits. One way of examining entry in this oligopolistic world is to envisage potential entry barriers as being either intended or unintended, though the difference between the two can be blurred. Broadly, an unintended or 'natural' barrier is one related to scale economies and the size of the market. An intended barrier involves a strategic decision on the part of the firm to prevent entry.
Unintended entry barriers
Oligopolists tend to have substantial fixed costs, accompanied by declining average costs up to high output levels. Such a cost structure 'naturally' gives rise to a supply side with a small number of suppliers. For examples, given demand and cost structures, could Vancouver support two professional soccer teams; could Calgary support two professional hockey teams; could Montreal sustain two professional football teams? The answer to each of these questions is likely 'no'. Because given the cost structure of these markets, it would not be possible to induce twice as many spectators without reducing the price per game ticket to such a degree that revenue would be insufficient to cover costs. (We will neglect for the moment that the governing bodies of these sports also have the power to limit entry.) Fixed costs include stadium costs, staff payrolls and player payrolls. In fact most costs in these markets are relatively fixed. Market size relative to fixed and variable costs is not large enough to sustain two teams in most cities. Exceptions in reality are huge urban areas such as New York and Los Angeles.
Accordingly, it is possible that the existing team, or teams, may earn economic profit from their present operation; but such profit does not entice further entry, because the market structure is such that the entry of an additional team could lead to each team making losses.
Patent Law
This is one form of protection for incumbent firms. Research and development is required for the development of many products in the modern era. Pharmaceuticals are an example. If innovations were not protected, firms and individuals would not be incentivized to devote their energies and resources to developing new drugs. Society would be poorer as a result. Patent protection is obviously a legal form of protection. At the same time, patent protection can be excessive. If patents provide immunity from replication or copying for an excessive period of time - for longer than required to recoup R & D costs - then social welfare declines because monopoly profits are being generated as a result of output restriction at too high a price.
Advertising
Advertising is a second form of entry deterrence. In this instance firms attempt to market their product as being distinctive and even enviable. For example, Coca-Cola and PepsiCo invest hundreds of millions annually to project their products in this light. They sponsor sports, artistic and cultural events. Entry into the cola business is not impossible, but brand image is so strong for these firms that potential competitors would have a very low probability of entering this sector profitably. Likewise, in the 'energy-drinks' market, Red Bull spends hundreds of millions of dollars per annum on Formula One racing, kite surfing contests, mountain biking events and other extreme sports. In doing this it it reinforcing its brand image and distinguishing its product from Pepsi or Coca-Cola. This form of advertising is one of product differentiation and enables the manufacturer to maintain a higher price for its products by convincing its buyers that there are no close substitutes.
Predatory pricing
This form of pricing constitutes an illegal form of entry deterrence. It involves an incumbent charging an artificially low price for its product in the event of entry of a new competitor. This is done with a view to making it impossible for the entrant to earn a profit. Given that incumbents have generally greater resources than entrants, they can survive a battle of losses for a more prolonged period, thus ultimately driving out the entrant.
An iconic example of predatory pricing is that of Amazon deciding to take on a startup called Quidsi that operated the website diapers.com. 3 The latter was proving to be a big hit with consumers in 2009 and Amazon decided that it was eating into Amazon profits on household and baby products. Amazon reacted by cutting its own prices dramatically, to the point where it was ready to loose a huge amount of money in order to grind Quidsi into the ground. The ultimate outcome was that Quidsi capitulated and sold to Amazon.
Whether this was a legal tactic or not we do not know, but it underlines the importance of war chests.
Maintaining a war chest
Many large corporations maintain a mountain of cash. This might seem like an odd thing to do when it could be paying that cash out to owners in the form of dividends. But there are at least two reasons for not doing this. First, personal taxes on dividends are frequently higher than taxes on capital gains; accordingly if a corporation can transform its cash into capital gain by making judicious investments, that strategy ultimately yields a higher post-tax return to the stock holders. A second reason is that a cash war chest serves as a credible threat to competitors of the type described involving Amazon and Quidsi above.
Network externalities
These externalities arise when the existing number of buyers itself influences the total demand for a product. Facebook is now a classic example. An individual contemplating joining a social network has an incentive to join one where she has many existing 'friends'. Not everyone views the Microsoft operating system (OS) as the best. Many prefer a simpler system such as Linux that also happens to be free. However, the fact that almost every new computer (that is not Apple) coming onto the market place uses Microsoft OS, there is an incentive for users to continue to use it because it is so easy to find a technician to repair a breakdown.
Transition costs and loyalty cards
Transition costs can be erected by firms who do not wish to lose their customer base. Cell-phone plans are a good example. Contract-termination costs are one obstacle to moving to a new supplier. Some carriers grant special low rates to users communicating with other users within the same network, or offer special rates for a block of users (perhaps within a family). Tim Hortons and other coffee chains offer loyalty cards that give one free cup of coffee for every eight purchased. These suppliers are not furnishing love to their caffeine consumers, they are providing their consumers with an incentive not to switch to a competing supplier. Air miles rewards operate on a similar principle. So too do loyalty cards for hotel chains.
How do competitors respond to these loyalty programs? Usually by offering their own. Hilton and Marriot each compete by offering a free night after a given points threshold is reached.
Over-investment
An over-investment strategy means that an existing supplier generates additional production capacity through investment in new plant or capital. This is costly to the incumbent and is intended as a signal to any potential entrant that this capacity could be brought on-line immediately should a potential competitor contemplate entry. For example, a ski-resort owner may invest in a new chair-lift, even if she does not use it frequently. The existence of the additional capacity may scare potential entrants. A key component of this strategy is that the incumbent firm invests ahead of time – and inflicts a cost on itself. The incumbent does not simply say "I will build another chair-lift if you decide to develop a nearby mountain into a ski hill." That policy does not carry the same degree of credibility as actually incurring the cost of construction ahead of time. However, such a strategy may not always be feasible: It might be just too costly to pre-empt entry by putting spare capacity in place. Spare capacity is not so different from brand development through advertising; both are types of sunk cost. The threats associated with the incumbent's behaviour become a credible threat because the incumbent incurs costs up front.
A credible threat is one that is effective in deterring specific behaviours; a competitor must believe that the threat will be implemented if the competitor behaves in a certain way.
Lobbying
In our chapter on monopoly we stressed the role of political/lobbying activity. Large firms invariably employ public relations firms, and maintain their own public relations departments. The role of these units is not simply to portray a positive image of the corporation to the public; it is to maintain and increase whatever market power such firms already possess. It is as much in the interest of an oligopolistic firm as a monopolist to prevent entry and preserve supernormal profits.
In analyzing perfect competition, we saw that free entry is critical to maintaining normal profits. Lobbying is designed to obstruct entry, and it is also designed to facilitate mergers and acquisitions. The economist Thomas Philippon has written about the increasing concentration of economic power in recent decades in the hands of a small number of corporations in many sectors of the North American economy. He argues that this concentration of power contributes to making the distribution of income more favorable to corporate interests and less favorable to workers. In his recent book ("The Great Reversal: How America Gave up Free Markets" ), he shows that, contrary to traditional beliefs, Europe is now much more competitive than the US in most sectors of the economy. More broadband suppliers result in rates in Europe that are about half of US rates. Whereas in the US four airlines control 80% of the market, In Europe they control 40%. If scale economies were the prime determinant of corporate concentration we should not expect such large differences. Likewise, if globalization and technological change were the main determinants of corporate concentration, we should expect experiences in Europe and North America to be similar. But they are not. Hence, it is reasonable to conclude that entry barriers in North America are more effective, or that regulatory forces are stronger in Europe.
11.9 Matching markets: design
Markets are institutions that facilitate the exchange of goods and services. They act as clearing houses. The normal medium of exchange is money in some form. But many markets deal in exchanges that do not involve money and frequently involve matching: Graduating medical students are normally matched with hospitals in order that graduates complete their residency requirement; in many jurisdictions in the US applicants for places in public schools that form a pool within a given school-board must go through an application process that sorts the applicants into the different schools within the board; patients in need of a new kidney must be matched with kidney donors.
These markets are clearinghouses and have characteristics that distinguish them from traditional currency-based markets that we have considered to this point.
• The good or service being traded is generally heterogeneous. For example, patients in search of a kidney donor must be medically compatible with the eventual donor if the organ transplant is not to be rejected. Hospitals may seek residents in particular areas of health, and they must find residents who are, likewise, seeking such placements. Students applying to public schools may be facing a choice between schools that focus upon science or upon the arts. Variety is key.
• Frequently the idea of a market that is mediated by money is repugnant. For example, the only economy in the world that permits the sale of human organs is Iran. Elsewhere the idea of a monetary payment for a kidney is unacceptable. A market in which potential suppliers of kidneys registered their reservation prices and demanders registered their willingness to pay is incompatible with our social mores. Consequently, potential living donors or actual deceased donors must be directly matched with a patient in need. While some individuals believe that a market in kidneys would do more good than harm, because a monetary payment might incentivize the availability of many more organs and therefore save many more lives, virtually every society considers the downside to such a trading system to outweigh the benefits.
• Modern matching markets are more frequently electronically mediated, and the communications revolution has led to an increase in the efficiency of these markets.
The Economics prize in memory of Alfred Nobel was awarded to Alvin Roth and Lloyd Shapley in 2011 in recognition of their contributions to designing markets that function efficiently in the matching of demanders and suppliers of the goods and services. What do we mean by an efficient mechanism? One way is to define it is similar to how we described the market for apartments in Chapter 5: following an equilibrium in the market, is it possible to improve the wellbeing of one participant without reducing the wellbeing of another? We showed in that example that the market performed efficiently: a different set of renters getting the apartments would reduce total surplus in the system.
Consider a system in which medical graduates are matched with hospitals, and the decision process results in the potential for improvement: Christina obtains a residency in the local University Hospital while Ulrich obtains a residency at the Childrens' Hospital. But Christina would have preferred the Childrens' and Ulrich would have preferred the University. The matching algorithm here was not efficient because, at the end of the allocation process, there is scope for gains for each individual. Alvin Roth devised a matching mechanism that surmounts this type of inefficiency. He called it the deferred acceptance algorithm.
Roth also worked on the matching of kidney donors to individuals in need of a kidney. The fundamental challenge in this area is that a patient in need of a kidney may have a family member, say a sibling, who is willing to donate a kidney, but the siblings are not genetically compatible. The patient's immune system may attack the implantation of a 'foreign' organ. One solution to this incompatibility is to find matching pairs of donors that come from a wider choice set. Two families in each of which there is patient and a donor may be able to cross-donate: donor in Family A can donate to patient in Family B, and donor in Family B can donate to patient in Family A, in the sense that the donor organs will not be rejected by recipients' immune systems. Hence if many patient-donor families register in a clearinghouse, a computer algorithm can search for matching pairs. Surgical operations may be performed simultaneously in order to prevent one donor from backing out following his sibling's receipt of a kidney.
A more recent development concerns 'chains'. In this case a good Samaritan ('unaligned donor') offers a kidney while seeking nothing in return. The algorithm then seeks a match for the good Samaritan's kidney among all of the recipient-donor couples registered in the data bank. Having found (at least) one, the algorithm seeks a recipient for the kidney that will come from the first recipient's donor partner. And so on. It turns out that an algorithm which seeks to maximize the potential number of participating pairs is fraught with technical and ethical challenges: should a young patient, who could benefit from the organ for a whole lifetime, get priority over an older patient, who will benefit for fewer years of life, even if the older patient is in greater danger of dying in the absence of a transplant? This is an ethical problem.
Examples where these algorithms have achieved more than a dozen linked transplants are easy to find on an internet search - they are called chains, for the obvious reason.
Consider the following efficiency aspect of the exchange. Suppose a patient has two siblings, each of whom is willing to donate (though only one of the two actually will); should such a patient get priority in the computer algorithm over a patient who has just a single sibling willing to donate? The answer may be yes; the dual donor patient should get priority because if his two siblings have different blood types, this greater variety on the supply side increases the chances for matching in the system as a whole and is therefore beneficial. If a higher priority were not given to the dual-donor patient, there would be an incentive for him to name just one potential donor, and that would impact the efficiency of the whole matching algorithm.
It is not always recognized that the discipline of Economics explores social problems of the nature we have described here, despite the fact that the discipline has developed the analytical tools to address them.
Conclusion
Monopoly and perfect competition are interesting paradigms; but few markets resemble them in the real world. In this chapter we addressed some of the complexities that define the economy we inhabit: It is characterized by strategic planning, entry deterrence, differentiated products and so forth.
Entry and exit are critical to competitive markets. Frequently entry is blocked because of scale economies – an example of a natural or unintended entry barrier. In addition, incumbents can formulate numerous strategies to limit entry.
Firms act strategically – particularly when there are just a few participants in the market. Before acting, firms make conjectures about how their competitors will react, and incorporate such reactions into their own planning. Competition between suppliers can frequently be analyzed in terms of a game, and such games usually have an equilibrium outcome. The Cournot duopoly model that we developed is a game between two competitors in which an equilibrium market output is determined from a pair of reaction functions.
Scale economies are critical. Large development costs or setup costs may mean that the market can generally support just a limited number of producers. In turn this implies that potential new (small-scale) firms cannot benefit from the scale economies and will not survive competition from large-scale suppliers.
Product differentiation is critical. If small differences exist between products produced in markets where there is free entry we get a monopolistically competitive structure. In these markets long-run profits are 'normal' and firms operate with some excess capacity. It is not possible to act strategically in this kind of market.
The modern economy also has sectors that have successfully erected barriers. These barriers lead to fewer competitors than could efficiently supply the market. Ultimately the owners of capital are the beneficiaries of these barriers and consumers suffer from higher prices.
Key Terms
Imperfectly competitive firms face a downward-sloping demand curve, and their output price reflects the quantity sold.
Oligopoly defines an industry with a small number of suppliers.
Monopolistic competition defines a market with many sellers of products that have similar characteristics. Monopolistically competitive firms can exert only a small influence on the whole market.
Duopoly defines a market or sector with just two firms.
Concentration ratio: N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.
Differentiated product is one that differs slightly from other products in the same market.
The monopolistically competitive equilibrium in the long run requires the firm's demand curve to be tangent to the ATC curve at the output where MR=MC.
Collusion is an explicit or implicit agreement to avoid competition with a view to increasing profit.
Conjecture: a belief that one firm forms about the strategic reaction of another competing firm.
Game: a situation in which contestants plan strategically to maximize their profits, taking account of rivals' behaviour.
Strategy: a game plan describing how a player acts, or moves, in each possible situation.
Nash equilibrium: one in which each player chooses the best strategy, given the strategies chosen by the other player, and there is no incentive for any player to move.
Dominant strategy: a player's best strategy, whatever the strategies adopted by rivals.
Payoff matrix: defines the rewards to each player resulting from particular choices.
Credible threat: one that, after the fact, is still optimal to implement.
Cournot behaviour involves each firm reacting optimally in their choice of output to their competitors' decisions.
Reaction functions define the optimal choice of output conditional upon a rival's output choice.
Exercises for Chapter 11
EXERCISE 11.1
Imagine that the biggest four firms in each of the sectors listed below produce the amounts defined in each cell. Compute the three-firm and four-firm concentration ratios for each sector, and rank the sectors by degree of industry concentration.
Sector Firm 1 Firm 2 Firm 3 Firm 4 Total market
Shoes 60 45 20 12 920
Chemicals 120 80 36 24 480
Beer 45 40 3 2 110
Tobacco 206 84 30 5 342
EXERCISE 11.2
You own a company in a monopolistically competitive market. Your marginal cost of production is \$12 per unit. There are no fixed costs. The demand for your own product is given by the equation P=48–(1/2)Q.
1. Plot the demand curve, the marginal revenue curve, and the marginal cost curve.
2. Compute the profit-maximizing output and price combination.
3. Compute total revenue and total profit [Hint: Remember AC=MC here].
4. In this monopolistically competitive industry, can these profits continue indefinitely?
EXERCISE 11.3
Two firms in a particular industry face a market demand curve given by the equation P=100–(1/3)Q. The marginal cost is \$40 per unit and the marginal revenue is MR=100–(2/3)Q. The quantity intercepts for demand and MR are 300 and 150.
1. Draw the demand curve and MR curve to scale on a diagram. Then insert the MC curve.
2. If these firms got together to form a cartel, what output would they produce and what price would they charge?
3. Assuming they each produce half of the total what is their individual profit?
EXERCISE 11.4
The classic game theory problem is the "prisoners' dilemma." In this game, two criminals are apprehended, but the police have only got circumstantial evidence to prosecute them for a small crime, without having the evidence to prosecute them for the major crime of which they are suspected. The interrogators then pose incentives to the crooks-incentives to talk. The crooks are put in separate jail cells and have the option to confess or deny. Their payoff depends upon what course of action each adopts. The payoff matrix is given below. The first element in each box is the payoff (years in jail) to the player in the left column, and the second element is the payoff to the player in the top row.
B's strategy
Confess Deny
A's strategy Confess 6,6 0,10
Deny 10,0 1,1
1. Does a "dominant strategy" present itself for each or both of the crooks?
2. What is the Nash equilibrium to this game?
3. Is the Nash equilibrium unique?
4. Was it important for the police to place the crooks in separate cells?
EXERCISE 11.5
Taylormade and Titlelist are considering a production strategy for their new golf drivers. If they each produce a small output, they can price the product higher and make more profit than if they each produce a large output. Their payoff/profit matrix is given below.
Taylormade strategy
Low output High output
Titleist strategy Low output 50,50 20,70
High output 70,20 40,40
1. Does either player have a dominant strategy here?
2. What is the Nash equilibrium to the game?
3. Do you think that a cartel arrangement would be sustainable?
EXERCISE 11.6
Ronnie's Wraps is the only supplier of sandwich food and makes a healthy profit. It currently charges a high price and makes a profit of six units. However, Flash Salads is considering entering the same market. The payoff matrix below defines the profit outcomes for different possibilities. The first entry in each cell is the payoff/profit to Flash Salads and the second to Ronnie's Wraps.
Ronnie's Wraps
High price Low price
Flash Salads Enter the market 2,3 -1,1
Stay out of market 0,6 0,4
1. If Ronnie's Wraps threatens to lower its price in response to the entry of a new competitor, should Flash Salads stay away or enter?
2. Explain the importance of threat credibility here.
EXERCISE 11.7
Optional: Consider the market demand curve for appliances: P=3,200–(1/4)Q. There are no fixed production costs, and the marginal cost of each appliance is . As usual, the MR curve has a slope that is twice as great as the slope of the demand curve.
1. Illustrate this market geometrically.
2. Determine the output that will be produced in a 'perfectly competitive' market structure where no profits accrue in equilibrium.
3. If this market is supplied by a monopolist, illustrate the choice of output.
EXERCISE 11.8
Optional: Consider the outputs you have obtained in Exercise 11.7.
1. Can you figure out how many firms would produce at the perfectly competitive output? If not, can you think of a reason?
2. If, in contrast, each firm in that market had to cover some fixed costs, in addition to the variable costs defined by the MC value, would that put a limit on the number of firms that could produce in this market?
11: Imperfect competition
The preceding chapters have explored extreme forms of supply: The monopolist is the sole supplier and possesses as much market power as possible. In contrast, the perfect competitor is small and has no market power whatsoever. He simply accepts the price for his product that is determined in the market by the forces of supply and demand. These are very useful paradigms to explore, but the real world for the most part lies between these extremes. We observe that there are a handful of dominant brewers in Canada who supply more than three quarters of the market, and they are accompanied by numerous micro brewers that form the fringe of the brewing business. We have a small number of air carriers and one of them controls half of the national market. The communications market has just three major suppliers; the Canadian Football League has nine teams and there are just a handful of major hardware/builders' suppliers stores nationally. At the other end of the spectrum we have countless restaurants and fitness centres, but they do not supply exactly the same product to the marketplaces for 'food' or 'health', and so these markets are not perfectly competitive, despite the enormous number of participants.
In this chapter we will explore three broad topics: First is the relationship between firm behaviour and firm size relative to the whole sector. This comes broadly under the heading of imperfect competition and covers a variety of market forms. Second, we will explore the principle modern ideas in strategic behavior. In a sense all decisions in microeconomics have an element of strategy to them - economic agents aim to attain certain goals and they adopt specific maximizing strategies to attain them. But in this chapter we explore a more specific concept of strategic behavior - one that focuses upon direct interactions between a small number of players in the market place. Third, we explore the principle characteristics of what are termed matching' markets. These are markets where transactions take place without money and involve matching heterogeneous suppliers with heterogeneous buyers. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.01%3A_The_principle_ideas.txt |
Imperfect competitors can be defined by the number of firms in their sector, or the share of total sales going to a small number of suppliers. They can also be defined in terms of the characteristics of the demand curves they all face. A perfect competitor faces a perfectly elastic demand at the existing market price, and this is the only market structure to have this characteristic. In all other market structures suppliers effectively face a downward-sloping demand. This means that they have some influence on the price of the good, and also that if they change the price they charge, they can expect demand to reflect this in a predictable manner. So, in theory, we can classify all market structures apart from perfect competition as being imperfectly competitive. In practice we use the term to denote firms that fall between the extremes of perfect competition and monopoly.
Imperfectly competitive firms face a downward-sloping demand curve, and their output price reflects the quantity sold.
The demand curve for the firm and industry coincide for the monopolist, but not for other imperfectly competitive firms. It is convenient to categorize the producing sectors of the economy as either having a relatively small number of participants, or having a large number. The former market structures are called oligopolistic, and the latter are called monopolistically competitive. The word oligopoly comes from the Greek word oligos meaning few, and polein meaning to sell.
Oligopoly defines a market with a small number of suppliers.
Monopolistic competition defines a market with many sellers of products that have similar characteristics. Monopolistically competitive firms can exert only a small influence on the whole market.
The home appliance industry is an oligopoly. The prices of KitchenAid appliances depend not only on their own output and sales, but also on the prices of Whirlpool, Maytag and Bosch. If a firm has just two main producers it is called a duopoly. Canadian National and Canadian Pacific are the only two major rail freight carriers in Canada; they thus form a duopoly. In contrast, the local Italian restaurant is a monopolistic competitor. Its output is a package of distinctive menu choices, personal service, and convenience for local customers. It can charge a different price than the out-of-neighbourhood restaurant, but if its prices are too high local diners may travel elsewhere for their food experience, or switch to a different cuisine locally. Many markets are defined by producers who supply similar but not identical products. Canada's universities all provide degrees, but they differ one from another in their programs, their balance of in-class and on-line courses, their student activities, whether they are science based or liberal arts based, whether they have cooperative programs or not, and so forth. While universities are not in the business of making profit, they certainly wish to attract students, and one way of doing this is to differentiate themselves from other institutions. The profit-oriented world of commerce likewise seeks to increase its market share by distinguishing its product line.
Duopoly defines a market or sector with just two firms.
These distinctions are not completely airtight. For example, if a sole domestic producer is subject to international competition it cannot act in the way we described in the previous chapter – it has potential, or actual, competition. Bombardier may be Canada's sole rail car manufacturer, but it is not a monopolist, even in Canada. It could best be described as being part of an international oligopoly in rail-car manufacture. Likewise, it is frequently difficult to delineate the boundary of a given market. For example, is Canada Post a monopoly in mail delivery, or an oligopolist in hard-copy communication? We can never fully remove these ambiguities.
The role of cost structures
A critical determinant of market structure is the way in which demand and cost interact to determine the likely number of market participants in a given sector or market. Structure also evolves over the long run: Time is required for entry and exit.
Figure 11.1 shows the demand curve D for the output of an industry in the long run. Suppose, initially, that all firms and potential entrants face the long-run average cost curve LATC1. At the price P1, free entry and exit means that each firm produces q1. With the demand curve D, industry output is Q1. The number of firms in the industry is N1 (=Q1/q1). If q1, the minimum average cost output on LATC1, is small relative to D, then N1 is large. This outcome might be perfect competition (N virtually infinite), or monopolistic competition (N large) with slightly differentiated products produced by each firm.
Figure 11.1 Demand, costs and market structure
With a cost structure defined by LATC1 this market has space for many firms – perfect or monopolistic competition, each producing approximately q1. If costs correspond to LATC2, where scale economies are substantial, there may be space for just one producer. The intermediate case, LATC3, can give rise to oligopoly, with each firm producing more than q1 but less than a monopolist. These curves encounter their MES at very different output levels.
Instead, suppose that the production structure in the industry is such that the long-run average cost curve is LATC2. Here, scale economies are vast, relative to the market size. At the lowest point on this cost curve, output is large relative to the demand curve D. If this one firm were to act like a monopolist it would produce an output where MR=MC in the long run and set a price such that the chosen output is sold. Given the scale economies, there may be no scope for another firm to enter this market, because such a firm would have to produce a very high output to compete with the existing producer. This situation is what we previously called a "natural" monopolist.
Finally, the cost structure might involve curves of the type LATC3, which would give rise to the possibility of several producers, rather than one or very many. This results in oligopoly.
It is clear that one crucial determinant of market structure is minimum efficient scale relative to the size of the total market as shown by the demand curve. The larger the minimum efficient scale relative to market size, the smaller is the number of producers in the industry. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.02%3A_Imperfect_competitors.txt |
Sectors of the economy do not fit neatly into the limited number of categories described above. The best we can say in most cases is that they resemble more closely one type of market than another. Consider the example of Canada's brewing sector: It has two large brewers in Molson-Coors and Labatt, a couple of intermediate sized firms such as Sleeman, and an uncountable number of small boutique brew pubs. While such a large number of brewers satisfy one requirement for perfect competition, it would not be true to say that the biggest brewers wield no market power; and this is the most critical element in defining market structure.
By the same token, we could not define this market as a duopoly: Even though there are just two major participants, there are countless others who, together, are important.
One way of defining what a particular structure most closely resembles is to examine the percentage of sales in the market that is attributable to a small number of firms. For example: What share is attributable to the largest three or four firms? The larger the share, the more concentrated the market power. Such a statistic is called a concentration ratio. The N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.
The N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.
Table 11.1 Concentration in Canadian food processing 2011
Sector % of shipments
Sugar 98
Breakfast cereal 96
Canning 60
Meat processing 23
Source: "Four Firm Concentration Ratios (CR4s) for selected food processing sectors," adapted from Statistics Canada publication Measuring industry concentration in Canada's food processing sectors, Agriculture and Rural Working Paper series no. 70, Catalogue 21-601, http://www.statcan.gc.ca/pub/21-601-m/21-601-m2004070-eng.pdf.
Table 11.1 contains information on the 4-firm concentration ratio for several sectors of the Canadian economy. It indicates that, at one extreme, sectors such as breakfast cereals and sugars have a high degree of concentration, whereas meat processing has much less. A high degree of concentration suggests market power, and possibly economies of scale.
11.04: Imperfect competition- monopolistic competition
Monopolistic competition presumes a large number of quite small producers or suppliers, each of whom may have a slightly differentiated product. The competition element of this name signifies that there are many participants, while the monopoly component signifies that each supplier faces a downward-sloping demand. In concrete terms, your local coffee shop that serves "fair trade" coffee has a product that differs slightly from that of neighbouring shops that sell the traditional product. They coexist in the same sector, and probably charge different prices: The fair trade supplier likely charges a higher price, but knows nonetheless that too large a difference between her price and the prices of her competitors will see some of her clientele migrate to those lower-priced establishments. That is to say, she faces a downward-sloping demand curve.
The competition part of the name also indicates that there is free entry and exit. There are no barriers to entry. As a consequence, we know at the outset that only normal profits will exist in a long-run equilibrium. Economic profits will be competed away by entry, just as losses will erode due to exit.
As a general rule then, each firm can influence its market share to some extent by changing its price. Its demand curve is not horizontal because different firms' products are only limited substitutes. A lower price level may draw some new customers away from competitors, but convenience or taste will prevent most patrons from deserting their local businesses. In concrete terms: A pasta special at the local Italian restaurant that reduces the price below the corresponding price at the competing local Thai restaurant will indeed draw clients away from the latter, but the foods are sufficiently different that only some customers will leave the Thai restaurant. The differentiated menus mean that many customers will continue to pay the higher price.
A differentiated product is one that differs slightly from other products in the same market.
Given that there are very many firms, the theory also envisages limits to scale economies. Firms are small and, with many competitors, individual firms do not compete strategically with particular rivals. Because the various products offered are slightly differentiated, we avoid graphics with a market demand, because this would imply that a uniform product is being considered. At the same time the market is a well-defined concept—it might be composed of all those restaurants within a reasonable distance, for example, even though each one is slightly different from the others. The market share of each firm depends on the price that it charges and on the number of competing firms. For a given number of suppliers, a shift in industry demand also shifts the demand facing each firm. Likewise, the presence of more firms in the industry reduces the demand facing each one.
Equilibrium is illustrated in Figure 11.2. Here D0 is the initial demand facing a representative firm, and MR0 is the corresponding marginal revenue curve. Profit is maximized where MC=MR, and the price P0 is obtained from the demand curve corresponding to the output q0. Total profit is the product of output times the difference between price and average cost, which equals .
Figure 11.2 Equilibrium for a monopolistic competitor
Profits exist at the initial equilibrium (q0,P0). Hence, new firms enter and reduce the share of the total market faced by each firm, thereby shifting back their demand curve. A final equilibrium is reached where economic profits are eliminated: At AC=PE and MR=MC.
With free entry, such profits attract new firms. The increased number of firms reduces the share of the market that any one firm can claim. That is, the firm's demand curve shifts inwards when entry occurs. As long as (economic) profits exist, this process continues. For entry to cease, average cost must equal price. A final equilibrium is illustrated by the combination , where the demand has shifted inward to D.
At this long-run equilibrium, two conditions must hold: First, the optimal pricing rule must be satisfied—that is MC=MR; second it must be the case that only normal profits are made at the final equilibrium. Economic profits are competed away as a result of free entry. Graphically this implies that ATC must equal price at the output where MC=MR. In turn this implies that the ATC is tangent to the demand curve where P=ATC. While this could be proven mathematically, it is easy to intuit why this tangency must exist: If ATC merely intersected the demand curve at the output where MC=MR, we could find some other output where the demand price would be above ATC, suggesting that profits could be made at such an output. Clearly that could not represent an equilibrium.
The monopolistically competitive equilibrium in the long run requires the firm's demand curve to be tangent to the ATC curve at the output where MR=MC. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.03%3A_Imperfect_competitors-_measures_of_structure_and_market_power.txt |
The communications revolution has impacted market structure in modern economies profoundly: it has facilitated economies of scope, meaning that firms may yield more collective profit if merged than if operating independently.
Economies of Scope
Imagine an aspiring entrepreneur who envisages a revolution of the traditional taxi sector of the economy. He decides to develop a smartphone application that will match independent income-seeking vehicle owners (drivers) with individuals seeking transport (passengers) from point A to point B. We know how this adventure evolves. In one case it takes the form of the corporation Uber, in another the corporation Lyft, and others worldwide.
These corporations have grown in leaps and bounds and have taken business from the conventional taxi corporations. As of 2019 they cannot turn a profit, yet the stock market continues to bet upon future success: investors believe that when these corporations evolve into fully integrated multi-product suppliers, both costs will decline and demand will increase for each component of the business. In the case of transportation companies, they aim to become a 'one-stop-shop' for mobility services. Uber is not only a ride-hailing service, it also transports meals through its Uber-eats platform, and is developing the electric scooter and electric bike markets in addition. In some local markets it is linked to public transport services. All of this is being achieved through a single smartphone application. The objective is to simplify movement for persons, by providing multiple options on a variety of transport modes, accessed through a single portal.
This phenomenon is described in Figure 11.3. The subscripts A and I represent market conditions when the service supplier is operating Alone or in an Integrated corporation. The initial equilibrium is defined by the A demand and cost conditions. The profit maximizing output occurs when , leading to a price and a quantity . Each unit of the good yields a profit margin of .
Figure 11.3 Summa's ride hailing service
Demand for a particular product increases when the autonomous supplier (A) merges with another firm to become an integrated firm (I), because customers switch to firms that offer several different services from the same platform: the demand curve shifts outward, from DA to DI. With integration, the fixed costs fall and average costs fall, even with marginal costs constant. Output and profit increase, and concentration in the marketplace rises.
This firm now merges with another transportation corporation - perhaps a food delivery service, perhaps an electric bike service. Since each firm has a similar type of fixed cost, these costs can be reduced by the merger. In technical terms, the merged firms, or merged operations, share a common hardware-cum-software platform. Each firm will therefore incur lower average costs, even if marginal costs remain unchanged: the AC curve declines to . In addition to the decline in average costs, each firm sees an increase in its customer base, because transportation service buyers find it preferable to choose their mode of transport through a single portal rather than through several different modes of access. This is represented by an outward shift in the demand curve for vehicle rides to .
The new profit maximizing equilibrium occurs at Total profit necessarily increases both because average costs have fallen and the number of buyers willing to buy at any price has risen. The analytics in this figure also describe the benefits accruing to the other firm or firms in the merger.
A platform describes a technology that is common to more than one product in a multi-product organization.
We conclude from this analysis that, if scope economies are substantial, it may be difficult for stand-alone firms specializing in just one component of the transportation services sector to remain profitable. It may also be impossible to define a conventional equilibrium in this kind of marketplace. This is because some conglomerate firms may have different component producers in their suite of firms. For example, Lyft may not have a food delivery service, but it may have a limousine or bus service. What is critical for an equilibrium is that firms of a particular type, whether they are part of a conglomerate or not, be able to compete with corresponding firms. This means that their cost structure must be similar.
As a further example: Amazon initially was primarily an on-line book seller. But it expanded to include the sale of other products. And once it became a 'market for everything' the demand side of the market exploded in parallel with the product line, because it becomes easy to shop for 'anything' or even different objects on a single site. Only Walmart, in North America, comes close to being able to compete with Amazon. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.05%3A_Imperfect_competition-_economies_of_scope_and_platforms.txt |
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