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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. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.06%3A_Strategic_behaviour-_Oligopoly_and_games.txt |
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? | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.07%3A_Strategic_behaviour-_Duopoly_and_Cournot_games.txt |
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. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.08%3A_Strategic_behaviour-_Entry_exit_and_potential_competition.txt |
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. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.09%3A_Matching_markets-_design.txt |
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.
11.11: 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. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.10%3A_Conclusion.txt |
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? | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/04%3A_Market_Structures/11%3A_Imperfect_competition/11.12%3A_Exercises_for_Chapter_11.txt |
Chapter 12: Labour and capital
In this chapter we will explore:
12.1
The demand for labour
12.2
Labour supply
12.3
Market equilibrium and labour mobility
12.4
The concepts of capital
12.5
The capital market
12.6
Land
The chapter deals with the markets for the factors of production—labour and capital. The analysis will be presented in terms of the demand, supply and market equilibrium for each. While this is a standard analytical approach in microeconomics, the markets for labour and capital differ from goods and services markets.
In the first instance, goods and services are purchased and consumed by the buyers. In contrast, labour and capital are used as inputs in producing those 'final' goods and services. So the value of labour and capital to a producer depends in part upon the value of the products that the labour and capital are used to produce. Economists say that the value of the factors of production derives from the value of the products they ultimately produce.
Secondly, labour and capital offer services. When an employer hires a worker, that worker supplies her time and skills and energy to the employer. When a piece of equipment is rented to a producer, or purchased by a producer, that equipment provides a stream of productive services also. The employer does not purchase the worker, given that we do not live in a society where slavery is legal. In contrast, she may decide to purchase the capital, or else rent it.
The third characteristic of these markets is the time dimension associated with labour and capital. Specifically, once built, a machine will customarily have a lifetime of several years, during which it depreciates in value. Furthermore, it may become obsolete on account of technological change before the end of its anticipated life. Labour too may become obsolete, or at least lose some of its value with the passage of time, if the skills embodied in the labour cease to be required in the economy.
12.1 Labour – a derived demand
The value of labour springs from the value of its use, that is the value placed upon goods and services that it produces – product prices. The wage is the price that equilibrates the supply and demand for a given type of labour, and it reflects the value of that labour in production. Formally, the demand for labour (and capital) is thus a derived demand, in contrast to being a 'final' demand.
Demand for labour: a derived demand, reflecting the value of the output it produces.
We must distinguish between the long run and the short run in our analysis of factor markets. On the supply side certain factors of production are fixed in the short run. For example, the supply of radiologists can be increased only over a period of years. While one hospital may be able to attract radiologists from another hospital to meet a shortage, this does not increase the supply in the economy as a whole.
On the demand side there is the conventional difference between the short and long run: In the short run some of a firm's factors of production, such as capital, are fixed, and therefore the demand for labour differs from when all factors are variable – the long run.
Demand in the short run
Table 12.1 contains information from the example developed in Chapter 8. It can be used to illustrate how a firm reacts in the short run to a change in an input price, or to a change in the output price. The response of a producer to a change in the wage rate constitutes a demand function for labour – a schedule relating the quantity of the input demanded to different input prices. The output produced by the various numbers of workers yields a marginal product curve, whose values are stated in column 3. The marginal product of labour, , as developed in Chapter 8, is the additional output resulting from one more worker being employed, while holding constant the other (fixed) factors. But what is the dollar value to the firm of an additional worker? It is the additional value of output resulting from the additional employee – the price of the output times the worker's marginal contribution to output, his MP. We term this the value of the marginal product.
The value of the marginal product is the marginal product multiplied by the price of the good produced.
Table 12.1 Short-run production and labour demand
Workers Output MPL Marginal profit = (VMPL–wage)
(1) (2) (3) (4) (5)
0 0
1 15 15 1050 150
2 40 25 1750 750
3 70 30 2100 1100
4 110 40 2800 1800
5 145 35 2450 1450
6 175 30 2100 1100
7 200 25 1750 750
8 220 20 1400 400
9 235 15 1050 50
10 240 5 350 negative
Each unit of labour costs \$1,000; output sells at a fixed price of \$70 per unit.
In this example the first rises as more labour is employed, and then falls. With each unit of output selling for \$70 the value of the marginal product of labour () is given in column 4. The first worker produces 15 units each week, and since each unit sells for a price of \$70, his production value to the firm is \$1,050 . A second worker produces 25 units, so his value to the firm is \$1,750, and so forth. If the weekly wage of each worker is \$1,000 then the firm can estimate its marginal profit from hiring each additional worker. This is the difference between the value of the marginal product and the wage paid, and is given in the final column of the table.
It is profitable to hire more workers as long as the cost of an extra worker is less than the . The equilibrium amount of labour to employ is therefore 9 units in this example. If the firm were to hire one more worker the contribution of that worker to its profit would be negative , and if it hired one worker less it would forego the opportunity to make an additional profit of \$50 on the 9th unit .
Profit maximizing hiring rule:
• If the VMPL of next worker > wage, hire more labour.
• If the VMPL < wage, hire less labour.
To this point we have determined the profit maximizing amount of labour to employ when the output price and the wage are given. However, a demand function for labour reflects the demand for labour at many different wage rates, just as the demand function for any product reflects the quantity demanded at various prices. Accordingly, suppose the wage rate is \$1,500 per week rather than \$1,000. The optimal amount of labour to employ in this case is determined in exactly the same manner: Employ the amount of labour where its contribution is marginally profitable. Clearly the optimal amount to employ is 7 units: The value of the seventh worker to the firm is \$1,750 and the value of the eighth worker is \$1,400. Hence it would not be profitable to employ the eighth, because his marginal contribution to profit would be negative. Following the same procedure we could determine the optimal amount of labour to employ at different wages. This implies that the function is the demand for labour function because it determines the most profitable amount of labour to employ at any wage.
The optimal amount of labour to hire is illustrated in Figure 12.1. The wage and VMPL curves come from Table 12.1. The VMPL curve has an upward sloping segment, reflecting increasing productivity, and then a regular downward slope as developed in Chapter 8. At employment levels where the VMPL is greater than the wage additional labour should be employed. But when the VMPL falls below the wage rate employment should stop. If labour is divisible into very small units, the optimal employment decision is where the MPL function intersects the wage line.
Figure 12.1 The demand for labour
The optimal hiring decision is defined by the condition that the value of the MPL is greater than or equal to the wage paid. 9 workers are employed when the wage is \$1,000 and the price of output is \$70; 6 workers are employed when the wage is \$1,500 and the price of output is \$50.
Figure 12.1 also illustrates what happens to hiring when the output price changes. Consider a reduction in its price to \$50 from \$70. The profit impact of such a change is negative because the value of each worker's output has declined. Accordingly, the demand curve must reflect this by shifting inward (down), as in the figure. At various wage rates, less labour is now demanded. The new schedule can be derived in Table 12.1 as before: It is the schedule multiplied by the lower value (\$50) of the final good.
In this example the firm is a perfect competitor in the output market, because the price of the good it produces is fixed. It can produce and sell more of the good without this having an impact on the price of the good in the marketplace. Where the firm is not a perfect competitor it faces a declining MR function. In this case the value of the is the product of MR and rather than P and . To distinguish the different output markets we use the term marginal revenue product of labour () when the demand for the output slopes downward. But the optimizing principle remains the same: The firm should calculate the value of each additional unit of labour, and hire up to the point where the additional revenue produced by the worker exceeds or equals the additional cost of that worker.
The marginal revenue product of labour is the additional revenue generated by hiring one more unit of labour where the marginal revenue declines.
Demand in the long run
In Chapter 8 we proposed that firms choose their factors of production in accordance with cost-minimizing principles. In producing a specific output, firms choose the least-cost combination of labour and plant size. But how is this choice affected when the price of labour or capital changes? While adjustment to price changes may require a long period of time, we know that if one factor becomes more (less) expensive, the firm will likely change the mix of capital and labour away from (towards) that factor. For example, when the accuracy and prices of production robots began to fall in the nineteen nineties, auto assemblers reduced their labour and used robots instead. When computers and computer software improved and declined in price, clerical workers were replaced by computers that were operated by accountants. But such adjustments and responses do not occur overnight.
In the short run a higher wage increases costs, but the firm is constrained in its choice of inputs by a fixed plant size. In the long run, a wage increase will induce the firm to use relatively more capital than when labour was less expensive in producing a given output. But despite the new choice of inputs, a rise in the cost of any input must increase the total cost of producing any output.
A change in the price of any factor has two impacts on firms: In the first place producers will substitute away from the factor whose price increases; second, there will be an impact on output and a change in the price of the final good it produces. Since the cost structure increases when the price of an input rises, the supply curve in the market for the good must reflect this – any given output will now be supplied at a higher price. With a downward sloping demand, this shift in supply must increase the price of the good and reduce the amount sold. This second effect can be called an output effect.
Monopsony
Some firms may have to pay a higher wage in order to employ more workers. Think of Hydro Quebec building a dam in Northern Quebec. Not every hydraulic engineer would be equally happy working there as in Montreal. Some engineers may demand only a small wage premium to work in the North, but others will demand a high premium. If so, Hydro Quebec must pay a higher wage to attract more workers – it faces an upward sloping supply of labour curve. Hydro Quebec is the sole buyer in this particular market and is called a monopsonist – a single buyer. Our general optimizing principle governing the employment of labour still holds, even if we have different names for the various functions: Hire any factor of production up to the point where the cost of an additional unit equals the value generated for the firm by that extra worker. The essential difference here is that when a firm faces an upward sloping labour supply it will have to pay more to attract additional workers and also pay more to its existing workers. This will impact the firm's willingness to hire additional workers.
A monopsonist is the sole buyer of a good or service and faces an upward-sloping supply curve.
Application Box 12.1 Monopsonies
Monopsonies are more than a curiosity; they exist in the real world. An excellent example is the cannabis market in Canada. Virtually every province has set up a trading agency that has the sole right to purchase cannabis from growers; growers and processors are not permitted to sell directly to retailers; they may only sell to the monopsony by law. In turn, these provincial cannabis monopsonies are frequently retail monopolists in that the agency owns all of the retail outlets in the province.
Firm versus industry demand
The demand for labour within an industry, or sector of the economy, is obtained from the sum of the demands by each individual firm. It is analogous to the goods market, but with a subtle difference. In Chapter 3 we obtained a market demand by summing individual demands horizontally. The same could be done here: At lower (or higher) wages, each firm will demand more (or less) labour. However, if all firms employ more labour in order to increase their output, the price of the output will likely decline. This in turn will moderate the demand for labour – it is slightly less valuable now that the price of the output it produces has fallen. This is a subtle point, and we can reasonably think of the demand for labour in a given sector of the economy as the sum of the demands on the part of the employers in that sector.
12.2 The supply of labour
Most prime-age individuals work, but some do not. The decision to join the labour force is called the participation decision. Of those who do participate in the labour force, some individuals work full time, others work part time, and yet others cannot find a job. The unemployment rate is the fraction of the labour force actively seeking employment that is not employed.
The participation rate for the economy is the fraction of the population in the working age group that joins the labour force.
The labour force is that part of the population either employed or seeking employment.
The unemployment rate is the fraction of the labour force actively seeking employment that is not employed.
Data on participation rates in Canada are given in Table 12.2 below for specific years in the modern era. The overall participation for men and women combined has increased since 1977 from 60.8% to 65.8% This aggregated rate camouflages different patterns for men and women. The rates for women have been rising while the rates for men have fallen. Women today are more highly educated, and their role in society and the economy is viewed very differently than in the earlier period. Female participation has increased both because of changing social norms, a rise in household productivity, the development of service industries designed to support home life, and the development of the institution of daycare for young children.
In contrast, male participation rates declined over the period, largely offsetting the increase in female participation. Fewer individuals in total are retiring before the age of 55 in the most recent decades. This reflects both the greater number of females in the market place, and perhaps also a recognition that many households have not saved enough to fund a retirement period that has become longer as a result of increased longevity.
Table 12.2 Labour force participation rate, Canada 1977-2015
Year Total Men Women All > 55 Unemployment
1977 60.8 80.2 42.1 30.5 5.9
1990 66.6 77.1 56.8 25.9 7.4
1994 65.4 74.9 56.8 24.5 9.2
2001 66.1 73.4 59.2 26.4 6.2
2008 67.5 73.6 61.6 34.2 5.1
2015 66.2 72.0 60.6 37.3 6.0
2019 65.8 71.0 60.8 38.0 4.4
Source: Statistics Canada, CANSIM 14-10-0287-02
September of each year, for individuals aged 25, unless stated.
At the micro level, the participation rate of individuals depends upon several factors. First, the wage rate that an individual can earn in the market is crucial. If that wage is low, then the individual may be more efficient in producing home services directly, rather than going into the labour market, earning a modest income and having to pay for home services. Second, there are fixed costs associated with working. A decision to work means that the individual must have work clothing, must undertake the costs of travel to work, and pay for daycare if there are children in the family. Third, the participation decision depends upon non-labour income. If the individual in question has a partner who earns a substantial amount, or if she has investment income, she will have less incentive to participate. Fourth, it depends inversely upon the tax rate.
The supply curve relates the supply decision to the price of labour – the wage rate. Economists who have studied the labour market tell us that the individual supply curve is upward sloping: As the wage increases, the individual wishes to supply more labour. From the point on the supply function in Figure 12.2, let the wage increase from to .
Figure 12.2 Individual labour supply
A wage increase from W0 to W1 induces the individual to substitute away from leisure, which is now more expensive, and work more. But the higher wage also means the individual can work fewer hours for a given standard of living; therefore the income effect induces fewer hours. On balance the substitution effect tends to dominate and the supply curve therefore slopes upward.
The individual offers more labour, , at the higher wage. What is the economic intuition behind the higher amount of labour supplied? Like much of choice theory there are two impacts associated with a higher price. First, the higher wage makes leisure more expensive relative to working. That midweek game of golf has become more expensive in terms of what the individual could earn. So the individual should substitute away from the more expensive 'good', leisure, towards labour. But at the same time, in order to generate a given income target the individual can work fewer hours at the higher wage. This is a type of income effect, indicating that income is greater at a higher wage regardless of the amount worked, and this induces the individual to work less. The fact that we draw the labour supply curve with a positive slope means that the substitution effect is the more important of the two. That is what statistical research has revealed.
Elasticity of the supply of labour
The value of the supply elasticity depends upon how the market in question is defined. In particular, it depends upon how large or small a given sector of the economy is, and whether we are considering the short run or the long run.
Suppose an industry is small relative to the whole economy and employs workers with common skills. These industries tend to pay the 'going wage'. For example, very many students are willing to work at the going rate for telemarketing firms, which compose a small sector of the economy. This means that the supply curve of such labour, as far as that sector is concerned, is in effect horizontal – infinitely elastic.
But some industries may not be small relative to the total labour supply. And in order to get more labour to work in such large sectors it may be necessary to provide the inducement of a higher wage: Additional workers may have to be attracted from another sector by means of higher wages. To illustrate: Consider the behaviour of two related sectors in housing – new construction and home restoration. In order to employ more plumbers and carpenters, new home builders may have to offer higher wages to induce them to move from the renovation sector. In this case the new housing industry's labour supply curve slopes upwards.
In the time dimension, a longer period is always associated with more flexibility. In this context, the supply of labour to any sector is more elastic, because it may take time for workers to move from one sector to another. Or, in cases where skills must be built up: When a sectoral expansion bids up the wages of information technology (IT) workers, more school leavers are likely to develop IT skills. Time will be required before additional graduates are produced, but in the long run, such additional supply will moderate the short-run wage increases.
Wages can be defined as being before-tax or after-tax. The after-tax, or take-home, wage is more important than the gross wage in determining the quantity of labour to be supplied. If taxes on additional hours of work are very high, workers are more likely to supply less hours than if tax rates are lower.
12.3 Labour market equilibrium and mobility
The fact that labour is a derived demand differentiates the labour market's equilibrium from the goods-market equilibrium. Let us investigate this with the help of Figure 12.3; it contains supply and demand functions for one particular industry – the cement industry, let us assume.
In Figure 12.1 we illustrated the impact on the demand for labour of a decline in the price of the output produced – a decline in the output price reduced the value of the marginal product of labour. In the current example, suppose that a slowdown in construction results in a decline in the price of cement. The impact of this price fall is to reduce the output value of each worker in the cement producing industry, because their output now yields a lower price. This decline in the is represented in Figure 12.3 as a shift from to , which results in the new equilibrium .
Figure 12.3 Equilibrium in an industry labour market
A fall in the price of the good produced in a particular industry reduces the value of the MPL. Demand for labour thus falls from D0 to D1 and a new equilibrium E1 results. Alternatively, from E0, an increase in wages in another sector of the economy induces some labour to move to that sector. This is represented by the shift of S0 to S1 and the new equilibrium E2.
As a second example: Suppose that wages in some other sectors of the economy increase. The impact of this on the cement sector is that the supply of labour to the cement sector is reduced. In Chapter 3 we showed that a change in other prices may shift the demand or supply curve of interest. In Figure 12.3 supply shifts from to and the equilibrium goes from to .
How large are these impacts likely to be? That will depend upon how mobile labour is between sectors: Spillover effects will be smaller if labour is less mobile. This brings us naturally to the concepts of transfer earnings and rent.
Transfer earnings and rent
Consider the case of a performing violinist whose wage is \$80,000. If, as a best alternative, she can earn \$60,000 as a music teacher then her rent is \$20,000 and her transfer earnings \$60,000: Her rent is the excess she currently earns above the best alternative. Another violinist in the same orchestra, earning the same amount, who could earn \$55,000 as a teacher has rent of \$25,000. The alternative is also called the reservation wage. The violinists should not work in the orchestra unless they earn at least what they can earn in the next best alternative.
Transfer earnings are the amount that an individual can earn in the next highest paying alternative job.
Rent is the excess remuneration an individual currently receives above the next best alternative. This alternative is the reservation wage.
These concepts are illustrated in Figure 12.4. In this illustration, different individuals are willing to work for different amounts, but all are paid the same wage . The market labour supply curve by definition defines the wage for which each individual is willing to work. Thus the rent earned by labour in this market is the sum of the excess of the wage over each individual's transfer earnings – the area . This area is also what we called producer or supplier surplus in Chapter 5.
Figure 12.4 Transfer earnings and rent
Rent is the excess of earnings over reservation wages. Each individual earns W0 and is willing to work for the amount defined by the labour supply curve. Hence rent is W0E0A and transfer earnings OAE0L0. Rent is thus the term for supplier surplus in this market.
Free labour markets?
Real-world labour markets are characterized by trade unions, minimum wage laws, benefit regulations, severance packages, parental leave, sick-day allowances and so forth. So can we really claim that markets work in the way we have described them – essentially as involving individual agents demanding and supplying labour? While labour markets are not completely 'free' in the conventional sense, the important issue is whether these interventions, that are largely designed to protect workers, have a large or small impact on the market. One reason why unemployment rates are generally higher in European economies than in Canada and the US is that labour markets are less subject to controls, and workers have a less supportive social safety net in North America.
Application Box 12.2 Are high salaries killing professional sports?
It is often said that the agents of professional players are killing their sport by demanding unreasonable salaries. On occasion, the major leagues are threatened with strikes, even though players are paid millions each year. In fact, wages are high because the derived demand is high. Fans are willing to pay high ticket prices, and television rights generate huge revenues. Combined, these revenues not only make ownership profitable, but increase the demand for the top players.
The lay person may be horrified at thirty-million dollar annual salaries. But in reality, many players receiving such salaries may be earning less than their marginal product! If Tom Brady did not play for the New England Patriots the team would have a lower winning record, attract fewer fans and make less profit. If Brady is paid \$25m per season, he is being paid less than his marginal product if the team were to lose \$40m in revenue as a result of his absence.
Given this, why do some teams incur financial losses? In fact very few teams make losses: Cries of poverty on the part of owners are more frequently part of the bargaining process, and revenue sharing means that very few teams do not make a profit.
The impact of 'frictions', such as unionization and minimum wages, in the labour market can be understood with the help of Figure 12.5. The initial 'free market' equilibrium is at , assuming that the workers are not unionized. In contrast, if the workers in this industry form a union, and negotiate a higher wage, for example rather than , then fewer workers will be employed. But how big will this reduction be? Clearly it depends on the elasticities of demand and supply. With the demand curve D, the excess supply at the wage is the difference . However, if the demand curve is less elastic, as illustrated by the curve , the excess supply is . The excess supply also depends upon the supply elasticity. It is straightforward to see that a less elastic (more vertical) supply curve through would result is less excess supply.
Figure 12.5 Market interventions
E0 is the equilibrium in the absence of a union. If the presence of a union forces the wage to W1 fewer workers are employed. The magnitude of the decline from L0 to L1 depends on the elasticity of demand for labour. The excess supply at the wage W1 is (F-E1). With a less elastic demand curve () the excess supply is reduced to (F-).
Beyond elasticity, the magnitude of the excess supply will also depend upon the degree to which the minimum wage, or the union-negotiated wage, lies above the equilibrium. That is, a larger value of the difference ( results in more excess supply than a smaller difference.
While the above discussion pertains to unionization, it could equally well be interpreted in a minimum-wage context. If this figure describes the market for low-skill labour, and the government intervenes by setting a legal minimum at , then this will induce some degree of excess supply, depending upon the actual value of and the elasticities of supply and demand.
Despite the fact that a higher wage may induce some excess supply, it may increase total earnings. In Chapter 4 we saw that the dollar value of expenditure on a good increases when the price rises if the demand is inelastic. In the current example the 'good' is labour. Hence, a union-negotiated wage increase, or a higher minimum wage will each increase total remuneration if the demand for labour is inelastic. A case which has stirred great interest is described in Application Box 12.3.
Application Box 12.3 David Card on minimum wage
David Card is a famous Canadian-born labour economist who has worked at Princeton University and University of California, Berkeley. He is a winner of the prestigious Clark medal, an award made annually to an outstanding economist under the age of forty. Among his many contributions to the discipline, is a study of the impact of minimum wage laws on the employment of fast-food workers. With Alan Krueger as his co-researcher, Card examined the impact of the 1992 increase in the minimum wage in New Jersey and contrasted the impact on employment changes with neighbouring Pennsylvania, which did not experience an increase. They found virtually no difference in employment patterns between the two states. This research generated so much interest that it led to a special conference. Most economists now believe that modest changes in the level of the minimum wage have a small impact on employment levels.
Since about 2015, numerous labor-friendly movements favoring higher wages for low-paid workers have proposed a \$15 minimum in both Canada and the US. Some political parties have supported this movement, as have specific cities and municipalities and governments. While any increase in the minimum wage must by definition help those working, care must be exercised in implementing particularly large increases. This is because large increases in particular areas or spheres may induce production units to move outside of the area covered, and thereby shift jobs to lower-wage areas.
12.4 Capital – concepts
The share of national income accruing to capital is more substantial than commonly recognized. National income in Canada is divided 60-40, favoring labour. This leaves a very large component going to the owners of capital. The stock of physical capital includes assembly-line machinery, rail lines, dwellings, consumer durables, school buildings and so forth. It is the stock of produced goods used as inputs to the production of other goods and services.
Physical capital is the stock of produced goods that are inputs in the production of other goods and services.
Physical capital is distinct from land in that the former is produced, whereas land is not. These in turn differ from financial wealth, which is not an input to production. We add to the capital stock by undertaking investment. But, because capital depreciates, investment in new capital goods is required merely to stand still. Depreciation accounts for the difference between gross and net investment.
Gross investment is the production of new capital goods and the improvement of existing capital goods.
Net investment is gross investment minus depreciation of the existing capital stock.
Depreciation is the annual change in the value of a physical asset.
Since capital is a stock of productive assets we must distinguish between the value of services that flow from capital and the value of capital assets themselves.
A stock is the quantity of an asset at a point in time.
A flow is the stream of services an asset provides during a period of time.
When a car is rented it provides the driver with a service; the car is the asset, or stock of capital, and the driving, or ability to move from place to place, is the service that flows from the use of the asset. When a photocopier is leased it provides a stream of services to the user. The copier is the asset; it represents a stock of physical capital. The printed products result from the service the copier provides per unit of time.
The price of an asset is what a purchaser pays for the asset. The owner then obtains the future stream of capital services it provides. Buying a car for \$30,000 entitles the owner to a stream of future transport services. The term rental rate defines the cost of the services from capital.
Capital services are the production inputs generated by capital assets.
The rental rate is the cost of using capital services.
The price of an asset is the financial sum for which the asset can be purchased.
But what determines the price of a productive asset? The price must reflect the value of future services that the capital provides. But we cannot simply add up these future values, because a dollar today is more valuable than a dollar several years from now. The key to valuing an asset lies in understanding how to compute the present value of a future income stream.
Present values and discounting
When capital is purchased it generates a stream of dollar values (returns) in the future. A critical question is: How is the price that should be paid for capital today related to the benefits that capital will bring in the future? Consider the simplest of examples: A business is contemplating buying a computer. This business has a two-year horizon. It believes that the purchase of the computer will yield a return of \$500 in the first year (today), \$500 in the second year (one period into the future), and have a scrap value of \$200. What is the maximum price the entrepreneur should pay for the computer? The answer is obtained by discounting the future returns to the present. Since a dollar today is worth more than a dollar tomorrow, we cannot simply add the dollar values from different time periods.
The value today of \$500 received a year from now is less than \$500, because if you had this amount today you could invest it at the going rate of interest and end up with more than \$500 tomorrow. For example, if the rate of interest is 10% (= 0.1), then \$500 today is worth \$550 next period. By the same reasoning, \$500 tomorrow is worth less than \$500 today. Formally, the value next period of any amount is that amount plus the interest earned; in this case the value next period of \$500 today is , where r is the interest rate. It follows that if we multiply a given sum by (1+r) to obtain its value next period, then we must divide a sum received next period to obtain its value today. Hence the value today of \$500 next period is simply . To see that this must be true, note that if you have \$454.54 today you can invest it and obtain \$500 next period if the interest rate is 10%. In general:
This rule carries over to any number of future periods. The value of a sum of money today two periods into the future is obtained by multiplying the today value by twice. Or the value of a sum of money today that will be received two periods from now is that sum divided by twice. And so on, for any number of time periods. So if the amount is received twenty years into the future, its value today would be obtained by dividing that sum by twenty times; if received 'n' periods into the future it must be divided by 'n' times.
Two features of this discounting are to be noted: First, if the interest rate is high, the value today of future sums is smaller than if the interest rate is low. Second, sums received far in the future are worth much less than sums received in the near future.
Let us return to our initial example, assuming the interest rate is 0.1 (or 10%). The value of the year 1 return is \$500. The value of the year 2 return today is \$454.54, and the scrap value in today's terms is \$181.81. The value of all returns discounted to today is thus \$1,136.35.
Table 12.3 Present value of an asset ()
Year Annual return Scrap value Discounted values
Year 1 500 500
Year 2 500 200 454.54 + 181.81
Asset value today 1,136.35
The present value of a stream of future earnings is the sum of each year's earnings divided by one plus the interest rate 'n' times, where 'n' is the number of years in the future when the amount will be received.
We are now in a position to determine how much the buyer should be willing to pay for the computer. Clearly if the value of the computer today, measured in terms of future returns to the entrepreneur's business, is \$1,136.35, then the potential buyer should be willing to pay any sum less than that amount. Paying more makes no economic sense.
Discounting is a technique used in countless applications. It underlies the prices we are willing to pay for corporate stocks: Analysts make estimates of future earnings of corporations; they then discount those earnings back to the present, and suggest that we not pay more for a unit of stock than indicated by the present value of future earnings.
12.5 The capital market
Demand
The analysis of the demand for the services of capital parallels closely that of labour demand: The rental rate for capital replaces the wage rate and capital services replace the hours of labour. It is important to keep in mind the distinction we drew above between capital services on the one hand and the amount of capital on the other. Capital services are produced by capital assets, just as work is produced by humans. Terms that are analogous to the marginal product of labour emerge naturally: The marginal product of capital (MPK) is the output produced by one additional unit of capital services, with other inputs held constant. The value of this marginal product (VMPK) is its value in the market place. It is the MPK multiplied by the price of output.
The MPK must eventually decline with a fixed amount of other factors of production. So, if the price of output is fixed for the firm, it follows that the VMPK must also decline. We could pursue an analysis of the short-run demand for capital services, assuming labour was fixed, that would completely mirror the short-run demand for labour that we have already developed. But this would not add any new insights, so we move on to the supply side.
The marginal product of capital is the output produced by one additional unit of capital services, with all other inputs being held constant.
The value of the marginal product of capital is the marginal product of capital multiplied by the price of the output it produces.
Supply
We can grasp the key features of the market for capital by recognizing that the flow of capital services is determined by the capital stock: More capital means more services. The analysis of supply is complex because we must distinguish between the long run and the short run, and also between the supply to an industry and the supply in the whole economy.
In the short run the total supply of capital assets, and therefore services, is fixed to the economy, since new production capacity cannot come on stream overnight: The short-run supply of services is therefore vertical. In contrast, a particular industry in the short run faces a positively sloped supply: By offering a higher rental rate for trucks, one industry can bid them away from others.
The long run is a period of sufficient length to permit an addition to the capital stock. A supplier of capital, or capital services, must estimate the likely return he will get on the equipment he is contemplating having built. To illustrate: He is analyzing the purchase or construction of an earthmover that will cost \$100,000. Assuming that the annual maintenance and depreciation costs are \$10,000, and that the interest rate is 5% (implying that annual interest cost is \$5,000), it follows that the annual cost of owning such a machine is \$15,000. If the entrepreneur is to undertake the investment she must therefore earn at least this amount annually (by renting it to others, or using it herself), and this is what is termed the required rental. We can think of it as the opportunity cost of ownership.
The required rental covers the sum of maintenance, depreciation and interest costs.
Prices and returns
In the long run, capital services in any sector of the economy must earn the required rental. If they earn more, entrepreneurs will be induced to build or purchase additional capital goods; if they earn less, owners of capital will allow machines to depreciate, or move the machines to other sectors of the economy.
As an example, the price of oil on world markets fell by half during 2015; from about \$100US per barrel to \$50US. At this price, many oil wells were no longer profitable, and oil drilling equipment was decommissioned. Technically, the value of the marginal product of capital declined, because the price of the good it was producing declined. In the near and medium term, no new investment in capital goods will take place in the oil drilling sector of the economy. If the price of oil should increase in the future, some of the decommissioned capital will be brought back into service. But some of this capital will deteriorate or depreciate and simply 'die', and be sold for scrap metal – particularly the older vintage capital. Only when the stock of oil drilling equipment is reduced by depreciation and decay to the required level will any new investment in this form of capital take place.
Note that the capital in this example is sector-specific. Drilling equipment cannot be easily redirected for use in other sectors. In contrast, earth movers can move from one sector of the economy to another with greater ease. An earth mover can be used to dig foundations for housing or commercial buildings; it can be used for strip mining; to build roads and bridges; to build tennis courts, golf courses and public parks. Such equipment may thus be moved to other sectors of the economy if in one particular sector the capital no longer can earn the required rental.
The prices of capital goods in the long run will be determined by the supply and demand for the services they provide. If the value of the services, as determined by supply and demand is high, then the price of assets will reflect this.
12.6 Land
Land is an input used in production, though is not a capital good in the way we defined capital goods earlier – production inputs that are themselves produced in the economy. Land is relatively fixed in supply to the economy, even in the long run. While this may not be literally true – the Netherlands reclaimed from the sea a great quantity of low-lying farmland, and fertilizers can turn marginal land into fertile land – it is a good approximation to reality. Figure 12.6 shows the derived demand D0 for land services. With a fixed supply S, the equilibrium rental is R0.
Figure 12.6 The market for land services
The supply of land is relatively fixed, and therefore the return to land is primarily demand determined. Shifts in demand give rise to differences in returns.
In contrast to this economy-wide perspective, consider now a retailer who rents space in a commercial mall. The area around the mall experiences a surge in development and more people are shopping and doing business there. The retailer finds that she sells more, but also finds that her rent increases on account of the additional demand for space by commercial enterprises in the area. Her landlord is able to charge a higher rent because so many potential clients wish to rent space in the area. Consequently, despite the additional commerce in the area, the retailer's profit increase will be moderated by the higher rents she must pay: The demand for retail space is a derived demand. The situation can be explained with reference to Figure 12.6 again. On account of growth in this area, the demand for retail space shifts from to . Space in the area is restricted, and thus the vertical supply curve describes the supply side well. So with little or no possibility of higher prices bringing forth additional supply, the additional demand makes for a steep price (rent) increase.
Land has many uses and the returns to land must reflect this. Land in downtown Vancouver is priced higher than land in rural Saskatchewan. Land cannot be moved from the latter to the former location however, and therefore the rent differences represent an equilibrium. In contrast, land in downtown Winnipeg that is used for a parking lot may not be able to compete with the use of that land for office development. Therefore, for it to remain as a parking lot, the rental must reflect its high opportunity cost. This explains why parking fees in big US cities such as Boston or New York may run to \$40 per day. If the parking owners could not obtain this fee, they could profitably sell the land to a developer. Ultimately it is the value in its most productive use that determines the price of land.
Key Terms
Demand for labour: a derived demand, reflecting the demand for the output of final goods and services.
Value of the marginal product is the marginal product multiplied by the price of the good produced.
Marginal revenue product of labour is the additional revenue generated by hiring one more unit of labour where the marginal revenue declines.
Monopsonist is the sole buyer of a good or service and faces an upward-sloping supply curve.
Participation rate: the fraction of the population in the working age group that joins the labour force.
The labour force is that part of the population either employed or seeking employment.
Unemployment rate: the fraction of the labour force actively seeking employment that is not employed.
Transfer earnings are the amount that an individual can earn in the next highest paying alternative job.
Rent is the excess remuneration an individual currently receives above the next best alternative. This alternative is the reservation wage.
Physical capital is the stock of produced goods that are inputs to the production of other goods and services.
Gross investment is the production of new capital goods and the improvement of existing capital goods.
Net investment is gross investment minus depreciation of the existing capital stock.
Depreciation is the annual change in the value of a physical asset.
Stock is the quantity of an asset at a point in time.
Flow is the stream of services an asset provides during a period of time.
Capital services are the production inputs generated by capital assets.
Rental rate: the cost of using capital services.
Asset price: the financial sum for which the asset can be purchased.
Present value of a stream of future earnings: the sum of each year's earnings divided by one plus the interest rate raised to the appropriate power.
Marginal product of capital is the output produced by one additional unit of capital services, with all other inputs being held constant.
Value of the marginal product of capital is the marginal product of capital multiplied by the price of the output it produces.
Required rental covers the sum of maintenance, depreciation and interest costs.
Exercises for Chapter 12
EXERCISE 12.1
Aerodynamics is a company specializing in the production of bicycle shirts. It has a fixed capital stock, and sells its shirts for \$20 each. It pays a weekly wage of \$400 per worker. Aerodynamics must maximize its profits by determining the optimal number of employees to hire. The marginal product of each worker can be inferred from the table below. Determine the optimal number of employees. [Hint: You must determine the VMPL schedule, having first computed the MPL.]
Employment 0 1 2 3 4 5 6
Total output 0 20 50 75 95 110 120
EXERCISE 12.2
Suppose that, in Exercise 12.1 above, wages are not fixed. Instead the firm must pay \$50 more to employ each individual worker: The first worker is willing to work for \$250, the second for \$300, the third for \$350, etc. But once employed, each worker actually earns the same wage. Determine the optimal number of workers to be employed. [Hint: You must recognize that each worker earns the same wage; so when one additional worker is hired, the wage must increase to all workers employed.]
EXERCISE 12.3
Consider the following supply and demand equations for berry pickers. Demand: W=22–0.4L; supply: W=10+0.2L.
1. For values of , calculate the corresponding wage in each of the supply and demand functions.
2. Using the data from part (a), plot and identify the equilibrium wage and quantity of labour.
3. Illustrate in the diagram the areas defining transfer earnings and rent.
4. Compute the transfer earnings and rent components of the total wage bill.
EXERCISE 12.4
The rows of the following table describe the income stream for three different capital investments. The income flows accrue in years 1 and 2. Only year 2 returns need to be discounted. The rate of interest is the first entry in each row, and the project cost is the final entry.
Interest rate Year 1 Year 2 Cost
8% 8,000 9,000 16,000
6% 0 1,000 900
10% 4,000 5,000 11,000
1. For each investment calculate the present value of the stream of services.
2. Decide whether or not the investment should be undertaken.
EXERCISE 12.5
Nihilist Nicotine is a small tobacco farm in south-western Ontario. It has three plots of land, each with a different productivity, in that the annual yield differs across plots. The output from each plot is given in the table below. Each plot is the same size and requires 3 workers and one machine to harvest the leaves. The cost of these inputs is \$10,000. If the price of each kilogram of leaves is \$4, how many plots should be planted?
Land plot Leaf yield in kilograms
One 3,000
Two 2,500
Three 2,000
EXERCISE 12.6
The timing of wine sales is a frequent problem encountered by vintners. This is because many red wines improve with age. Let us suppose you own a particular vintage and you envisage that each bottle should increase in value by 10% the first year, 9% the second year, 8% the third year, etc.
1. Suppose the interest rate is 5%, for how many years would you hold the wine if there is no storage cost?
2. If in addition to interest rate costs, there is a cost of storing the wine that equals 2% of the wine's value each year, for how many years would you hold the wine before selling?
EXERCISE 12.7
Optional: The industry demand for plumbers is given by the equation W=50–0.08L, and there is a fixed supply of 300 qualified plumbers.
1. Draw a diagram illustrating the supply, demand and equilibrium, knowing that the quantity intercept for the demand equation is 625.
2. Solve the supply and demand equations for the equilibrium wage, W.
3. If the plumbers now form a union, and supply their labour at a wage of \$30 per hour, illustrate the new equilibrium on your diagram and calculate the new level of employment.
12: Labour and capital
The value of labour springs from the value of its use, that is the value placed upon goods and services that it produces – product prices. The wage is the price that equilibrates the supply and demand for a given type of labour, and it reflects the value of that labour in production. Formally, the demand for labour (and capital) is thus a derived demand, in contrast to being a 'final' demand.
Demand for labour: a derived demand, reflecting the value of the output it produces.
We must distinguish between the long run and the short run in our analysis of factor markets. On the supply side certain factors of production are fixed in the short run. For example, the supply of radiologists can be increased only over a period of years. While one hospital may be able to attract radiologists from another hospital to meet a shortage, this does not increase the supply in the economy as a whole.
On the demand side there is the conventional difference between the short and long run: In the short run some of a firm's factors of production, such as capital, are fixed, and therefore the demand for labour differs from when all factors are variable – the long run.
Demand in the short run
Table 12.1 contains information from the example developed in Chapter 8. It can be used to illustrate how a firm reacts in the short run to a change in an input price, or to a change in the output price. The response of a producer to a change in the wage rate constitutes a demand function for labour – a schedule relating the quantity of the input demanded to different input prices. The output produced by the various numbers of workers yields a marginal product curve, whose values are stated in column 3. The marginal product of labour, , as developed in Chapter 8, is the additional output resulting from one more worker being employed, while holding constant the other (fixed) factors. But what is the dollar value to the firm of an additional worker? It is the additional value of output resulting from the additional employee – the price of the output times the worker's marginal contribution to output, his MP. We term this the value of the marginal product.
The value of the marginal product is the marginal product multiplied by the price of the good produced.
Table 12.1 Short-run production and labour demand
Workers Output MPL Marginal profit = (VMPL–wage)
(1) (2) (3) (4) (5)
0 0
1 15 15 1050 150
2 40 25 1750 750
3 70 30 2100 1100
4 110 40 2800 1800
5 145 35 2450 1450
6 175 30 2100 1100
7 200 25 1750 750
8 220 20 1400 400
9 235 15 1050 50
10 240 5 350 negative
Each unit of labour costs \$1,000; output sells at a fixed price of \$70 per unit.
In this example the first rises as more labour is employed, and then falls. With each unit of output selling for \$70 the value of the marginal product of labour () is given in column 4. The first worker produces 15 units each week, and since each unit sells for a price of \$70, his production value to the firm is \$1,050 . A second worker produces 25 units, so his value to the firm is \$1,750, and so forth. If the weekly wage of each worker is \$1,000 then the firm can estimate its marginal profit from hiring each additional worker. This is the difference between the value of the marginal product and the wage paid, and is given in the final column of the table.
It is profitable to hire more workers as long as the cost of an extra worker is less than the . The equilibrium amount of labour to employ is therefore 9 units in this example. If the firm were to hire one more worker the contribution of that worker to its profit would be negative , and if it hired one worker less it would forego the opportunity to make an additional profit of \$50 on the 9th unit .
Profit maximizing hiring rule:
• If the VMPL of next worker > wage, hire more labour.
• If the VMPL < wage, hire less labour.
To this point we have determined the profit maximizing amount of labour to employ when the output price and the wage are given. However, a demand function for labour reflects the demand for labour at many different wage rates, just as the demand function for any product reflects the quantity demanded at various prices. Accordingly, suppose the wage rate is \$1,500 per week rather than \$1,000. The optimal amount of labour to employ in this case is determined in exactly the same manner: Employ the amount of labour where its contribution is marginally profitable. Clearly the optimal amount to employ is 7 units: The value of the seventh worker to the firm is \$1,750 and the value of the eighth worker is \$1,400. Hence it would not be profitable to employ the eighth, because his marginal contribution to profit would be negative. Following the same procedure we could determine the optimal amount of labour to employ at different wages. This implies that the function is the demand for labour function because it determines the most profitable amount of labour to employ at any wage.
The optimal amount of labour to hire is illustrated in Figure 12.1. The wage and VMPL curves come from Table 12.1. The VMPL curve has an upward sloping segment, reflecting increasing productivity, and then a regular downward slope as developed in Chapter 8. At employment levels where the VMPL is greater than the wage additional labour should be employed. But when the VMPL falls below the wage rate employment should stop. If labour is divisible into very small units, the optimal employment decision is where the MPL function intersects the wage line.
Figure 12.1 The demand for labour
The optimal hiring decision is defined by the condition that the value of the MPL is greater than or equal to the wage paid. 9 workers are employed when the wage is \$1,000 and the price of output is \$70; 6 workers are employed when the wage is \$1,500 and the price of output is \$50.
Figure 12.1 also illustrates what happens to hiring when the output price changes. Consider a reduction in its price to \$50 from \$70. The profit impact of such a change is negative because the value of each worker's output has declined. Accordingly, the demand curve must reflect this by shifting inward (down), as in the figure. At various wage rates, less labour is now demanded. The new schedule can be derived in Table 12.1 as before: It is the schedule multiplied by the lower value (\$50) of the final good.
In this example the firm is a perfect competitor in the output market, because the price of the good it produces is fixed. It can produce and sell more of the good without this having an impact on the price of the good in the marketplace. Where the firm is not a perfect competitor it faces a declining MR function. In this case the value of the is the product of MR and rather than P and . To distinguish the different output markets we use the term marginal revenue product of labour () when the demand for the output slopes downward. But the optimizing principle remains the same: The firm should calculate the value of each additional unit of labour, and hire up to the point where the additional revenue produced by the worker exceeds or equals the additional cost of that worker.
The marginal revenue product of labour is the additional revenue generated by hiring one more unit of labour where the marginal revenue declines.
Demand in the long run
In Chapter 8 we proposed that firms choose their factors of production in accordance with cost-minimizing principles. In producing a specific output, firms choose the least-cost combination of labour and plant size. But how is this choice affected when the price of labour or capital changes? While adjustment to price changes may require a long period of time, we know that if one factor becomes more (less) expensive, the firm will likely change the mix of capital and labour away from (towards) that factor. For example, when the accuracy and prices of production robots began to fall in the nineteen nineties, auto assemblers reduced their labour and used robots instead. When computers and computer software improved and declined in price, clerical workers were replaced by computers that were operated by accountants. But such adjustments and responses do not occur overnight.
In the short run a higher wage increases costs, but the firm is constrained in its choice of inputs by a fixed plant size. In the long run, a wage increase will induce the firm to use relatively more capital than when labour was less expensive in producing a given output. But despite the new choice of inputs, a rise in the cost of any input must increase the total cost of producing any output.
A change in the price of any factor has two impacts on firms: In the first place producers will substitute away from the factor whose price increases; second, there will be an impact on output and a change in the price of the final good it produces. Since the cost structure increases when the price of an input rises, the supply curve in the market for the good must reflect this – any given output will now be supplied at a higher price. With a downward sloping demand, this shift in supply must increase the price of the good and reduce the amount sold. This second effect can be called an output effect.
Monopsony
Some firms may have to pay a higher wage in order to employ more workers. Think of Hydro Quebec building a dam in Northern Quebec. Not every hydraulic engineer would be equally happy working there as in Montreal. Some engineers may demand only a small wage premium to work in the North, but others will demand a high premium. If so, Hydro Quebec must pay a higher wage to attract more workers – it faces an upward sloping supply of labour curve. Hydro Quebec is the sole buyer in this particular market and is called a monopsonist – a single buyer. Our general optimizing principle governing the employment of labour still holds, even if we have different names for the various functions: Hire any factor of production up to the point where the cost of an additional unit equals the value generated for the firm by that extra worker. The essential difference here is that when a firm faces an upward sloping labour supply it will have to pay more to attract additional workers and also pay more to its existing workers. This will impact the firm's willingness to hire additional workers.
A monopsonist is the sole buyer of a good or service and faces an upward-sloping supply curve.
Application Box 12.1 Monopsonies
Monopsonies are more than a curiosity; they exist in the real world. An excellent example is the cannabis market in Canada. Virtually every province has set up a trading agency that has the sole right to purchase cannabis from growers; growers and processors are not permitted to sell directly to retailers; they may only sell to the monopsony by law. In turn, these provincial cannabis monopsonies are frequently retail monopolists in that the agency owns all of the retail outlets in the province.
Firm versus industry demand
The demand for labour within an industry, or sector of the economy, is obtained from the sum of the demands by each individual firm. It is analogous to the goods market, but with a subtle difference. In Chapter 3 we obtained a market demand by summing individual demands horizontally. The same could be done here: At lower (or higher) wages, each firm will demand more (or less) labour. However, if all firms employ more labour in order to increase their output, the price of the output will likely decline. This in turn will moderate the demand for labour – it is slightly less valuable now that the price of the output it produces has fallen. This is a subtle point, and we can reasonably think of the demand for labour in a given sector of the economy as the sum of the demands on the part of the employers in that sector. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/12%3A_Labour_and_capital/12.01%3A_Labour_-_a_derived_demand.txt |
Most prime-age individuals work, but some do not. The decision to join the labour force is called the participation decision. Of those who do participate in the labour force, some individuals work full time, others work part time, and yet others cannot find a job. The unemployment rate is the fraction of the labour force actively seeking employment that is not employed.
The participation rate for the economy is the fraction of the population in the working age group that joins the labour force.
The labour force is that part of the population either employed or seeking employment.
The unemployment rate is the fraction of the labour force actively seeking employment that is not employed.
Data on participation rates in Canada are given in Table 12.2 below for specific years in the modern era. The overall participation for men and women combined has increased since 1977 from 60.8% to 65.8% This aggregated rate camouflages different patterns for men and women. The rates for women have been rising while the rates for men have fallen. Women today are more highly educated, and their role in society and the economy is viewed very differently than in the earlier period. Female participation has increased both because of changing social norms, a rise in household productivity, the development of service industries designed to support home life, and the development of the institution of daycare for young children.
In contrast, male participation rates declined over the period, largely offsetting the increase in female participation. Fewer individuals in total are retiring before the age of 55 in the most recent decades. This reflects both the greater number of females in the market place, and perhaps also a recognition that many households have not saved enough to fund a retirement period that has become longer as a result of increased longevity.
Table 12.2 Labour force participation rate, Canada 1977-2015
Year Total Men Women All > 55 Unemployment
1977 60.8 80.2 42.1 30.5 5.9
1990 66.6 77.1 56.8 25.9 7.4
1994 65.4 74.9 56.8 24.5 9.2
2001 66.1 73.4 59.2 26.4 6.2
2008 67.5 73.6 61.6 34.2 5.1
2015 66.2 72.0 60.6 37.3 6.0
2019 65.8 71.0 60.8 38.0 4.4
Source: Statistics Canada, CANSIM 14-10-0287-02
September of each year, for individuals aged 25, unless stated.
At the micro level, the participation rate of individuals depends upon several factors. First, the wage rate that an individual can earn in the market is crucial. If that wage is low, then the individual may be more efficient in producing home services directly, rather than going into the labour market, earning a modest income and having to pay for home services. Second, there are fixed costs associated with working. A decision to work means that the individual must have work clothing, must undertake the costs of travel to work, and pay for daycare if there are children in the family. Third, the participation decision depends upon non-labour income. If the individual in question has a partner who earns a substantial amount, or if she has investment income, she will have less incentive to participate. Fourth, it depends inversely upon the tax rate.
The supply curve relates the supply decision to the price of labour – the wage rate. Economists who have studied the labour market tell us that the individual supply curve is upward sloping: As the wage increases, the individual wishes to supply more labour. From the point on the supply function in Figure 12.2, let the wage increase from to .
Figure 12.2 Individual labour supply
A wage increase from W0 to W1 induces the individual to substitute away from leisure, which is now more expensive, and work more. But the higher wage also means the individual can work fewer hours for a given standard of living; therefore the income effect induces fewer hours. On balance the substitution effect tends to dominate and the supply curve therefore slopes upward.
The individual offers more labour, , at the higher wage. What is the economic intuition behind the higher amount of labour supplied? Like much of choice theory there are two impacts associated with a higher price. First, the higher wage makes leisure more expensive relative to working. That midweek game of golf has become more expensive in terms of what the individual could earn. So the individual should substitute away from the more expensive 'good', leisure, towards labour. But at the same time, in order to generate a given income target the individual can work fewer hours at the higher wage. This is a type of income effect, indicating that income is greater at a higher wage regardless of the amount worked, and this induces the individual to work less. The fact that we draw the labour supply curve with a positive slope means that the substitution effect is the more important of the two. That is what statistical research has revealed.
Elasticity of the supply of labour
The value of the supply elasticity depends upon how the market in question is defined. In particular, it depends upon how large or small a given sector of the economy is, and whether we are considering the short run or the long run.
Suppose an industry is small relative to the whole economy and employs workers with common skills. These industries tend to pay the 'going wage'. For example, very many students are willing to work at the going rate for telemarketing firms, which compose a small sector of the economy. This means that the supply curve of such labour, as far as that sector is concerned, is in effect horizontal – infinitely elastic.
But some industries may not be small relative to the total labour supply. And in order to get more labour to work in such large sectors it may be necessary to provide the inducement of a higher wage: Additional workers may have to be attracted from another sector by means of higher wages. To illustrate: Consider the behaviour of two related sectors in housing – new construction and home restoration. In order to employ more plumbers and carpenters, new home builders may have to offer higher wages to induce them to move from the renovation sector. In this case the new housing industry's labour supply curve slopes upwards.
In the time dimension, a longer period is always associated with more flexibility. In this context, the supply of labour to any sector is more elastic, because it may take time for workers to move from one sector to another. Or, in cases where skills must be built up: When a sectoral expansion bids up the wages of information technology (IT) workers, more school leavers are likely to develop IT skills. Time will be required before additional graduates are produced, but in the long run, such additional supply will moderate the short-run wage increases.
Wages can be defined as being before-tax or after-tax. The after-tax, or take-home, wage is more important than the gross wage in determining the quantity of labour to be supplied. If taxes on additional hours of work are very high, workers are more likely to supply less hours than if tax rates are lower. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/12%3A_Labour_and_capital/12.02%3A_The_supply_of_labour.txt |
The fact that labour is a derived demand differentiates the labour market's equilibrium from the goods-market equilibrium. Let us investigate this with the help of Figure 12.3; it contains supply and demand functions for one particular industry – the cement industry, let us assume.
In Figure 12.1 we illustrated the impact on the demand for labour of a decline in the price of the output produced – a decline in the output price reduced the value of the marginal product of labour. In the current example, suppose that a slowdown in construction results in a decline in the price of cement. The impact of this price fall is to reduce the output value of each worker in the cement producing industry, because their output now yields a lower price. This decline in the is represented in Figure 12.3 as a shift from to , which results in the new equilibrium .
Figure 12.3 Equilibrium in an industry labour market
A fall in the price of the good produced in a particular industry reduces the value of the MPL. Demand for labour thus falls from D0 to D1 and a new equilibrium E1 results. Alternatively, from E0, an increase in wages in another sector of the economy induces some labour to move to that sector. This is represented by the shift of S0 to S1 and the new equilibrium E2.
As a second example: Suppose that wages in some other sectors of the economy increase. The impact of this on the cement sector is that the supply of labour to the cement sector is reduced. In Chapter 3 we showed that a change in other prices may shift the demand or supply curve of interest. In Figure 12.3 supply shifts from to and the equilibrium goes from to .
How large are these impacts likely to be? That will depend upon how mobile labour is between sectors: Spillover effects will be smaller if labour is less mobile. This brings us naturally to the concepts of transfer earnings and rent.
Transfer earnings and rent
Consider the case of a performing violinist whose wage is \$80,000. If, as a best alternative, she can earn \$60,000 as a music teacher then her rent is \$20,000 and her transfer earnings \$60,000: Her rent is the excess she currently earns above the best alternative. Another violinist in the same orchestra, earning the same amount, who could earn \$55,000 as a teacher has rent of \$25,000. The alternative is also called the reservation wage. The violinists should not work in the orchestra unless they earn at least what they can earn in the next best alternative.
Transfer earnings are the amount that an individual can earn in the next highest paying alternative job.
Rent is the excess remuneration an individual currently receives above the next best alternative. This alternative is the reservation wage.
These concepts are illustrated in Figure 12.4. In this illustration, different individuals are willing to work for different amounts, but all are paid the same wage . The market labour supply curve by definition defines the wage for which each individual is willing to work. Thus the rent earned by labour in this market is the sum of the excess of the wage over each individual's transfer earnings – the area . This area is also what we called producer or supplier surplus in Chapter 5.
Figure 12.4 Transfer earnings and rent
Rent is the excess of earnings over reservation wages. Each individual earns W0 and is willing to work for the amount defined by the labour supply curve. Hence rent is W0E0A and transfer earnings OAE0L0. Rent is thus the term for supplier surplus in this market.
Free labour markets?
Real-world labour markets are characterized by trade unions, minimum wage laws, benefit regulations, severance packages, parental leave, sick-day allowances and so forth. So can we really claim that markets work in the way we have described them – essentially as involving individual agents demanding and supplying labour? While labour markets are not completely 'free' in the conventional sense, the important issue is whether these interventions, that are largely designed to protect workers, have a large or small impact on the market. One reason why unemployment rates are generally higher in European economies than in Canada and the US is that labour markets are less subject to controls, and workers have a less supportive social safety net in North America.
Application Box 12.2 Are high salaries killing professional sports?
It is often said that the agents of professional players are killing their sport by demanding unreasonable salaries. On occasion, the major leagues are threatened with strikes, even though players are paid millions each year. In fact, wages are high because the derived demand is high. Fans are willing to pay high ticket prices, and television rights generate huge revenues. Combined, these revenues not only make ownership profitable, but increase the demand for the top players.
The lay person may be horrified at thirty-million dollar annual salaries. But in reality, many players receiving such salaries may be earning less than their marginal product! If Tom Brady did not play for the New England Patriots the team would have a lower winning record, attract fewer fans and make less profit. If Brady is paid \$25m per season, he is being paid less than his marginal product if the team were to lose \$40m in revenue as a result of his absence.
Given this, why do some teams incur financial losses? In fact very few teams make losses: Cries of poverty on the part of owners are more frequently part of the bargaining process, and revenue sharing means that very few teams do not make a profit.
The impact of 'frictions', such as unionization and minimum wages, in the labour market can be understood with the help of Figure 12.5. The initial 'free market' equilibrium is at , assuming that the workers are not unionized. In contrast, if the workers in this industry form a union, and negotiate a higher wage, for example rather than , then fewer workers will be employed. But how big will this reduction be? Clearly it depends on the elasticities of demand and supply. With the demand curve D, the excess supply at the wage is the difference . However, if the demand curve is less elastic, as illustrated by the curve , the excess supply is . The excess supply also depends upon the supply elasticity. It is straightforward to see that a less elastic (more vertical) supply curve through would result is less excess supply.
Figure 12.5 Market interventions
E0 is the equilibrium in the absence of a union. If the presence of a union forces the wage to W1 fewer workers are employed. The magnitude of the decline from L0 to L1 depends on the elasticity of demand for labour. The excess supply at the wage W1 is (F-E1). With a less elastic demand curve () the excess supply is reduced to (F-).
Beyond elasticity, the magnitude of the excess supply will also depend upon the degree to which the minimum wage, or the union-negotiated wage, lies above the equilibrium. That is, a larger value of the difference ( results in more excess supply than a smaller difference.
While the above discussion pertains to unionization, it could equally well be interpreted in a minimum-wage context. If this figure describes the market for low-skill labour, and the government intervenes by setting a legal minimum at , then this will induce some degree of excess supply, depending upon the actual value of and the elasticities of supply and demand.
Despite the fact that a higher wage may induce some excess supply, it may increase total earnings. In Chapter 4 we saw that the dollar value of expenditure on a good increases when the price rises if the demand is inelastic. In the current example the 'good' is labour. Hence, a union-negotiated wage increase, or a higher minimum wage will each increase total remuneration if the demand for labour is inelastic. A case which has stirred great interest is described in Application Box 12.3.
Application Box 12.3 David Card on minimum wage
David Card is a famous Canadian-born labour economist who has worked at Princeton University and University of California, Berkeley. He is a winner of the prestigious Clark medal, an award made annually to an outstanding economist under the age of forty. Among his many contributions to the discipline, is a study of the impact of minimum wage laws on the employment of fast-food workers. With Alan Krueger as his co-researcher, Card examined the impact of the 1992 increase in the minimum wage in New Jersey and contrasted the impact on employment changes with neighbouring Pennsylvania, which did not experience an increase. They found virtually no difference in employment patterns between the two states. This research generated so much interest that it led to a special conference. Most economists now believe that modest changes in the level of the minimum wage have a small impact on employment levels.
Since about 2015, numerous labor-friendly movements favoring higher wages for low-paid workers have proposed a \$15 minimum in both Canada and the US. Some political parties have supported this movement, as have specific cities and municipalities and governments. While any increase in the minimum wage must by definition help those working, care must be exercised in implementing particularly large increases. This is because large increases in particular areas or spheres may induce production units to move outside of the area covered, and thereby shift jobs to lower-wage areas. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/12%3A_Labour_and_capital/12.03%3A_Labour_market_equilibrium_and_mobility.txt |
The share of national income accruing to capital is more substantial than commonly recognized. National income in Canada is divided 60-40, favoring labour. This leaves a very large component going to the owners of capital. The stock of physical capital includes assembly-line machinery, rail lines, dwellings, consumer durables, school buildings and so forth. It is the stock of produced goods used as inputs to the production of other goods and services.
Physical capital is the stock of produced goods that are inputs in the production of other goods and services.
Physical capital is distinct from land in that the former is produced, whereas land is not. These in turn differ from financial wealth, which is not an input to production. We add to the capital stock by undertaking investment. But, because capital depreciates, investment in new capital goods is required merely to stand still. Depreciation accounts for the difference between gross and net investment.
Gross investment is the production of new capital goods and the improvement of existing capital goods.
Net investment is gross investment minus depreciation of the existing capital stock.
Depreciation is the annual change in the value of a physical asset.
Since capital is a stock of productive assets we must distinguish between the value of services that flow from capital and the value of capital assets themselves.
A stock is the quantity of an asset at a point in time.
A flow is the stream of services an asset provides during a period of time.
When a car is rented it provides the driver with a service; the car is the asset, or stock of capital, and the driving, or ability to move from place to place, is the service that flows from the use of the asset. When a photocopier is leased it provides a stream of services to the user. The copier is the asset; it represents a stock of physical capital. The printed products result from the service the copier provides per unit of time.
The price of an asset is what a purchaser pays for the asset. The owner then obtains the future stream of capital services it provides. Buying a car for \$30,000 entitles the owner to a stream of future transport services. The term rental rate defines the cost of the services from capital.
Capital services are the production inputs generated by capital assets.
The rental rate is the cost of using capital services.
The price of an asset is the financial sum for which the asset can be purchased.
But what determines the price of a productive asset? The price must reflect the value of future services that the capital provides. But we cannot simply add up these future values, because a dollar today is more valuable than a dollar several years from now. The key to valuing an asset lies in understanding how to compute the present value of a future income stream.
Present values and discounting
When capital is purchased it generates a stream of dollar values (returns) in the future. A critical question is: How is the price that should be paid for capital today related to the benefits that capital will bring in the future? Consider the simplest of examples: A business is contemplating buying a computer. This business has a two-year horizon. It believes that the purchase of the computer will yield a return of \$500 in the first year (today), \$500 in the second year (one period into the future), and have a scrap value of \$200. What is the maximum price the entrepreneur should pay for the computer? The answer is obtained by discounting the future returns to the present. Since a dollar today is worth more than a dollar tomorrow, we cannot simply add the dollar values from different time periods.
The value today of \$500 received a year from now is less than \$500, because if you had this amount today you could invest it at the going rate of interest and end up with more than \$500 tomorrow. For example, if the rate of interest is 10% (= 0.1), then \$500 today is worth \$550 next period. By the same reasoning, \$500 tomorrow is worth less than \$500 today. Formally, the value next period of any amount is that amount plus the interest earned; in this case the value next period of \$500 today is , where r is the interest rate. It follows that if we multiply a given sum by (1+r) to obtain its value next period, then we must divide a sum received next period to obtain its value today. Hence the value today of \$500 next period is simply . To see that this must be true, note that if you have \$454.54 today you can invest it and obtain \$500 next period if the interest rate is 10%. In general:
This rule carries over to any number of future periods. The value of a sum of money today two periods into the future is obtained by multiplying the today value by twice. Or the value of a sum of money today that will be received two periods from now is that sum divided by twice. And so on, for any number of time periods. So if the amount is received twenty years into the future, its value today would be obtained by dividing that sum by twenty times; if received 'n' periods into the future it must be divided by 'n' times.
Two features of this discounting are to be noted: First, if the interest rate is high, the value today of future sums is smaller than if the interest rate is low. Second, sums received far in the future are worth much less than sums received in the near future.
Let us return to our initial example, assuming the interest rate is 0.1 (or 10%). The value of the year 1 return is \$500. The value of the year 2 return today is \$454.54, and the scrap value in today's terms is \$181.81. The value of all returns discounted to today is thus \$1,136.35.
Table 12.3 Present value of an asset ()
Year Annual return Scrap value Discounted values
Year 1 500 500
Year 2 500 200 454.54 + 181.81
Asset value today 1,136.35
The present value of a stream of future earnings is the sum of each year's earnings divided by one plus the interest rate 'n' times, where 'n' is the number of years in the future when the amount will be received.
We are now in a position to determine how much the buyer should be willing to pay for the computer. Clearly if the value of the computer today, measured in terms of future returns to the entrepreneur's business, is \$1,136.35, then the potential buyer should be willing to pay any sum less than that amount. Paying more makes no economic sense.
Discounting is a technique used in countless applications. It underlies the prices we are willing to pay for corporate stocks: Analysts make estimates of future earnings of corporations; they then discount those earnings back to the present, and suggest that we not pay more for a unit of stock than indicated by the present value of future earnings. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/12%3A_Labour_and_capital/12.04%3A_Capital_-_concepts.txt |
Demand
The analysis of the demand for the services of capital parallels closely that of labour demand: The rental rate for capital replaces the wage rate and capital services replace the hours of labour. It is important to keep in mind the distinction we drew above between capital services on the one hand and the amount of capital on the other. Capital services are produced by capital assets, just as work is produced by humans. Terms that are analogous to the marginal product of labour emerge naturally: The marginal product of capital (MPK) is the output produced by one additional unit of capital services, with other inputs held constant. The value of this marginal product (VMPK) is its value in the market place. It is the MPK multiplied by the price of output.
The MPK must eventually decline with a fixed amount of other factors of production. So, if the price of output is fixed for the firm, it follows that the VMPK must also decline. We could pursue an analysis of the short-run demand for capital services, assuming labour was fixed, that would completely mirror the short-run demand for labour that we have already developed. But this would not add any new insights, so we move on to the supply side.
The marginal product of capital is the output produced by one additional unit of capital services, with all other inputs being held constant.
The value of the marginal product of capital is the marginal product of capital multiplied by the price of the output it produces.
Supply
We can grasp the key features of the market for capital by recognizing that the flow of capital services is determined by the capital stock: More capital means more services. The analysis of supply is complex because we must distinguish between the long run and the short run, and also between the supply to an industry and the supply in the whole economy.
In the short run the total supply of capital assets, and therefore services, is fixed to the economy, since new production capacity cannot come on stream overnight: The short-run supply of services is therefore vertical. In contrast, a particular industry in the short run faces a positively sloped supply: By offering a higher rental rate for trucks, one industry can bid them away from others.
The long run is a period of sufficient length to permit an addition to the capital stock. A supplier of capital, or capital services, must estimate the likely return he will get on the equipment he is contemplating having built. To illustrate: He is analyzing the purchase or construction of an earthmover that will cost \$100,000. Assuming that the annual maintenance and depreciation costs are \$10,000, and that the interest rate is 5% (implying that annual interest cost is \$5,000), it follows that the annual cost of owning such a machine is \$15,000. If the entrepreneur is to undertake the investment she must therefore earn at least this amount annually (by renting it to others, or using it herself), and this is what is termed the required rental. We can think of it as the opportunity cost of ownership.
The required rental covers the sum of maintenance, depreciation and interest costs.
Prices and returns
In the long run, capital services in any sector of the economy must earn the required rental. If they earn more, entrepreneurs will be induced to build or purchase additional capital goods; if they earn less, owners of capital will allow machines to depreciate, or move the machines to other sectors of the economy.
As an example, the price of oil on world markets fell by half during 2015; from about \$100US per barrel to \$50US. At this price, many oil wells were no longer profitable, and oil drilling equipment was decommissioned. Technically, the value of the marginal product of capital declined, because the price of the good it was producing declined. In the near and medium term, no new investment in capital goods will take place in the oil drilling sector of the economy. If the price of oil should increase in the future, some of the decommissioned capital will be brought back into service. But some of this capital will deteriorate or depreciate and simply 'die', and be sold for scrap metal – particularly the older vintage capital. Only when the stock of oil drilling equipment is reduced by depreciation and decay to the required level will any new investment in this form of capital take place.
Note that the capital in this example is sector-specific. Drilling equipment cannot be easily redirected for use in other sectors. In contrast, earth movers can move from one sector of the economy to another with greater ease. An earth mover can be used to dig foundations for housing or commercial buildings; it can be used for strip mining; to build roads and bridges; to build tennis courts, golf courses and public parks. Such equipment may thus be moved to other sectors of the economy if in one particular sector the capital no longer can earn the required rental.
The prices of capital goods in the long run will be determined by the supply and demand for the services they provide. If the value of the services, as determined by supply and demand is high, then the price of assets will reflect this. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/12%3A_Labour_and_capital/12.05%3A_The_capital_market.txt |
Land is an input used in production, though is not a capital good in the way we defined capital goods earlier – production inputs that are themselves produced in the economy. Land is relatively fixed in supply to the economy, even in the long run. While this may not be literally true – the Netherlands reclaimed from the sea a great quantity of low-lying farmland, and fertilizers can turn marginal land into fertile land – it is a good approximation to reality. Figure 12.6 shows the derived demand D0 for land services. With a fixed supply S, the equilibrium rental is R0.
Figure 12.6 The market for land services
The supply of land is relatively fixed, and therefore the return to land is primarily demand determined. Shifts in demand give rise to differences in returns.
In contrast to this economy-wide perspective, consider now a retailer who rents space in a commercial mall. The area around the mall experiences a surge in development and more people are shopping and doing business there. The retailer finds that she sells more, but also finds that her rent increases on account of the additional demand for space by commercial enterprises in the area. Her landlord is able to charge a higher rent because so many potential clients wish to rent space in the area. Consequently, despite the additional commerce in the area, the retailer's profit increase will be moderated by the higher rents she must pay: The demand for retail space is a derived demand. The situation can be explained with reference to Figure 12.6 again. On account of growth in this area, the demand for retail space shifts from to . Space in the area is restricted, and thus the vertical supply curve describes the supply side well. So with little or no possibility of higher prices bringing forth additional supply, the additional demand makes for a steep price (rent) increase.
Land has many uses and the returns to land must reflect this. Land in downtown Vancouver is priced higher than land in rural Saskatchewan. Land cannot be moved from the latter to the former location however, and therefore the rent differences represent an equilibrium. In contrast, land in downtown Winnipeg that is used for a parking lot may not be able to compete with the use of that land for office development. Therefore, for it to remain as a parking lot, the rental must reflect its high opportunity cost. This explains why parking fees in big US cities such as Boston or New York may run to \$40 per day. If the parking owners could not obtain this fee, they could profitably sell the land to a developer. Ultimately it is the value in its most productive use that determines the price of land.
12.07: Key Terms
Demand for labour: a derived demand, reflecting the demand for the output of final goods and services.
Value of the marginal product is the marginal product multiplied by the price of the good produced.
Marginal revenue product of labour is the additional revenue generated by hiring one more unit of labour where the marginal revenue declines.
Monopsonist is the sole buyer of a good or service and faces an upward-sloping supply curve.
Participation rate: the fraction of the population in the working age group that joins the labour force.
The labour force is that part of the population either employed or seeking employment.
Unemployment rate: the fraction of the labour force actively seeking employment that is not employed.
Transfer earnings are the amount that an individual can earn in the next highest paying alternative job.
Rent is the excess remuneration an individual currently receives above the next best alternative. This alternative is the reservation wage.
Physical capital is the stock of produced goods that are inputs to the production of other goods and services.
Gross investment is the production of new capital goods and the improvement of existing capital goods.
Net investment is gross investment minus depreciation of the existing capital stock.
Depreciation is the annual change in the value of a physical asset.
Stock is the quantity of an asset at a point in time.
Flow is the stream of services an asset provides during a period of time.
Capital services are the production inputs generated by capital assets.
Rental rate: the cost of using capital services.
Asset price: the financial sum for which the asset can be purchased.
Present value of a stream of future earnings: the sum of each year's earnings divided by one plus the interest rate raised to the appropriate power.
Marginal product of capital is the output produced by one additional unit of capital services, with all other inputs being held constant.
Value of the marginal product of capital is the marginal product of capital multiplied by the price of the output it produces.
Required rental covers the sum of maintenance, depreciation and interest costs. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/12%3A_Labour_and_capital/12.06%3A_Land.txt |
EXERCISE 12.1
Aerodynamics is a company specializing in the production of bicycle shirts. It has a fixed capital stock, and sells its shirts for \$20 each. It pays a weekly wage of \$400 per worker. Aerodynamics must maximize its profits by determining the optimal number of employees to hire. The marginal product of each worker can be inferred from the table below. Determine the optimal number of employees. [Hint: You must determine the VMPL schedule, having first computed the MPL.]
Employment 0 1 2 3 4 5 6
Total output 0 20 50 75 95 110 120
EXERCISE 12.2
Suppose that, in Exercise 12.1 above, wages are not fixed. Instead the firm must pay \$50 more to employ each individual worker: The first worker is willing to work for \$250, the second for \$300, the third for \$350, etc. But once employed, each worker actually earns the same wage. Determine the optimal number of workers to be employed. [Hint: You must recognize that each worker earns the same wage; so when one additional worker is hired, the wage must increase to all workers employed.]
EXERCISE 12.3
Consider the following supply and demand equations for berry pickers. Demand: W=22–0.4L; supply: W=10+0.2L.
1. For values of , calculate the corresponding wage in each of the supply and demand functions.
2. Using the data from part (a), plot and identify the equilibrium wage and quantity of labour.
3. Illustrate in the diagram the areas defining transfer earnings and rent.
4. Compute the transfer earnings and rent components of the total wage bill.
EXERCISE 12.4
The rows of the following table describe the income stream for three different capital investments. The income flows accrue in years 1 and 2. Only year 2 returns need to be discounted. The rate of interest is the first entry in each row, and the project cost is the final entry.
Interest rate Year 1 Year 2 Cost
8% 8,000 9,000 16,000
6% 0 1,000 900
10% 4,000 5,000 11,000
1. For each investment calculate the present value of the stream of services.
2. Decide whether or not the investment should be undertaken.
EXERCISE 12.5
Nihilist Nicotine is a small tobacco farm in south-western Ontario. It has three plots of land, each with a different productivity, in that the annual yield differs across plots. The output from each plot is given in the table below. Each plot is the same size and requires 3 workers and one machine to harvest the leaves. The cost of these inputs is \$10,000. If the price of each kilogram of leaves is \$4, how many plots should be planted?
Land plot Leaf yield in kilograms
One 3,000
Two 2,500
Three 2,000
EXERCISE 12.6
The timing of wine sales is a frequent problem encountered by vintners. This is because many red wines improve with age. Let us suppose you own a particular vintage and you envisage that each bottle should increase in value by 10% the first year, 9% the second year, 8% the third year, etc.
1. Suppose the interest rate is 5%, for how many years would you hold the wine if there is no storage cost?
2. If in addition to interest rate costs, there is a cost of storing the wine that equals 2% of the wine's value each year, for how many years would you hold the wine before selling?
EXERCISE 12.7
Optional: The industry demand for plumbers is given by the equation W=50–0.08L, and there is a fixed supply of 300 qualified plumbers.
1. Draw a diagram illustrating the supply, demand and equilibrium, knowing that the quantity intercept for the demand equation is 625.
2. Solve the supply and demand equations for the equilibrium wage, W.
3. If the plumbers now form a union, and supply their labour at a wage of \$30 per hour, illustrate the new equilibrium on your diagram and calculate the new level of employment. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/12%3A_Labour_and_capital/12.08%3A_Exercises_for_Chapter_12.txt |
Chapter 13: Human capital and the income distribution
In this chapter we will explore:
13.1
The concept of human capital
13.2
Productivity and education
13.3
On-the-job training
13.4
Education as signaling
13.5
Returns to education and education quality
13.6
Discrimination
13.7
The income and earnings distribution in Canada
13.8
Wealth and capitalism
Individuals with different characteristics earn different amounts because their productivity levels differ. While it is convenient to work with a single marginal productivity of labour function to illustrate the functioning of the labour market, as we did in Chapter 12, for the most part wages and earnings vary by education level and experience, and sometimes by ethnicity and gender. In this chapter we develop an understanding of the sources of these differentials, and how they are reflected in the distribution of income.
13.1 Human capital
Human capital, HK, is the stock of knowledge and ability accumulated by a worker that determines future productivity and earnings. It depends on many different attributes – education, experience, intelligence, interpersonal skills etc. While human capital influences own earnings, it also impacts the productivity of the economy at large, and is therefore a vital force in determining long-run growth. Canada has been investing heavily in human capital in recent decades, and this suggests that future productivity and earnings will benefit accordingly.
Human capital is the stock of knowledge and ability accumulated by a worker that determines future productivity and earning.
Several features of Canada's recent human capital accumulation are noteworthy. First, Canada's enrollment rate in post-secondary education now exceeds the US rate, and that of virtually every economy in the world. Second is the fact that the number of women in third-level institutions exceeds the number of men. Almost 60% of university students are women. Third, international testing of high-school students sees Canadian students performing well, which indicates that the quality of the Canadian educational system appears to be high. These are positive aspects of a system that frequently comes under criticism. Nonetheless, the distribution of income that emerges from market forces in Canada has become more unequal.
Let us now try to understand individuals' economic motivation for embarking on the accumulation of human capital, and in the process see why different groups earn different amounts. We start by analyzing the role of education and then turn to on-the-job training. At the outset, we recognize that many individuals acquire knowledge for its own sake or in order to improve the quality of their lives. Education can improve one's appreciation of art, literature and the sciences.
13.2 Productivity and education
Human capital is the result of past investment that raises future incomes. A critical choice for individuals is to decide upon exactly how much additional human capital to accumulate. The cost of investing in another year of school is the direct cost, such as school fees, plus the indirect, or opportunity, cost, which can be measured by the foregone earnings during that extra year. The benefit of the additional investment is that the future flow of earnings is augmented. Consequently, wage differentials should reflect different degrees of education-dependent productivity.
Age-earnings profiles
Figure 13.1 illustrates two typical age-earnings profiles for individuals with different levels of education. These profiles define the typical pattern of earnings over time, and are usually derived by examining averages across individuals in surveys. Two aspects are clear: People with more education not only earn more, but the spread tends to grow with time. Less educated, healthy young individuals who work hard may earn a living wage but, unlike their more educated counterparts, they cannot look forward to a wage that rises substantially over time. More highly-educated individuals go into jobs and occupations that take a longer time to master: Lawyers, doctors and most professionals not only undertake more schooling than truck drivers, they also spend many years learning on the job, building up a clientele and accumulating expertise.
Age-earnings profiles define the pattern of earnings over time for individuals with different characteristics.
Figure 13.1 Age-Earnings profiles by education level
Individuals with a higher level of education earn more than individuals with a 'standard' level of education. In addition, the differential grows over time.
The education premium
Individuals with different education levels earn different wages. The education premium is the difference in earnings between the more and less highly educated. Quantitatively, Professors Kelly Foley and David Green have recently proposed that the completion of a college or trade certification adds about 15% to one's income, relative to an individual who has completed high school. A Bachelor's degree brings a premium of 20-25%, and a graduate degree several percentage points more1. The failure to complete high school penalizes individuals to the extent of about 10%. These are average numbers, and they vary depending upon the province of residence, time period and gender. Nonetheless the findings underline that more human capital is associated with higher earnings. The earnings premium depends upon both the supply and demand of high HK individuals. Ceteris paribus, if high-skill workers are heavily in demand by employers, then the premium should be greater than if lower-skill workers are more in demand.
Education premium: the difference in earnings between the more and less highly educated.
The distribution of earnings has become more unequal in Canada and the US in recent decades, and one reason that has been proposed for this development is that the modern economy demands more high-skill workers; in particular that technological change has a bigger impact on productivity when combined with high-skill workers than with low-skill workers. Consider Figure 13.2 which contains supply and demand functions with a twist. We imagine that there are two types of labour: One with a high level of human capital, the other with a lower level. The vertical axis measures the wage premium of the high-education group (which can be measured in dollars or percentage terms), and the horizontal axis measures the fraction of the total labour force that is of the high-skill type. D is the relative demand for the high skill workers, in this example for the economy as a whole. There is some degree of substitution between high and low-skill workers in the modern economy. We do not propose that several low-skill workers can perform the work of one neuro-surgeon; but several individual households (low-skill) could complete their income tax submissions in the same time as one skilled tax specialist. In this example there is a degree of substitutability. In a production environment, a high-skill manager, equipped with technology and capital, can perform the tasks of several line workers.
Figure 13.2 The education/skill premium
A shift in demand increases the wage premium in the short run (from E0 to E1) by more than in the long run (to E2). In the short run, the percentage of the labour force (SS) that is highly skilled is fixed. In the long run it (SL) is variable and responds to the wage premium.
The demand curve D defines the premium that employers (demanders) are willing to pay to the higher skill group. The negative slope indicates that if demanders were to employ a high proportion of skilled workers, the premium they would be willing to pay would be less than if they demanded a smaller share of high-skilled workers, and a larger share of lower-skilled workers. The wage premium for high HK individuals at any given time is determined by the intersection of supply and demand.
In the short run the make-up of the labour force is fixed, and this is reflected in the vertical supply curve Ss. The equilibrium is at E0, and is the premium, or excess, paid to the higher-skill worker over the lower-skill worker. In the long run it is possible for the economy to change the composition of its labour supply: If the wage premium increases, more individuals will find it profitable to train as high-skill workers. That is to say, the fraction of the total that is high-skill increases. It follows that the long-run supply curve slopes upwards.
So what happens when there is an increase in the demand for high-skill workers relative to low-skill workers? The demand curve shifts upward to , and the new equilibrium is at . The supply mix is fixed in the short run, so there is an increase in the wage premium. But over time, some individuals who might have been just indifferent between educating themselves more and going into the workplace with lower skill levels now find it worthwhile to pursue further education. Their higher anticipated returns to the additional human capital they invest in now exceed the additional costs of more schooling, whereas before the premium increase these additional costs and benefits were in balance. In Figure 13.2 the new short-run equilibrium at has a corresponding wage premium of . In the long run, after additional supply has reached the market, the increased premium is moderated to at the equilibrium .
This figure displays what many economists believe has happened in North America in recent decades: The demand for high HK individuals has increased, and the additional supply has not been as great. Consequently the wage premium for the high-skill workers has increased. As we describe later in this chapter, that is not the only perspective on what has happened.
Are students credit-constrained or culture-constrained?
The foregoing analysis assumes that students and potential students make rational decisions on the costs and benefits of further education and act accordingly. It also assumes implicitly that individuals can borrow the funds necessary to build their human capital: If the additional returns to further education are worthwhile, individuals should borrow the money to make the investment, just as entrepreneurs do with physical capital.
However, there is a key difference in the credit markets. If an entrepreneur fails in her business venture the lender will have a claim on the physical capital. But a bank cannot repossess a human being who drops out of school without having accumulated the intended human capital. Accordingly, the traditional lending institutions are frequently reluctant to lend the amount that students might like to borrow—students are credit constrained. The sons and daughters of affluent families therefore find it easier to attend university, because they are more likely to have a supply of funds domestically. Governments customarily step into the breach and supply loans and bursaries to students who have limited resources. While funding frequently presents an obstacle to attending a third-level institution, a stronger determinant of attendance is the education of the parents, as detailed in Application Box 13.1.
Application Box 13.1 Parental education and university attendance in Canada
The biggest single determinant of university attendance in the modern era is parental education. A recent study* of who goes to university examined the level of parental education of young people 'in transition' – at the end of their high school – for the years 1991 and 2000.
For the year 2000 they found that, if a parent had not completed high school, there was just a 12% chance that their son would attend university and an 18% chance that a daughter would attend. In contrast, for parents who themselves had completed a university degree, the probability that a son would also attend university was 53% and for a daughter 62%. Hence, the probability of a child attending university was roughly four times higher if the parent came from the top educational category rather than the bottom category! Furthermore the authors found that this probability gap opened wider between 1991 and 2000.
In the United States, Professor Sear Reardon of Stanford University has followed the performance of children from low-income households and compared their achievement with children from high-income households. He has found that the achievement gap between these groups of children has increased substantially over the last three decades. The reason for this growing separation is not because children from low-income households are performing worse in school, it is because high-income parents invest much more of their time and resources in educating their children, both formally in the school environment, and also in extra-school activities.
*Finnie, R., C. Laporte and E. Lascelles. "Family Background and Access to Post-Secondary Education: What Happened in the Nineties?" Statistics Canada Research Paper, Catalogue number 11F0019MIE-226, 2004
Reardon, Sean, "The Great Divide", New York Times, April 8, 2015.
13.3 On-the-job training
As is clear from Figure 13.1, earnings are raised both by education and experience. Learning on the job is central to the age-earnings profiles of the better educated, and is less important for those with lower levels of education. On-the-job training improves human capital through work experience. If on-the-job training increases worker productivity, who should pay for this learning – firms or workers? To understand who should pay, we distinguish between two kinds of skills: Firm-specific skills that raise a worker's productivity in a particular firm, and general skills that enhance productivity in many jobs or firms.
Firm-specific HK could involve knowing how particular components of a somewhat unique production structure functions, whereas general human capital might involve an understanding of engineering or architectural principles that can be applied universally. As for who should pay for the accumulation of skills: An employer should be willing to undertake most of the cost of firm-specific skills, because they are of less value to the worker should she go elsewhere. Firms offering general or transferable training try to pass the cost on to the workers, perhaps by offering a wage-earnings profile that starts very low, but that rises over time. Low-wage apprenticeships are examples. Hence, whether an employee is a medical doctor in residence, a plumber in an apprenticeship or a young lawyer in a law partnership, she 'pays' for the accumulation of her portable HK by facing a low wage when young. Workers are willing to accept such an earnings profile because their projected future earnings will compensate for lower initial earning.
On-the-job training improves human capital through work experience.
Firm-specific skills raise a worker's productivity in a particular firm.
General skills enhance productivity in many jobs or firms.
13.4 Education as signalling
An alternative view of education springs from the theory of signalling. This is a provocative theory that proposes education may be worthwhile, even if it generates little additional skills. The theory recognizes that individuals possess different abilities. However, firms cannot easily recognize the more productive workers without actually hiring them and finding out ex-post – sometimes a costly process. Signalling theory says that, in pursuing more education, people who know they are more capable thereby send a signal to potential employers that they are the more capable workers. Education therefore screens out the low-productivity workers from the high-productivity (more educated) workers. Firms pay more to the latter, because firms know that the high-ability workers are those with the additional education.
Signalling is the decision to undertake an action in order to reveal information.
Screening is the process of obtaining information by observing differences in behaviour.
To be effective, the process must separate the two types. Why don't lower-ability workers go to university and pretend they are of the high-ability type? Primarily because that strategy could backfire: Such individuals are less likely to succeed at school and there are costs associated with school in the form of school fees, books and foregone earnings. While they may have lower innate skills, they are likely smart enough to recognize a bad bet.
On balance economists believe that further education does indeed add to productivity, although there may be an element of screening present: An engineering degree (we should hope) increases an individual's understanding of mechanical forces so that she can design a bridge that will not collapse, in addition to telling a potential employer that the student is smart!
Finally, it should be evident that if education raises productivity, it is also good for society and the economy at large.
13.5 Education returns and quality
How can we be sure that further education really does generate the returns, in the form of higher future incomes, to justify the investment? For many years econometricians proposed that an extra year of schooling might offer a return in the region of 10% – quite a favourable return in comparison with what is frequently earned on physical capital. Doubters then asked if the econometric estimation might be subject to bias – what if the additional earnings of those with more education are simply attributable to the fact that it is the innately more capable individuals who both earn more and who have more schooling? And since we cannot observe who has more innate ability, how can we be sure that it is the education itself, rather than just differences in ability, that generate the extra income?
This is a classical problem in inference: Does correlation imply causation? The short answer to this question is that education economists are convinced that the time invested in additional schooling does indeed produce additional rewards, even if it is equally true that individuals who are innately smarter do choose to invest in that way. Furthermore, it appears that the returns to graduate education are higher than the returns to undergraduate education.
What can be said of the quality of different educational systems? Are educational institutions in different countries equally good at producing knowledgeable students? Or, viewed another way: Has a grade nine student in Canada the same skill set as a grade nine student in France or Hong Kong? An answer to this question is presented in Table 13.1, which contains results from the Program for International Student Assessment (PISA) – an international survey of 15-year old student abilities in mathematics, science and literacy. This particular table presents the results for a sample of the countries that were surveyed. The results indicate that Canadian students perform well in all three dimensions of the test.
Table 13.1 Mean scores in PISA tests
Country Math Science Reading
Australia 494 510 503
Austria 497 495 485
Belgium 507 502 499
Canada 516 528 527
Denmark 511 502 500
Finland 511 531 526
France 493 495 499
Germany 506 509 509
Greece 454 455 467
Hong Kong 548 523 527
Ireland 504 503 521
Italy 490 481 485
Japan 532 538 516
Korea 524 516 517
Mexico 408 416 423
New Zealand 495 513 509
Norway 502 498 513
Spain 486 493 496
Sweden 494 493 500
Switzerland 521 506 492
Turkey 420 425 428
United States 470 496 497
United Kingdom 492 509 498
An interesting paradox arises at this point: If productivity growth in Canada has lagged behind some other economies in recent decades, as many economists believe, how can this be explained if Canada produces many well-educated high-skill workers? The answer may be that there is a considerable time lag before high participation rates in third-level education and high quality make themselves felt on the national stage in the form of elevated productivity. The evidence suggests a good productivity future, in so far as it depends upon human capital. At the same time, if investment in human capital is not matched by investment in physical capital then the human capital may not be able to perform to its ability.
13.6 Discrimination
Wage differences are a natural response to differences in human capital. But we frequently observe wage differences that might be discriminatory. For example, women on average earn less than men with similar qualifications; older workers may be paid less than those in their prime years; immigrants may be paid less than native-born Canadians, and ethnic minorities may be paid less than traditional white workers. The term discrimination describes an earnings differential that is attributable to a trait other than human capital.
If two individuals have the same HK, in the broadest sense of having the same capability to perform a particular task, then a wage premium paid to one represents discrimination. Correctly measured then, the discrimination premium between individuals from these various groups is the differential in earnings after correcting for HK differences. Thousands of studies have been undertaken on discrimination, and most conclude that discrimination abounds. Women, particularly those who have children, are paid less than men, and frequently face a 'glass ceiling' – a limit on their promotion possibilities within organizations.
Discrimination implies an earnings differential that is attributable to a trait other than human capital.
In contrast, women no longer face discrimination in university and college admissions, and form a much higher percentage of the student population than men in many of the higher paying professions such as medicine and law. Immigrants to Canada also suffer from a wage deficit. This is especially true for the most recent cohorts of working migrants who now come predominantly, not from Europe, as was once the case, but from China, South Asia, Africa and the Caribbean. For similarly-measured HK as Canadian-born individuals, these migrants frequently have an initial wage deficit of 30%, and require a period of more than twenty years to catch-up. How much of this differential might be due to the quality of the education or human capital received abroad is difficult to determine.
13.7 The income distribution
How does all of our preceding discussion play out when it comes to the income distribution? That is, when we examine the incomes of all individuals or households in the economy, how equally or unequally are they distributed?
The study of inequality is a critical part of economic analysis. It recognizes that income differences that are in some sense 'too large' are not good for society. Inordinately large differences can reflect poverty and foster social exclusion and crime. Economic growth that is concentrated in the hands of the few can increase social tensions, and these can have economic as well as social or psychological costs. Crime is one reflection of the divide between 'haves' and 'have-nots'. It is economically costly; but so too is child poverty. Impoverished children rarely achieve their social or economic potential and this is a loss both to the individual and society at large.
In this section we will first describe a subset of the basic statistical tools that economists use to measure inequality. Second, we will examine how income inequality has evolved in recent decades. We shall see that, while the picture is complex, market income inequality has indeed increased in Canada. Third, we shall investigate some of the proposed reasons for the observed increase in inequality. Finally we will examine if the government offsets the inequality that arises from the marketplace through its taxation and redistribution policies.
It is to be emphasized that income inequality is just one proximate measure of the distribution of wellbeing. The extent of poverty is another such measure. Income is not synonymous with happiness but, that being said, income inequality can be computed reliably, and it provides a good measure of households' control over economic resources.
Theory and measurement
Let us rank the market incomes of all households in the economy from poor to rich, and categorize this ordering into different quantiles or groups. With five such quantiles the shares are called quintiles. The richest group forms the highest quintile, while the poorest group forms the lowest quintile. Such a representation is given in Table 13.2. The first numerical column displays the income in each quintile as a percentage of total income. If we wanted a finer breakdown, we could opt for decile (ten), or even vintile (twenty) shares, rather than quintile shares. These data can be graphed in a variety of ways. Since the data are in share, or percentage, form, we can compare, in a meaningful manner, distributions from economies that have different average income levels.
Table 13.2 Quintile shares of total family income in Canada, 2011
Quintile share of total income Cumulative share
First quintile 4.1 4.1
Second quintile 9.6 13.7
Third quintile 15.3 29.0
Fourth quintile 23.8 52.8
Fifth quintile 47.2 100.0
Total 100
Source: Statistics Canada, CANSIM Matrix 2020405. These combinations are represented by the circles in the figure.
Figure 13.3 Gini index and Lorenz curve
The more equal are the income shares, the closer is the Lorenz curve to the diagonal line of equality. The Gini index is the ratio of the area A to the area (A+B). The Lorenz curve plots the cumulative percentage of total income against the cumulative percentage of the population.
An informative way of presenting these data graphically is to plot the cumulative share of income against the cumulative share of the population. This is given in the final column, and also presented graphically in Figure 13.3. The bottom quintile has 4.1% of total income. The bottom two quintiles together have , and so forth. By joining the coordinate pairs represented by the circles, a Lorenz curve is obtained. Relative to the diagonal line it is a measure of how unequally incomes are distributed: If everyone had the same income, each 20% of the population would have 20% of total income and by joining the points for such a distribution we would get a straight diagonal line joining the corners of the box. In consequence, if the Lorenz curve is further from the line of equality the distribution is less equal than if the Lorenz curve is close to the line of equality.
Lorenz curve describes the cumulative percentage of the income distribution going to different quantiles of the population.
This suggests that the area A relative to the area (A + B) forms a measure of inequality in the income distribution. This fraction obviously lies between zero and one, and it is called the Gini index. A larger value of the Gini index indicates that inequality is greater. We will not delve into the mathematical formula underlying the Gini, but for this set of numbers its value is 0.4.
Gini index: a measure of how far the Lorenz curve lies from the line of equality. Its maximum value is one; its minimum value is zero.
The Gini index is what is termed summary index of inequality – it encompasses a lot of information in one number. There exist very many other such summary statistics.
It is important to recognize that very different Gini index values emerge for a given economy by using different income definitions of the variable going into the calculations. For example, the quintile shares of the earnings of individuals rather than the incomes of households could be very different. Similarly, the shares of income post tax and post transfers will differ from their shares on a pre-tax, pre-transfer basis.
Figure 13.4 Gini index Canada 1976–2015
Source: Statistics Canada, CANSIM Table 206-0033
Figure 13.4 contains Gini index values for two different definitions of income from 1976 to 2011. The upper line represents the Gini index values for households where the income measure is market income; the lower line defines the Gini values when income is defined as post-tax and post-transfer incomes. The latter income measure deducts taxes paid and adds income such as Employment Insurance or Social Assistance benefits. Two messages emerge from this graphic: The first is that the distribution of market incomes displays more inequality than the distribution of incomes after the government has intervened. In the latter case incomes are more equally distributed than in the former. The second message to emerge is that inequality increased over time – the Gini values are larger in the years after approximately 2000 than in the earlier years, although the increase in market income inequality is greater than the increase in income inequality based on a 'post-government' measure of income.
This is a very brief description of recent events. It is also possible to analyze inequality among women and men, for example, as well as among individuals and households. But the essential message remains clear: Definitions are important; in particular the distinction between incomes generated in the market place and incomes after the government has intervened through its tax and transfer policies.
Application Box 13.2 The very rich
McMaster University Professor Michael Veall and his colleague Emmanuel Saez, from University of California, Berkeley, have examined the evolution of the top end of the Canadian earnings distribution in the twentieth century. Using individual earnings from a database built upon tax returns, they show how the share of the very top of the distribution declined in the nineteen thirties and forties, remained fairly stable in the decades following World War II, and then increased from the eighties to the present time. The increase in share is particularly strong for the top 1% and even stronger for the top one tenth of the top 1%. These changes are driven primarily by changes in earnings, not on stock options awarded to high-level corporate employees. The authors conclude that the change in this region of the distribution is attributable to changes in social norms. Whereas, in the nineteen eighties, it was expected that a top executive would earn perhaps a half million dollars, the 'norm' has become several million dollars in the present day. Such high remuneration became a focal point of public discussion after so many banks in the United States in 2008 and 2009 required government loans and support in order to avoid collapse. It also motivated the many 'occupy' movements of 2011 and 2012, and the US presidential race in 2019.
Saez, E. and M. Veall. "The evolution of high incomes in Canada, 1920-2000." Department of Economics research paper, McMaster University, March 2003.
In the international context, Canada is neither a strongly egalitarian economy nor one characterized by great income inequality. OECD data indicate that the economies with the lowest Gini index values are the Czech and Slovak republics and Iceland, with values in the neighborhood of 0.25 based on a post-government measure of income. Canada has a Gini index of .31, the US a value of .38 and at the upper end are economies such as Mexico and Chile with values of .47 (https://data.oecd.org/inequality/income-inequality.htm).
Economic forces
The increase in inequality of earnings in the market place in Canada has been reflected in many other developed economies – to a greater degree in the US and to a lesser extent in some European economies. Economists have devoted much energy to studying why, and as a result there are several accepted reasons.
Younger workers and those with lower skill levels have faired poorly in the last three decades. Globalization and out-sourcing have put pressure on low-end wages. In effect the workers in the lower tail of the distribution are increasingly competing with workers from low-wage less-developed economies. While this is a plausible causation, the critics of the perspective point out that wages at the bottom have fallen not only for those workers who compete with overseas workers in manufacturing, but also in the domestic services sector right across the economy. Obviously the workers at McDonalds have not the same competition from low-wage economies as workers who assemble toys.
A competing perspective is that it is technological change that has enabled some workers to do better than others. In explaining why high wage workers in many economies have seen their wages increase, whereas low-wage workers have seen a relative decline, the technological change hypothesis proposes that the form of recent technological change is critical: Change has been such as to require other complementary skills and education in order to benefit from it. For example, the introduction of computer-aided design technology is a benefit to workers who are already skilled and earning a high wage: Existing high skills and technological change are complementary. Such technological change is therefore different from the type underlying the production line. Automation in the early twentieth century in Henry Ford's plants improved the wages of lower skilled workers. But in the modern economy it is the highly skilled rather than the low skilled that benefit most from innovation.
A third perspective is that key institutional changes manifested themselves in the eighties and nineties, and these had independent impacts on the distribution. In particular, declines in the extent of unionization and changes in the minimum wage had significant impacts on earnings in the middle and bottom of the distribution: If unionization declines or the minimum wage fails to keep up with inflation, these workers will suffer. An alternative 'institutional' player is the government: In Canada the federal government became slightly less supportive, or 'generous', with its array of programs that form Canada's social safety net in the nineteen nineties. This tightening goes some way to explaining the modest inequality increase in the post-government income distribution in Figure 13.3 at this time. Nonetheless, most Canadian provincial governments increased the legal minimum wage in the first decade of the new millennium by substantially more than the rate of inflation. This meant that the economy's low-income workers did not fall further behind.
We conclude this overview of distributional issues by pointing out that we have not analyzed the distribution of wealth. Wealth too represents purchasing power, and it is wealth rather than income flows that primarily distinguishes Warren Buffet, Mark Zuckerberg and Bill Gates from the rest of us mortals. A detailed treatment of wealth inequality is beyond the scope of this book. We describe briefly, in the final section, the recent contribution of Thomas Piketty to the inequality debate.
13.8 Wealth and capitalism
In an insightful and popular study of capital accumulation, from both a historical and contemporary perspective, Thomas Piketty draws our attention to the enormous inequality in the distribution of wealth and explores what the future may hold in his book Capital in the Twenty-First Century.
The distribution of wealth is universally more unequal than the distribution of incomes or earnings. Gini coefficients in the neighbourhood of 0.8 are commonplace in developed economies. In terms of shares of the wealth pie, such a magnitude may imply that the top 1% of wealth holders own more than one third of all of an economy's wealth, that the top decile may own two-thirds of all wealth, and that the remaining one third is held by the 'bottom 90%'. And within this bottom 90%, virtually all of the remaining wealth is held by the 40% of the population below the top decile, leaving only a few percent of all wealth to the bottom 50% of the population.
Figure 13.5 Wealth inequality in Europe and the US, 1810-2010
While such an unequal holding pattern may appear shockingly unjust, Piketty informs us that current wealth inequality is not as great in most economies as it was about 1900. Figure 13.5 (Piketty 10.6) above is borrowed from his web site. Wealth was more unequally distributed in Old World Europe than New World America a century ago, but this relativity has since been reversed. A great transformation in the wealth holding pattern of societies in the twentieth century took the form of the emergence of a 'patrimonial middle class', by which he means the emergence of substantial wealth holdings on the part of that 40% of the population below the top decile. This development is noteworthy, but Piketty warns that the top percentiles of the wealth distribution may be on their way to controlling a share of all wealth close to their share in the early years of the twentieth century. He illustrates that two elements are critical to this prediction; first is the rate of growth in the economy relative to the return on capital, the second is inheritances.
To illustrate: Imagine an economy with very low growth, and where the owners of capital obtain an annual return of say 5%. If the owners merely maintain their capital intact and consume the remainder of this 5%, then the pattern of wealth holding will continue to be stable. However, if the holders of wealth can reinvest from their return an amount more than is necessary to replace depreciation then their wealth will grow. And if labour income in this economy is almost static on account of low overall growth, then wealth holders will secure a larger share of the economic pie. In contrast, if economic growth is significant, then labour income may grow in line with income from capital and inequality may remain stable. This summarizes Piketty's famous (rg) law – inequality depends upon the difference between the return on wealth and the growth rate of the economy. This potential for an ever-expanding degree of inequality is magnified when the stock of capital in the economy is large.
Consider now the role of inheritances. That is to say, do individuals leave large or small inheritances when they die, and how concentrated are such inheritances? If individual wealth accumulation patterns are generated by a desire to save for retirement and old age – during which time individuals decumulate by spending their assets – such motivation should result in small bequests being left to following generations. In contrast, if individuals who are in a position to do so save and accumulate, not just for their old age, but because they have dynastic preferences, or if they take pleasure simply from the ownership of wealth, or even if they are very cautious about running down their wealth in their old age, then we should see substantial inheritances passed on to the sons and daughters of these individuals, thereby perpetuating, and perhaps exacerbating, the inequality of wealth holding in the economy.
Piketty shows that in fact individuals who save substantial amounts tend to leave large bequests; that is they do not save purely for life-cycle motives. In modern economies the annual amount of bequests and gifts from parents to children falls in the range of 10% to 15% of annual GDP. This may grow in future decades, and since wealth is highly concentrated, these bequests in turn are concentrated among a small number of the following generation – inequality is transmitted from one generation to the next.
As a final observation, if we consider the distribution of income and wealth together, particularly at the very top end, we can see readily that a growing concentration of income among the top 1% should ultimately translate itself into greater wealth inequality. This is because top earners can save more easily than lower earners. To compound matters, if individuals who inherit wealth also tend to inherit more human capital from their parents than others, the concentration of income and wealth may become yet stronger.
The study of distributional issues in economics has probably received too little attention in the modern era. Yet it is vitally important both in terms of the well-being of the individuals who constitute an economy and in terms of adherence to social norms. Given that utility declines with additions to income and wealth, transfers from those at the top to those at the bottom have the potential to increase total utility in the economy. Furthermore, an economy in which justice is seen to prevail—in the form of avoiding excessive inequality—is more likely to achieve a higher degree of social coherence than one where inequality is large.
Key Terms
Human capital is the stock of expertise accumulated by a worker that determines future productivity and earnings.
Age-earnings profiles define the pattern of earnings over time for individuals with different characteristics.
Education premium: the difference in earnings between the more and less highly educated.
On-the-job training improves human capital through work experience.
Firm-specific skills raise a worker's productivity in a particular firm.
General skills enhance productivity in many jobs or firms.
Signalling is the decision to undertake an action in order to reveal information.
Screening is the process of obtaining information by observing differences in behaviour.
Discrimination implies an earnings differential that is attributable to a trait other than human capital.
Lorenz curve describes the cumulative percentage of the income distribution going to different quantiles of the population.
Gini index: a measure of how far the Lorenz curve lies from the line of equality. Its maximum value is one; its minimum value is zero.
Exercises for Chapter 13
EXERCISE 13.1
Georgina is contemplating entering the job market after graduating from high school. Her future lifespan is divided into two phases: An initial one during which she may go to university, and a second when she will work. Since dollars today are worth more than dollars in the future she discounts the future by 20%, that is the value today of that future income is the income divided by 1.2. By going to university and then working she will earn (i) -\$60,000; (ii) \$600,000. The negative value implies that she will incur costs in educating herself in the first period. In contrast, if she decides to work for both periods she will earn \$30,000 in the first period and \$480,000 in the second.
1. If her objective is to maximize her lifetime earnings, should she go to university or enter the job market immediately?
2. If instead of discounting the future at the rate of 20%, she discounts it at the rate of 50%, what should she do?
EXERCISE 13.2
Imagine that you have the following data on the income distribution for two economies.
Quintile share of total income
First quintile 4.1 3.0
Second quintile 9.6 9.0
Third quintile 15.3 17.0
Fourth quintile 23.8 29.0
Fifth quintile 47.2 42.0
Total 100 100
1. On graph paper, or in a spreadsheet program, plot the Lorenz curves corresponding to the two sets of quintile shares. You must first compute the cumulative shares as we did for Figure 13.3.
2. Can you say, from a visual analysis, which distribution is more equal?
EXERCISE 13.3
The distribution of income in the economy is given in the table below. The first numerical column represents the dollars earned by each quintile. Since the numbers add to 100 you can equally think of the dollar values as shares of the total pie. In this economy the government changes the distribution by levying taxes and distributing benefits.
Quintile Gross income \$m Taxes \$m Benefits \$m
First 4 0 9
Second 11 1 6
Third 19 3 5
Fourth 26 7 3
Fifth 40 15 3
Total 100 26 26
1. Plot the Lorenz curve for gross income to scale.
2. Now subtract the taxes paid and add the benefits received by each quintile. Check that the total income is still \$100. Calculate the cumulative income shares and plot the resulting Lorenz curve. Can you see that taxes and benefits reduce inequality?
EXERCISE 13.4
Consider two individuals, each facing a 45 year horizon at the age of 20. Ivan decides to work immediately and his earnings path takes the following form: Earnings =20,000+1,000t–10t2, where the t is time, and it takes on values from 1 to 25, reflecting the working lifespan.
1. In a spreadsheet enter values 1... 25 in the first column and then compute the value of earnings in each of the 25 years in the second column using the earnings equation.
2. John decides to study some more and only earns a part-time salary in his first few years. He hopes that the additional earnings in future years will compensate for that. His function is given by 10,000+2,000t–12t2. In the same spreadsheet compute his annual earnings for 25 years.
3. Plot the two earnings functions you have computed using the 'charts' feature of Excel. Does your graph indicate that John passes Ivan between year 10 and year 11?
EXERCISE 13.5
In the short run one half of the labour force has high skills and one half low skills (in terms of Figure 13.2 this means that the short-run supply curve is vertical at 0.5). The relative demand for the high-skill workers is given by , where W is the wage premium and f is the fraction that is skilled. The premium is measured in percent and f has a maximum value of 1. The W function thus has vertical and horizontal intercepts of .
1. Illustrate the supply and demand curves graphically, and illustrate the skill premium going to the high-skill workers in the short run by determining the value of W when f=0.5.
2. If demand increases to what is the new premium? Illustrate your answer graphically.
EXERCISE 13.6
Consider the foregoing problem in a long-run context, when the fraction of the labour force that is high-skilled is more elastic with respect to the premium. Let this long-run relative supply function be .
1. Graph this long-run supply function and verify that it goes through the same initial equilibrium as in Exercise 13.5.
2. Illustrate the long run and short run on the same diagram.
3. What is the numerical value of the premium in the long run after the increase in demand? Illustrate graphically.
13: Human capital and the income distribution
Human capital, HK, is the stock of knowledge and ability accumulated by a worker that determines future productivity and earnings. It depends on many different attributes – education, experience, intelligence, interpersonal skills etc. While human capital influences own earnings, it also impacts the productivity of the economy at large, and is therefore a vital force in determining long-run growth. Canada has been investing heavily in human capital in recent decades, and this suggests that future productivity and earnings will benefit accordingly.
Human capital is the stock of knowledge and ability accumulated by a worker that determines future productivity and earning.
Several features of Canada's recent human capital accumulation are noteworthy. First, Canada's enrollment rate in post-secondary education now exceeds the US rate, and that of virtually every economy in the world. Second is the fact that the number of women in third-level institutions exceeds the number of men. Almost 60% of university students are women. Third, international testing of high-school students sees Canadian students performing well, which indicates that the quality of the Canadian educational system appears to be high. These are positive aspects of a system that frequently comes under criticism. Nonetheless, the distribution of income that emerges from market forces in Canada has become more unequal.
Let us now try to understand individuals' economic motivation for embarking on the accumulation of human capital, and in the process see why different groups earn different amounts. We start by analyzing the role of education and then turn to on-the-job training. At the outset, we recognize that many individuals acquire knowledge for its own sake or in order to improve the quality of their lives. Education can improve one's appreciation of art, literature and the sciences. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/13%3A_Human_capital_and_the_income_distribution/13.01%3A_Human_capital.txt |
Human capital is the result of past investment that raises future incomes. A critical choice for individuals is to decide upon exactly how much additional human capital to accumulate. The cost of investing in another year of school is the direct cost, such as school fees, plus the indirect, or opportunity, cost, which can be measured by the foregone earnings during that extra year. The benefit of the additional investment is that the future flow of earnings is augmented. Consequently, wage differentials should reflect different degrees of education-dependent productivity.
Age-earnings profiles
Figure 13.1 illustrates two typical age-earnings profiles for individuals with different levels of education. These profiles define the typical pattern of earnings over time, and are usually derived by examining averages across individuals in surveys. Two aspects are clear: People with more education not only earn more, but the spread tends to grow with time. Less educated, healthy young individuals who work hard may earn a living wage but, unlike their more educated counterparts, they cannot look forward to a wage that rises substantially over time. More highly-educated individuals go into jobs and occupations that take a longer time to master: Lawyers, doctors and most professionals not only undertake more schooling than truck drivers, they also spend many years learning on the job, building up a clientele and accumulating expertise.
Age-earnings profiles define the pattern of earnings over time for individuals with different characteristics.
Figure 13.1 Age-Earnings profiles by education level
Individuals with a higher level of education earn more than individuals with a 'standard' level of education. In addition, the differential grows over time.
The education premium
Individuals with different education levels earn different wages. The education premium is the difference in earnings between the more and less highly educated. Quantitatively, Professors Kelly Foley and David Green have recently proposed that the completion of a college or trade certification adds about 15% to one's income, relative to an individual who has completed high school. A Bachelor's degree brings a premium of 20-25%, and a graduate degree several percentage points more1. The failure to complete high school penalizes individuals to the extent of about 10%. These are average numbers, and they vary depending upon the province of residence, time period and gender. Nonetheless the findings underline that more human capital is associated with higher earnings. The earnings premium depends upon both the supply and demand of high HK individuals. Ceteris paribus, if high-skill workers are heavily in demand by employers, then the premium should be greater than if lower-skill workers are more in demand.
Education premium: the difference in earnings between the more and less highly educated.
The distribution of earnings has become more unequal in Canada and the US in recent decades, and one reason that has been proposed for this development is that the modern economy demands more high-skill workers; in particular that technological change has a bigger impact on productivity when combined with high-skill workers than with low-skill workers. Consider Figure 13.2 which contains supply and demand functions with a twist. We imagine that there are two types of labour: One with a high level of human capital, the other with a lower level. The vertical axis measures the wage premium of the high-education group (which can be measured in dollars or percentage terms), and the horizontal axis measures the fraction of the total labour force that is of the high-skill type. D is the relative demand for the high skill workers, in this example for the economy as a whole. There is some degree of substitution between high and low-skill workers in the modern economy. We do not propose that several low-skill workers can perform the work of one neuro-surgeon; but several individual households (low-skill) could complete their income tax submissions in the same time as one skilled tax specialist. In this example there is a degree of substitutability. In a production environment, a high-skill manager, equipped with technology and capital, can perform the tasks of several line workers.
Figure 13.2 The education/skill premium
A shift in demand increases the wage premium in the short run (from E0 to E1) by more than in the long run (to E2). In the short run, the percentage of the labour force (SS) that is highly skilled is fixed. In the long run it (SL) is variable and responds to the wage premium.
The demand curve D defines the premium that employers (demanders) are willing to pay to the higher skill group. The negative slope indicates that if demanders were to employ a high proportion of skilled workers, the premium they would be willing to pay would be less than if they demanded a smaller share of high-skilled workers, and a larger share of lower-skilled workers. The wage premium for high HK individuals at any given time is determined by the intersection of supply and demand.
In the short run the make-up of the labour force is fixed, and this is reflected in the vertical supply curve Ss. The equilibrium is at E0, and is the premium, or excess, paid to the higher-skill worker over the lower-skill worker. In the long run it is possible for the economy to change the composition of its labour supply: If the wage premium increases, more individuals will find it profitable to train as high-skill workers. That is to say, the fraction of the total that is high-skill increases. It follows that the long-run supply curve slopes upwards.
So what happens when there is an increase in the demand for high-skill workers relative to low-skill workers? The demand curve shifts upward to , and the new equilibrium is at . The supply mix is fixed in the short run, so there is an increase in the wage premium. But over time, some individuals who might have been just indifferent between educating themselves more and going into the workplace with lower skill levels now find it worthwhile to pursue further education. Their higher anticipated returns to the additional human capital they invest in now exceed the additional costs of more schooling, whereas before the premium increase these additional costs and benefits were in balance. In Figure 13.2 the new short-run equilibrium at has a corresponding wage premium of . In the long run, after additional supply has reached the market, the increased premium is moderated to at the equilibrium .
This figure displays what many economists believe has happened in North America in recent decades: The demand for high HK individuals has increased, and the additional supply has not been as great. Consequently the wage premium for the high-skill workers has increased. As we describe later in this chapter, that is not the only perspective on what has happened.
Are students credit-constrained or culture-constrained?
The foregoing analysis assumes that students and potential students make rational decisions on the costs and benefits of further education and act accordingly. It also assumes implicitly that individuals can borrow the funds necessary to build their human capital: If the additional returns to further education are worthwhile, individuals should borrow the money to make the investment, just as entrepreneurs do with physical capital.
However, there is a key difference in the credit markets. If an entrepreneur fails in her business venture the lender will have a claim on the physical capital. But a bank cannot repossess a human being who drops out of school without having accumulated the intended human capital. Accordingly, the traditional lending institutions are frequently reluctant to lend the amount that students might like to borrow—students are credit constrained. The sons and daughters of affluent families therefore find it easier to attend university, because they are more likely to have a supply of funds domestically. Governments customarily step into the breach and supply loans and bursaries to students who have limited resources. While funding frequently presents an obstacle to attending a third-level institution, a stronger determinant of attendance is the education of the parents, as detailed in Application Box 13.1.
Application Box 13.1 Parental education and university attendance in Canada
The biggest single determinant of university attendance in the modern era is parental education. A recent study* of who goes to university examined the level of parental education of young people 'in transition' – at the end of their high school – for the years 1991 and 2000.
For the year 2000 they found that, if a parent had not completed high school, there was just a 12% chance that their son would attend university and an 18% chance that a daughter would attend. In contrast, for parents who themselves had completed a university degree, the probability that a son would also attend university was 53% and for a daughter 62%. Hence, the probability of a child attending university was roughly four times higher if the parent came from the top educational category rather than the bottom category! Furthermore the authors found that this probability gap opened wider between 1991 and 2000.
In the United States, Professor Sear Reardon of Stanford University has followed the performance of children from low-income households and compared their achievement with children from high-income households. He has found that the achievement gap between these groups of children has increased substantially over the last three decades. The reason for this growing separation is not because children from low-income households are performing worse in school, it is because high-income parents invest much more of their time and resources in educating their children, both formally in the school environment, and also in extra-school activities.
*Finnie, R., C. Laporte and E. Lascelles. "Family Background and Access to Post-Secondary Education: What Happened in the Nineties?" Statistics Canada Research Paper, Catalogue number 11F0019MIE-226, 2004
Reardon, Sean, "The Great Divide", New York Times, April 8, 2015. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/13%3A_Human_capital_and_the_income_distribution/13.02%3A_Productivity_and_education.txt |
As is clear from Figure 13.1, earnings are raised both by education and experience. Learning on the job is central to the age-earnings profiles of the better educated, and is less important for those with lower levels of education. On-the-job training improves human capital through work experience. If on-the-job training increases worker productivity, who should pay for this learning – firms or workers? To understand who should pay, we distinguish between two kinds of skills: Firm-specific skills that raise a worker's productivity in a particular firm, and general skills that enhance productivity in many jobs or firms.
Firm-specific HK could involve knowing how particular components of a somewhat unique production structure functions, whereas general human capital might involve an understanding of engineering or architectural principles that can be applied universally. As for who should pay for the accumulation of skills: An employer should be willing to undertake most of the cost of firm-specific skills, because they are of less value to the worker should she go elsewhere. Firms offering general or transferable training try to pass the cost on to the workers, perhaps by offering a wage-earnings profile that starts very low, but that rises over time. Low-wage apprenticeships are examples. Hence, whether an employee is a medical doctor in residence, a plumber in an apprenticeship or a young lawyer in a law partnership, she 'pays' for the accumulation of her portable HK by facing a low wage when young. Workers are willing to accept such an earnings profile because their projected future earnings will compensate for lower initial earning.
On-the-job training improves human capital through work experience.
Firm-specific skills raise a worker's productivity in a particular firm.
General skills enhance productivity in many jobs or firms.
13.04: Education as signalling
An alternative view of education springs from the theory of signalling. This is a provocative theory that proposes education may be worthwhile, even if it generates little additional skills. The theory recognizes that individuals possess different abilities. However, firms cannot easily recognize the more productive workers without actually hiring them and finding out ex-post – sometimes a costly process. Signalling theory says that, in pursuing more education, people who know they are more capable thereby send a signal to potential employers that they are the more capable workers. Education therefore screens out the low-productivity workers from the high-productivity (more educated) workers. Firms pay more to the latter, because firms know that the high-ability workers are those with the additional education.
Signalling is the decision to undertake an action in order to reveal information.
Screening is the process of obtaining information by observing differences in behaviour.
To be effective, the process must separate the two types. Why don't lower-ability workers go to university and pretend they are of the high-ability type? Primarily because that strategy could backfire: Such individuals are less likely to succeed at school and there are costs associated with school in the form of school fees, books and foregone earnings. While they may have lower innate skills, they are likely smart enough to recognize a bad bet.
On balance economists believe that further education does indeed add to productivity, although there may be an element of screening present: An engineering degree (we should hope) increases an individual's understanding of mechanical forces so that she can design a bridge that will not collapse, in addition to telling a potential employer that the student is smart!
Finally, it should be evident that if education raises productivity, it is also good for society and the economy at large. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/13%3A_Human_capital_and_the_income_distribution/13.03%3A_On-the-job_training.txt |
How can we be sure that further education really does generate the returns, in the form of higher future incomes, to justify the investment? For many years econometricians proposed that an extra year of schooling might offer a return in the region of 10% – quite a favourable return in comparison with what is frequently earned on physical capital. Doubters then asked if the econometric estimation might be subject to bias – what if the additional earnings of those with more education are simply attributable to the fact that it is the innately more capable individuals who both earn more and who have more schooling? And since we cannot observe who has more innate ability, how can we be sure that it is the education itself, rather than just differences in ability, that generate the extra income?
This is a classical problem in inference: Does correlation imply causation? The short answer to this question is that education economists are convinced that the time invested in additional schooling does indeed produce additional rewards, even if it is equally true that individuals who are innately smarter do choose to invest in that way. Furthermore, it appears that the returns to graduate education are higher than the returns to undergraduate education.
What can be said of the quality of different educational systems? Are educational institutions in different countries equally good at producing knowledgeable students? Or, viewed another way: Has a grade nine student in Canada the same skill set as a grade nine student in France or Hong Kong? An answer to this question is presented in Table 13.1, which contains results from the Program for International Student Assessment (PISA) – an international survey of 15-year old student abilities in mathematics, science and literacy. This particular table presents the results for a sample of the countries that were surveyed. The results indicate that Canadian students perform well in all three dimensions of the test.
Table 13.1 Mean scores in PISA tests
Country Math Science Reading
Australia 494 510 503
Austria 497 495 485
Belgium 507 502 499
Canada 516 528 527
Denmark 511 502 500
Finland 511 531 526
France 493 495 499
Germany 506 509 509
Greece 454 455 467
Hong Kong 548 523 527
Ireland 504 503 521
Italy 490 481 485
Japan 532 538 516
Korea 524 516 517
Mexico 408 416 423
New Zealand 495 513 509
Norway 502 498 513
Spain 486 493 496
Sweden 494 493 500
Switzerland 521 506 492
Turkey 420 425 428
United States 470 496 497
United Kingdom 492 509 498
An interesting paradox arises at this point: If productivity growth in Canada has lagged behind some other economies in recent decades, as many economists believe, how can this be explained if Canada produces many well-educated high-skill workers? The answer may be that there is a considerable time lag before high participation rates in third-level education and high quality make themselves felt on the national stage in the form of elevated productivity. The evidence suggests a good productivity future, in so far as it depends upon human capital. At the same time, if investment in human capital is not matched by investment in physical capital then the human capital may not be able to perform to its ability.
13.06: Discrimination
Wage differences are a natural response to differences in human capital. But we frequently observe wage differences that might be discriminatory. For example, women on average earn less than men with similar qualifications; older workers may be paid less than those in their prime years; immigrants may be paid less than native-born Canadians, and ethnic minorities may be paid less than traditional white workers. The term discrimination describes an earnings differential that is attributable to a trait other than human capital.
If two individuals have the same HK, in the broadest sense of having the same capability to perform a particular task, then a wage premium paid to one represents discrimination. Correctly measured then, the discrimination premium between individuals from these various groups is the differential in earnings after correcting for HK differences. Thousands of studies have been undertaken on discrimination, and most conclude that discrimination abounds. Women, particularly those who have children, are paid less than men, and frequently face a 'glass ceiling' – a limit on their promotion possibilities within organizations.
Discrimination implies an earnings differential that is attributable to a trait other than human capital.
In contrast, women no longer face discrimination in university and college admissions, and form a much higher percentage of the student population than men in many of the higher paying professions such as medicine and law. Immigrants to Canada also suffer from a wage deficit. This is especially true for the most recent cohorts of working migrants who now come predominantly, not from Europe, as was once the case, but from China, South Asia, Africa and the Caribbean. For similarly-measured HK as Canadian-born individuals, these migrants frequently have an initial wage deficit of 30%, and require a period of more than twenty years to catch-up. How much of this differential might be due to the quality of the education or human capital received abroad is difficult to determine. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/13%3A_Human_capital_and_the_income_distribution/13.05%3A_Education_returns_and_quality.txt |
How does all of our preceding discussion play out when it comes to the income distribution? That is, when we examine the incomes of all individuals or households in the economy, how equally or unequally are they distributed?
The study of inequality is a critical part of economic analysis. It recognizes that income differences that are in some sense 'too large' are not good for society. Inordinately large differences can reflect poverty and foster social exclusion and crime. Economic growth that is concentrated in the hands of the few can increase social tensions, and these can have economic as well as social or psychological costs. Crime is one reflection of the divide between 'haves' and 'have-nots'. It is economically costly; but so too is child poverty. Impoverished children rarely achieve their social or economic potential and this is a loss both to the individual and society at large.
In this section we will first describe a subset of the basic statistical tools that economists use to measure inequality. Second, we will examine how income inequality has evolved in recent decades. We shall see that, while the picture is complex, market income inequality has indeed increased in Canada. Third, we shall investigate some of the proposed reasons for the observed increase in inequality. Finally we will examine if the government offsets the inequality that arises from the marketplace through its taxation and redistribution policies.
It is to be emphasized that income inequality is just one proximate measure of the distribution of wellbeing. The extent of poverty is another such measure. Income is not synonymous with happiness but, that being said, income inequality can be computed reliably, and it provides a good measure of households' control over economic resources.
Theory and measurement
Let us rank the market incomes of all households in the economy from poor to rich, and categorize this ordering into different quantiles or groups. With five such quantiles the shares are called quintiles. The richest group forms the highest quintile, while the poorest group forms the lowest quintile. Such a representation is given in Table 13.2. The first numerical column displays the income in each quintile as a percentage of total income. If we wanted a finer breakdown, we could opt for decile (ten), or even vintile (twenty) shares, rather than quintile shares. These data can be graphed in a variety of ways. Since the data are in share, or percentage, form, we can compare, in a meaningful manner, distributions from economies that have different average income levels.
Table 13.2 Quintile shares of total family income in Canada, 2011
Quintile share of total income Cumulative share
First quintile 4.1 4.1
Second quintile 9.6 13.7
Third quintile 15.3 29.0
Fourth quintile 23.8 52.8
Fifth quintile 47.2 100.0
Total 100
Source: Statistics Canada, CANSIM Matrix 2020405. These combinations are represented by the circles in the figure.
Figure 13.3 Gini index and Lorenz curve
The more equal are the income shares, the closer is the Lorenz curve to the diagonal line of equality. The Gini index is the ratio of the area A to the area (A+B). The Lorenz curve plots the cumulative percentage of total income against the cumulative percentage of the population.
An informative way of presenting these data graphically is to plot the cumulative share of income against the cumulative share of the population. This is given in the final column, and also presented graphically in Figure 13.3. The bottom quintile has 4.1% of total income. The bottom two quintiles together have , and so forth. By joining the coordinate pairs represented by the circles, a Lorenz curve is obtained. Relative to the diagonal line it is a measure of how unequally incomes are distributed: If everyone had the same income, each 20% of the population would have 20% of total income and by joining the points for such a distribution we would get a straight diagonal line joining the corners of the box. In consequence, if the Lorenz curve is further from the line of equality the distribution is less equal than if the Lorenz curve is close to the line of equality.
Lorenz curve describes the cumulative percentage of the income distribution going to different quantiles of the population.
This suggests that the area A relative to the area (A + B) forms a measure of inequality in the income distribution. This fraction obviously lies between zero and one, and it is called the Gini index. A larger value of the Gini index indicates that inequality is greater. We will not delve into the mathematical formula underlying the Gini, but for this set of numbers its value is 0.4.
Gini index: a measure of how far the Lorenz curve lies from the line of equality. Its maximum value is one; its minimum value is zero.
The Gini index is what is termed summary index of inequality – it encompasses a lot of information in one number. There exist very many other such summary statistics.
It is important to recognize that very different Gini index values emerge for a given economy by using different income definitions of the variable going into the calculations. For example, the quintile shares of the earnings of individuals rather than the incomes of households could be very different. Similarly, the shares of income post tax and post transfers will differ from their shares on a pre-tax, pre-transfer basis.
Figure 13.4 Gini index Canada 1976–2015
Source: Statistics Canada, CANSIM Table 206-0033
Figure 13.4 contains Gini index values for two different definitions of income from 1976 to 2011. The upper line represents the Gini index values for households where the income measure is market income; the lower line defines the Gini values when income is defined as post-tax and post-transfer incomes. The latter income measure deducts taxes paid and adds income such as Employment Insurance or Social Assistance benefits. Two messages emerge from this graphic: The first is that the distribution of market incomes displays more inequality than the distribution of incomes after the government has intervened. In the latter case incomes are more equally distributed than in the former. The second message to emerge is that inequality increased over time – the Gini values are larger in the years after approximately 2000 than in the earlier years, although the increase in market income inequality is greater than the increase in income inequality based on a 'post-government' measure of income.
This is a very brief description of recent events. It is also possible to analyze inequality among women and men, for example, as well as among individuals and households. But the essential message remains clear: Definitions are important; in particular the distinction between incomes generated in the market place and incomes after the government has intervened through its tax and transfer policies.
Application Box 13.2 The very rich
McMaster University Professor Michael Veall and his colleague Emmanuel Saez, from University of California, Berkeley, have examined the evolution of the top end of the Canadian earnings distribution in the twentieth century. Using individual earnings from a database built upon tax returns, they show how the share of the very top of the distribution declined in the nineteen thirties and forties, remained fairly stable in the decades following World War II, and then increased from the eighties to the present time. The increase in share is particularly strong for the top 1% and even stronger for the top one tenth of the top 1%. These changes are driven primarily by changes in earnings, not on stock options awarded to high-level corporate employees. The authors conclude that the change in this region of the distribution is attributable to changes in social norms. Whereas, in the nineteen eighties, it was expected that a top executive would earn perhaps a half million dollars, the 'norm' has become several million dollars in the present day. Such high remuneration became a focal point of public discussion after so many banks in the United States in 2008 and 2009 required government loans and support in order to avoid collapse. It also motivated the many 'occupy' movements of 2011 and 2012, and the US presidential race in 2019.
Saez, E. and M. Veall. "The evolution of high incomes in Canada, 1920-2000." Department of Economics research paper, McMaster University, March 2003.
In the international context, Canada is neither a strongly egalitarian economy nor one characterized by great income inequality. OECD data indicate that the economies with the lowest Gini index values are the Czech and Slovak republics and Iceland, with values in the neighborhood of 0.25 based on a post-government measure of income. Canada has a Gini index of .31, the US a value of .38 and at the upper end are economies such as Mexico and Chile with values of .47 (https://data.oecd.org/inequality/income-inequality.htm).
Economic forces
The increase in inequality of earnings in the market place in Canada has been reflected in many other developed economies – to a greater degree in the US and to a lesser extent in some European economies. Economists have devoted much energy to studying why, and as a result there are several accepted reasons.
Younger workers and those with lower skill levels have faired poorly in the last three decades. Globalization and out-sourcing have put pressure on low-end wages. In effect the workers in the lower tail of the distribution are increasingly competing with workers from low-wage less-developed economies. While this is a plausible causation, the critics of the perspective point out that wages at the bottom have fallen not only for those workers who compete with overseas workers in manufacturing, but also in the domestic services sector right across the economy. Obviously the workers at McDonalds have not the same competition from low-wage economies as workers who assemble toys.
A competing perspective is that it is technological change that has enabled some workers to do better than others. In explaining why high wage workers in many economies have seen their wages increase, whereas low-wage workers have seen a relative decline, the technological change hypothesis proposes that the form of recent technological change is critical: Change has been such as to require other complementary skills and education in order to benefit from it. For example, the introduction of computer-aided design technology is a benefit to workers who are already skilled and earning a high wage: Existing high skills and technological change are complementary. Such technological change is therefore different from the type underlying the production line. Automation in the early twentieth century in Henry Ford's plants improved the wages of lower skilled workers. But in the modern economy it is the highly skilled rather than the low skilled that benefit most from innovation.
A third perspective is that key institutional changes manifested themselves in the eighties and nineties, and these had independent impacts on the distribution. In particular, declines in the extent of unionization and changes in the minimum wage had significant impacts on earnings in the middle and bottom of the distribution: If unionization declines or the minimum wage fails to keep up with inflation, these workers will suffer. An alternative 'institutional' player is the government: In Canada the federal government became slightly less supportive, or 'generous', with its array of programs that form Canada's social safety net in the nineteen nineties. This tightening goes some way to explaining the modest inequality increase in the post-government income distribution in Figure 13.3 at this time. Nonetheless, most Canadian provincial governments increased the legal minimum wage in the first decade of the new millennium by substantially more than the rate of inflation. This meant that the economy's low-income workers did not fall further behind.
We conclude this overview of distributional issues by pointing out that we have not analyzed the distribution of wealth. Wealth too represents purchasing power, and it is wealth rather than income flows that primarily distinguishes Warren Buffet, Mark Zuckerberg and Bill Gates from the rest of us mortals. A detailed treatment of wealth inequality is beyond the scope of this book. We describe briefly, in the final section, the recent contribution of Thomas Piketty to the inequality debate. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/13%3A_Human_capital_and_the_income_distribution/13.07%3A_The_income_distribution.txt |
In an insightful and popular study of capital accumulation, from both a historical and contemporary perspective, Thomas Piketty draws our attention to the enormous inequality in the distribution of wealth and explores what the future may hold in his book Capital in the Twenty-First Century.
The distribution of wealth is universally more unequal than the distribution of incomes or earnings. Gini coefficients in the neighbourhood of 0.8 are commonplace in developed economies. In terms of shares of the wealth pie, such a magnitude may imply that the top 1% of wealth holders own more than one third of all of an economy's wealth, that the top decile may own two-thirds of all wealth, and that the remaining one third is held by the 'bottom 90%'. And within this bottom 90%, virtually all of the remaining wealth is held by the 40% of the population below the top decile, leaving only a few percent of all wealth to the bottom 50% of the population.
Figure 13.5 Wealth inequality in Europe and the US, 1810-2010
While such an unequal holding pattern may appear shockingly unjust, Piketty informs us that current wealth inequality is not as great in most economies as it was about 1900. Figure 13.5 (Piketty 10.6) above is borrowed from his web site. Wealth was more unequally distributed in Old World Europe than New World America a century ago, but this relativity has since been reversed. A great transformation in the wealth holding pattern of societies in the twentieth century took the form of the emergence of a 'patrimonial middle class', by which he means the emergence of substantial wealth holdings on the part of that 40% of the population below the top decile. This development is noteworthy, but Piketty warns that the top percentiles of the wealth distribution may be on their way to controlling a share of all wealth close to their share in the early years of the twentieth century. He illustrates that two elements are critical to this prediction; first is the rate of growth in the economy relative to the return on capital, the second is inheritances.
To illustrate: Imagine an economy with very low growth, and where the owners of capital obtain an annual return of say 5%. If the owners merely maintain their capital intact and consume the remainder of this 5%, then the pattern of wealth holding will continue to be stable. However, if the holders of wealth can reinvest from their return an amount more than is necessary to replace depreciation then their wealth will grow. And if labour income in this economy is almost static on account of low overall growth, then wealth holders will secure a larger share of the economic pie. In contrast, if economic growth is significant, then labour income may grow in line with income from capital and inequality may remain stable. This summarizes Piketty's famous (rg) law – inequality depends upon the difference between the return on wealth and the growth rate of the economy. This potential for an ever-expanding degree of inequality is magnified when the stock of capital in the economy is large.
Consider now the role of inheritances. That is to say, do individuals leave large or small inheritances when they die, and how concentrated are such inheritances? If individual wealth accumulation patterns are generated by a desire to save for retirement and old age – during which time individuals decumulate by spending their assets – such motivation should result in small bequests being left to following generations. In contrast, if individuals who are in a position to do so save and accumulate, not just for their old age, but because they have dynastic preferences, or if they take pleasure simply from the ownership of wealth, or even if they are very cautious about running down their wealth in their old age, then we should see substantial inheritances passed on to the sons and daughters of these individuals, thereby perpetuating, and perhaps exacerbating, the inequality of wealth holding in the economy.
Piketty shows that in fact individuals who save substantial amounts tend to leave large bequests; that is they do not save purely for life-cycle motives. In modern economies the annual amount of bequests and gifts from parents to children falls in the range of 10% to 15% of annual GDP. This may grow in future decades, and since wealth is highly concentrated, these bequests in turn are concentrated among a small number of the following generation – inequality is transmitted from one generation to the next.
As a final observation, if we consider the distribution of income and wealth together, particularly at the very top end, we can see readily that a growing concentration of income among the top 1% should ultimately translate itself into greater wealth inequality. This is because top earners can save more easily than lower earners. To compound matters, if individuals who inherit wealth also tend to inherit more human capital from their parents than others, the concentration of income and wealth may become yet stronger.
The study of distributional issues in economics has probably received too little attention in the modern era. Yet it is vitally important both in terms of the well-being of the individuals who constitute an economy and in terms of adherence to social norms. Given that utility declines with additions to income and wealth, transfers from those at the top to those at the bottom have the potential to increase total utility in the economy. Furthermore, an economy in which justice is seen to prevail—in the form of avoiding excessive inequality—is more likely to achieve a higher degree of social coherence than one where inequality is large. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/13%3A_Human_capital_and_the_income_distribution/13.08%3A_Wealth_and_capitalism.txt |
Human capital is the stock of expertise accumulated by a worker that determines future productivity and earnings.
Age-earnings profiles define the pattern of earnings over time for individuals with different characteristics.
Education premium: the difference in earnings between the more and less highly educated.
On-the-job training improves human capital through work experience.
Firm-specific skills raise a worker's productivity in a particular firm.
General skills enhance productivity in many jobs or firms.
Signalling is the decision to undertake an action in order to reveal information.
Screening is the process of obtaining information by observing differences in behaviour.
Discrimination implies an earnings differential that is attributable to a trait other than human capital.
Lorenz curve describes the cumulative percentage of the income distribution going to different quantiles of the population.
Gini index: a measure of how far the Lorenz curve lies from the line of equality. Its maximum value is one; its minimum value is zero.
13.10: Exercises for Chapter 13
EXERCISE 13.1
Georgina is contemplating entering the job market after graduating from high school. Her future lifespan is divided into two phases: An initial one during which she may go to university, and a second when she will work. Since dollars today are worth more than dollars in the future she discounts the future by 20%, that is the value today of that future income is the income divided by 1.2. By going to university and then working she will earn (i) -\$60,000; (ii) \$600,000. The negative value implies that she will incur costs in educating herself in the first period. In contrast, if she decides to work for both periods she will earn \$30,000 in the first period and \$480,000 in the second.
1. If her objective is to maximize her lifetime earnings, should she go to university or enter the job market immediately?
2. If instead of discounting the future at the rate of 20%, she discounts it at the rate of 50%, what should she do?
EXERCISE 13.2
Imagine that you have the following data on the income distribution for two economies.
Quintile share of total income
First quintile 4.1 3.0
Second quintile 9.6 9.0
Third quintile 15.3 17.0
Fourth quintile 23.8 29.0
Fifth quintile 47.2 42.0
Total 100 100
1. On graph paper, or in a spreadsheet program, plot the Lorenz curves corresponding to the two sets of quintile shares. You must first compute the cumulative shares as we did for Figure 13.3.
2. Can you say, from a visual analysis, which distribution is more equal?
EXERCISE 13.3
The distribution of income in the economy is given in the table below. The first numerical column represents the dollars earned by each quintile. Since the numbers add to 100 you can equally think of the dollar values as shares of the total pie. In this economy the government changes the distribution by levying taxes and distributing benefits.
Quintile Gross income \$m Taxes \$m Benefits \$m
First 4 0 9
Second 11 1 6
Third 19 3 5
Fourth 26 7 3
Fifth 40 15 3
Total 100 26 26
1. Plot the Lorenz curve for gross income to scale.
2. Now subtract the taxes paid and add the benefits received by each quintile. Check that the total income is still \$100. Calculate the cumulative income shares and plot the resulting Lorenz curve. Can you see that taxes and benefits reduce inequality?
EXERCISE 13.4
Consider two individuals, each facing a 45 year horizon at the age of 20. Ivan decides to work immediately and his earnings path takes the following form: Earnings =20,000+1,000t–10t2, where the t is time, and it takes on values from 1 to 25, reflecting the working lifespan.
1. In a spreadsheet enter values 1... 25 in the first column and then compute the value of earnings in each of the 25 years in the second column using the earnings equation.
2. John decides to study some more and only earns a part-time salary in his first few years. He hopes that the additional earnings in future years will compensate for that. His function is given by 10,000+2,000t–12t2. In the same spreadsheet compute his annual earnings for 25 years.
3. Plot the two earnings functions you have computed using the 'charts' feature of Excel. Does your graph indicate that John passes Ivan between year 10 and year 11?
EXERCISE 13.5
In the short run one half of the labour force has high skills and one half low skills (in terms of Figure 13.2 this means that the short-run supply curve is vertical at 0.5). The relative demand for the high-skill workers is given by , where W is the wage premium and f is the fraction that is skilled. The premium is measured in percent and f has a maximum value of 1. The W function thus has vertical and horizontal intercepts of .
1. Illustrate the supply and demand curves graphically, and illustrate the skill premium going to the high-skill workers in the short run by determining the value of W when f=0.5.
2. If demand increases to what is the new premium? Illustrate your answer graphically.
EXERCISE 13.6
Consider the foregoing problem in a long-run context, when the fraction of the labour force that is high-skilled is more elastic with respect to the premium. Let this long-run relative supply function be .
1. Graph this long-run supply function and verify that it goes through the same initial equilibrium as in Exercise 13.5.
2. Illustrate the long run and short run on the same diagram.
3. What is the numerical value of the premium in the long run after the increase in demand? Illustrate graphically. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/05%3A_The_Factors_of_Production/13%3A_Human_capital_and_the_income_distribution/13.09%3A_Key_Terms.txt |
Chapter 14: Government
In this chapter we will explore:
14.1
Market failure and the role of government
14.2
Fiscal federalism in Canada
14.3
Federal-provincial relations and powers
14.4
Redistribution to individuals
14.5
Regulatory activity and competition policy
Governments have a profound impact on economies. The economies of Scandinavia are very different from those in North America. North and South Korea are night and day, even though they were identical several decades ago. Canada and Argentina were very similar in the early decades of the twentieth century. Both had abundant space, natural resources and migrants. Today Canada is one of the most prosperous economies in the world, while Argentina struggles as a middle-income economy.
Governments are not peripheral to the marketplace. They can facilitate or hinder the operation of markets. They can ignore poverty or implement policies to support those on low income and those who are incapacitated. Governments can treat the economy as their fiefdoms, as has been the case for decades in many underdeveloped economies. By assuming the role of warlords, local governors inhibit economic development, because the fruits of investment and labour are subject to capture by the ruling power elite.
In Canada we take for granted the existence of a generally benign government that serves the economy, rather than one which expects the economy to serve it. The separation of powers, the existence of a constitution, property rights, a police force, and a free press are all crucial ingredients in the mix that ferments economic development and a healthy society.
The analysis of government is worthy not just of a full course, but a full program of study. Accordingly, our objective in this chapter must be limited. We begin by describing the various ways in which markets may be inadequate and what government can do to remedy these deficiencies. Next we describe the size and scope of government in Canada, and define the sources of government revenues. On the expenditure side, we emphasize the redistributive and transfer roles that are played by Canadian governments. Tax revenues, particularly at the federal level, go predominantly to transfers rather than the provision of goods and services. Finally we examine how governments seek to control, limit and generally influence the marketplace: How do governments foster the operation of markets in Canada? How do they attempt to limit monopolies and cartels? How do they attempt to encourage the entry of new producers and generally promote a market structure that is conducive to competition, economic growth and consumer well-being?
14.1 Market failure
Markets are fine institutions when all of the conditions for their efficient operation are in place. In Chapter 5 we explored the meaning of efficient resource allocation, by developing the concepts of consumer and producer surpluses. But, while we have emphasized the benefits of efficient resource allocation in a market economy, there are many situations where markets deliver inefficient outcomes. Several problems beset the operation of markets. The principal sources of market failure are: Externalities, public goods, asymmetric information, and the concentration of power. In addition markets may produce outcomes that are unfavourable to certain groups – perhaps those on low incomes. The circumstances described here lead to what is termed market failure.
Market failure defines outcomes in which the allocation of resources is not efficient.
Externalities
A negative externality is one resulting, perhaps, from the polluting activity of a producer, or the emission of greenhouse gases into the atmosphere. A positive externality is one where the activity of one individual confers a benefit on others. An example here is where individuals choose to get immunized against a particular illness. As more people become immune, the lower is the probability that the illness can propagate itself through hosts, and therefore the greater the benefits to those not immunized.
Solutions to these market failures come in several forms: Government taxes and subsidies, or quota systems that place limits on the production of products generating externalities. Such solutions were explored in Chapter 5. Taxes on gasoline discourage its use and therefore reduce the emission of poisons into the atmosphere. Taxes on cigarettes and alcohol lower the consumption of goods that may place an additional demand on our publicly-funded health system. The provision of free, or low-cost, immunization against specific diseases to children benefits the whole population.
These measures attempt to compensate for the absence of a market in certain activities. Producers may not wish to pay for the right to emit pollutants, and consequently if the government steps in to counter such an externality, the government is effectively implementing a solution to the missing market.
Public goods
Public goods are sometimes called collective consumption goods, on account of their non-rivalrous and non-excludability characteristics. For example, if the government meteorological office provides daily forecasts over the nation's airwaves, it is no more expensive to supply that information to one million than to one hundred individuals in the same region. Its provision to one is not rivalrous with its provision to others – in contrast to private goods that cannot be 'consumed' simultaneously by more than one individual. In addition, it may be difficult to exclude certain individuals from receiving the information.
Public goods are non-rivalrous, in that they can be consumed simultaneously by more than one individual; additionally they may have a non-excludability characteristic.
Examples of such goods and services abound: Highways (up to their congestion point), street lighting, information on trans-fats and tobacco, or public defence provision. Such goods pose a problem for private markets: If it is difficult to exclude individuals from their consumption, then potential private suppliers will likely be deterred from supplying them because the suppliers cannot generate revenue from free-riders. Governments therefore normally supply such goods and services. But how much should governments supply? An answer is provided with the help of Figure 14.1.
Figure 14.1 Optimal provision of a public good
The total demand for the public good D is the vertical sum of the individual demands DA and DB. The optimal provision is where the MC equals the aggregate marginal valuation, as defined by the demand curve D. At the optimum Q×, each individual is supplied the same amount of the public good.
This is a supply-demand diagram with a difference. The supply side is conventional, with the MC of production representing the supply curve. An efficient use of the economy's resources, we already know, dictates that an amount should be produced so that the cost at the margin equals the benefit to consumers at the margin. In contrast to the total market demand for private goods, which is obtained by summing individual demands horizontally, the demand for public goods is obtained by summing individual demands vertically.
Figure 14.1 depicts an economy with just two individuals whose demands for street lighting are given by DA and DB. These demands reveal the value each individual places on the various output levels of the public good, measured on the x-axis. However, since each individual can consume the public good simultaneously, the aggregate value of any output produced is the sum of each individual valuation. The valuation in the market of any quantity produced is therefore the vertical sum of the individual demands. D is the vertical sum of DA and DB, and the optimal output is Q×. At this equilibrium each individual consumes the same quantity of street lighting, and the MC of the last unit supplied equals the value placed upon it by society – both individuals. Note that this 'optimal' supply depends upon the income distribution, as we have stated several times to date. A different distribution of income may give rise to different demands DA and DB, and therefore a different 'optimal' output.
Efficient supply of public goods is where the marginal cost equals the sum of individual marginal valuations, and each individual consumes the same quantity.
Application Box 14.1 Are Wikipedia, Google and MOOCs public goods?
Wikipedia is one of the largest on-line sources of free information in the world. It is an encyclopedia that functions in multiple languages and that furnishes information on millions of topics. It is freely accessible, and is maintained and expanded by its users. Google is the most frequently used search engine on the World Wide Web. It provides information to millions of users simultaneously on every subject imaginable. But it is not quite free of charge; when the user searches she supplies information on herself that can be used profitably by Google in its advertising. MOOCs are 'monster open online courses' offered by numerous universities, frequently for no charge to the student. Are these services public goods in the sense we have described?
Very few goods and services are pure public goods, some have the major characteristics of public goods nonetheless. In this general sense, Google, Wikipedia and MOOCs have public good characteristics. Wikipedia is funded by philanthropic contributions, and its users expand its range by posting information on its servers. Google is funded from advertising revenue. MOOCs are funded by university budgets.
A pure public good is available to additional users at zero marginal cost. This condition is essentially met by these services since their server capacity rarely reaches its limit. Nonetheless, they are constantly adding server capacity, and in that sense cannot furnish their services to an unlimited number of additional users at no additional cost.
Knowledge is perhaps the ultimate public good; Wikipedia, Google and MOOCs all disseminate knowledge, knowledge which has been developed through the millennia by philosophers, scientists, artists, teachers, research laboratories and universities.
A challenge in providing the optimal amount of government-supplied public goods is to know the value that users may place upon them – how can the demand curves DA and DB, be ascertained, for example, in Figure 14.1? In contrast to markets for private goods, where consumer demands are essentially revealed through the process of purchase, the demands for public goods may have to be uncovered by means of surveys that are designed so as to elicit the true valuations that users place upon different amounts of a public good. A second challenge relates to the pricing and funding of public goods: For example, should highway lighting be funded from general tax revenue, or should drivers pay for it? These are complexities that are beyond our scope of our current inquiry.
Asymmetric information
Markets for information abound in the modern economy. Governments frequently supply information on account of its public good characteristics. But the problem of asymmetric information poses additional challenges. Asymmetric information is where at least one party in an economic relationship has less than full information. This situation characterizes many interactions: Life-insurance companies do not have perfect information on the lifestyle and health of their clients; used vehicle buyers may not know the history of the vehicles they are buying.
Asymmetric information is where at least one party in an economic relationship has less than full information and has a different amount of information from another party.
Asymmetric information can lead to two kinds of problems. The first is adverse selection. For example, can the life-insurance company be sure that it is not insuring only the lives of people who are high risk and likely to die young? If primarily high-risk people buy such insurance then the insurance company must set its premiums accordingly: The company is getting an adverse selection rather than a random selection of clients. Frequently governments decide to run universal compulsory-membership insurance plans (auto or health are examples in Canada) precisely because they may not wish to charge higher rates to higher-risk individuals.
Adverse selection occurs when incomplete or asymmetric information describes an economic relationship.
A related problem is moral hazard. If an individual does not face the full consequences of his actions, his behaviour may be influenced: if a homeowner has a fully insured home he may be less security conscious than an owner who does not.
In Chapter 7 we described how US mortgage providers lent large sums to borrowers with uncertain incomes in the early years of the new millennium. The individuals responsible for the lending were being rewarded on the basis of the amount lent, not the safety of the loan. Nor were the lenders responsible for loans that were not repaid. This 'sub-prime mortgage crisis' was certainly a case of moral hazard.
Moral hazard may characterize behaviour where the costs of certain activities are not incurred by those undertaking them.
Solutions to these problems do not always involve the government, but in critical situations do. For example, the government requires most professional societies and orders to ensure that their members are trained, accredited and capable. Whether for a medical doctor, a plumber or an engineer, a license or certificate of competence is a signal that the work and advice of these professionals is bona fide. Equally, the government sets standards so that individuals do not have to incur the cost of ascertaining the quality of their purchases – bicycle helmets must satisfy specific crash norms; so too must air-bags in automobiles.
These situations differ from those where solutions to the information problem can be dealt with reasonably well in the market place. For example, with the advent of buyer and seller rating on Airbnb, a potential renter can learn of the quality of the accommodation he is considering, and the letor can assess the potential renter.
Concentration of power
Monopolistic and imperfectly-competitive market structures can give rise to inefficient outcomes, in the sense that the value placed on the last unit of output does not equal the cost at the margin. This arises because the supplier uses his market power in order to maximize profits by limiting output and selling at a higher price.
What can governments do about such power concentrations? Every developed economy has a body similar to Canada's Competition Bureau. Such regulatory bodies are charged with seeing that the interests of the consumer, and the economy more broadly, are represented in the market place. Interventions, regulatory procedures and efforts to prevent the abuse of market power come in a variety of forms. These measures are examined in Section 14.5.
Unfavourable market outcomes
Even if governments successfully address the problems posed by the market failures described above, there is nothing to guarantee that market-driven outcomes will be 'fair', or accord with the prevailing notions of justice or equity. The marketplace generates many low-paying jobs, unemployment and poverty. The concentration of economic power has led to the growth in income and wealth inequality in many economies. Governments, to varying degrees, attempt to moderate these outcomes through a variety of social programs and transfers that are discussed in Section 14.4.
14.2 Fiscal federalism: Taxing and spending
Canada is a federal state, in which the federal, provincial and municipal governments exercise different powers and responsibilities. In contrast, most European states are unitary and power is not devolved to their regions to the same degree as in Canada or the US or Australia. Federalism confers several advantages over a unitary form of government where an economy is geographically extensive, or where identifiable differences distinguish one region from another: Regions can adopt different policies in response to the expression of different preferences by their respective voters; smaller governments may be better at experimentation and the introduction of new policies than large governments; political representatives are 'closer' to their constituents.
Despite these advantages, the existence of an additional level of government creates a tension between these levels. Such tension is evident in every federation, and federal and provincial governments argue over the appropriate division of taxation powers and revenue-raising power in general. For example, how should the royalties and taxes from oil and gas deposits offshore be distributed – to the federal government or a provincial government?
In Canada, the federal government collects more in tax revenue than it expends on its own programs. This is a feature of most federations. The provinces simultaneously face a shortfall in their own revenues relative to their program expenditure requirements. The federal government therefore redistributes, or transfers, funds to the provinces so that the latter can perform their constitutionally-assigned roles in the economy. The fact that the federal government bridges this fiscal gap gives it a degree of power over the provinces. This influence is commonly termed federal spending power.
Spending power of a federal government arises when the federal government can influence lower level governments due to its financial rather than constitutional power.
The principal revenue sources for financing federal government activity are given in Figure 14.1 for the fiscal year 2015-16, and the expenditure of these revenues is broken down in Figure 14.2. Further details are accessible in the Department of Finance's 'fiscal reference tables' at www.fin.gc.ca/frt-trf/2019/frt-trf-19-eng.asp. Total revenues for that fiscal year amounted to \$333.2b, and expenditures to \$346.2b.
The federal and provincial governments each transfer these revenues to individuals and other levels of government, supply goods and services directly, and also pay interest on accumulated borrowings – the national debt or provincial debt.
Provincial and local governments supply more goods and services than the federal government – health care, drug insurance, education and welfare are the responsibility of provincial and municipal governments. In contrast, national defence, the provision of main traffic arteries, Corrections Canada and a variety of transfer programs to individuals – such as Employment Insurance, Old Age Security and the Canada Pension Plan – are federally funded. The greater part of federal revenues goes towards transfers to individuals and provincial governments, as opposed to the supply of goods and services.
14.3 Federal-provincial fiscal relations
The federal government transfers revenue to the provinces using three main programs: Equalization, the Canada Social Transfer and the Canada Health Transfer. Each of these has a different objective. Equalization aims to reduce fiscal disparities among the provinces; The Canada Social Transfer (CST) is for educational and Social Assistance ('welfare') expenditures; The Canada Health Transfer (CHT) performs the same function for health.
Equalization and Territorial Funding
Canada's provinces receive unconditional funding through Canada's Equalization program, whereas the Territories receive federal funding through a separate mechanism - the Territorial Funding Formula.
"Parliament and the Government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public service at reasonably comparable levels of taxation."
This statement, from Section 36(2) of the Constitution Act of 1982, defines the purpose of Equalization. Equalization payments are unconditional – receiving provinces are free to spend the funds on public services according to their own priorities, or even use the revenue to reduce their provincial taxes. Payments are calculated according to a formula that ensures those provinces with revenue-raising ability, or fiscal capacity, below a threshold or 'standard' receive payments from the federal government to bring their capacity up to that standard.
Equalization has gone through very many changes in the several decades of its existence. Its current rules and regulations reflect the 2006 recommendations of a federal Expert Panel. The fiscal capacity of a province is measured by its ability to raise revenues from five major sources: Personal and business income taxes, sales taxes, property taxes, and natural resources. This ability is then compared to the ability of all of the provinces combined to raise revenue; if a difference or shortfall exists, the federal government transfers revenue accordingly, with the amount determined by both the population of the province and the magnitude of its per-person shortfall. Data on annual transfers for Equalization, the Territorial Funding Formula, and the CHT and CST are available at fin.gc.ca/fedprov/mtp-eng.asp
The program transferred \$19.8b to the provinces in 2019-20. The recipiency status of some provinces varies from year to year. Variation in energy prices and energy-based government revenues are the principal cause of this. British Columbia, Alberta, Saskatchewan and Ontario tend to receive little or zero. Manitoba, Quebec and the Atlantic Provinces have been the major recipient provinces. Quebec receives the largest single amount – approximately two thirds of the total allocation, both on account of its population size and the fact that it has a lower than average fiscal capacity. The Territories received a total of \$3.9b in 2019-20 through the Territorial Funding Formula.
The Canada Social Transfer and the Canada Health Transfer
The CST is a block transfer to provinces in support of post-secondary education, Social Assistance and social services more generally. The CST came into effect in 2004. Prior to that date it was integrated with the health component of federal transfers in a program titled the Canada Health and Social Transfer (CHST). The objective of the separation was to increase the transparency and accountability of federal support for health while continuing to provide funding for other objectives. The CHT is the other part of the unbundled CHST: It provides funding to the provinces for their health expenditures.
The CST and CHT funding comes in two parts: A cash transfer and tax transfer. A tax transfer essentially provides the same support as a cash transfer of equal value, but comes in a different form. In 1977 the federal government agreed with provincial governments to reduce federal personal and corporate tax rates in order to permit the provincial governments to increase the corresponding provincial rates. The net effect was that the federal government got less tax revenue and the provinces got more. And to this day, the federal and provincial governments keep a record of the implied tax transfers that arise from this long-ago agreement. This is the tax transfer component of the CST and the CHT.
The CST support is allocated to provinces and territories on an equal per-capita basis to ensure equal support for all Canadians regardless of their place of residence. The CHT is distributed likewise, and it requires the provinces to abide by the federally-legislated Canada Health Act, which demands that provincial health coverage be comprehensive, universal, portable, accessible and publicly administered.
The CHT transfer amounted to \$40.4b and the CST amounted to \$14.6b, in cash, for the year 2019-20. Health care and health expenditures are a core issue of policy at all levels of government on account of the envisaged growth in these expenditures that will inevitably accompany the aging of the baby-boomers.
14.4 Government-to-individual transfers
Many Canadians take pride in Canada's extensive 'social safety net' that aims to protect individuals from misfortune and the reduction of income in old age. Others believe it is too generous. While it is more supportive than the safety net in the US, the Canadian safety net is no more protective than the nets of the developed economies of the European Union. The extent of such support depends in large measure upon the degree to which governments are willing to impose, and individuals are willing to pay, higher or lower tax rates. The major elements of this umbrella of programs are the following.
The Canada and Quebec Pension Plans (C/QPP) are funded from the contributions of workers and their employers. Contributions form 9.9% of an individual's earnings up to the maximum pensionable earnings (MPE) figure of \$57,400 in 2019. The contributions are shared equally by employer and employee. The Canada and Quebec components of the plan operate similarly, but are managed separately. The contribution rate to the QPP stands at 10.65%. Contributions to the plans from workers and their employers are largely transferred immediately to retired workers. Part of the contributions is invested in a fund. The objective of the plans is to ensure that some income is saved for retirement. Many individuals are not very good at planning – they constantly postpone the decision to save, so the state steps in and requires them to save. An individual contributing throughout a full-time working lifecycle can expect an annual pension of about \$14,000 in 2019. The Plans provide a maximum payout of 25% of maximum insurable earnings. The objective is to provide a minimum level of retirement income, not an income that will see individuals live in great comfort.
The C/QPP plans have contributed greatly to the reduction of poverty among the elderly since their introduction in the mid-sixties. The aging of the baby-boom generation – that very large cohort born in the late forties through to the early sixties – means that the percentage of the population in the post-65 age group has begun to increase. To meet this changing demographic, the federal and provincial governments reshaped the plans in the late nineties in order to put them on a sound financial footing – primarily by increasing contributions, that in turn will enable the build-up of a CPP 'fund' that will support the aged in the following decades.
A number of recent studies in Canada on the retirement savings practices of Canadians have proposed that households on average are not saving a sufficient amount for their retirement; many households may thus see a notable decline in their incomes upon retirement. In response to this finding, the federal government agreed with the provinces in June 2016, to add a supplement to the CPP. The new federal provisions, which will be phased in over the period 2019-2025, envisage an increase in contributions that will ultimately lead to a maximum replacement rate of 33% of MPE as opposed to the current goal of 25%. However, full benefits will be experienced only by individuals contributing for their complete lifecycle, meaning that full implementation will take about four decades.
Details of the CPP and the 2016 enhancements are to be found at www.fin.gc.ca/n16/data/16-113_3-eng.asp.
Old Age Security (OAS), the Guaranteed Income Supplement (GIS) and the Spousal Allowance (SPA) together form the second support leg for the retired. OAS is a payment made automatically to individuals once they attain the age of 65. The GIS is an additional payment made only to those on very low incomes – for example, individuals who have little income from their C/QPP or private pension plans. The SPA, which is payable to the spouse or survivor of an OAS recipient, accounts for a small part of the sums disbursed. As of 2019 the maximum annual OAS payment stood at \$7,360. The federal government in 2016 reversed a plan that would have seen the eligible age for receipt of OAS move to 67.
The payments for these plans come from the general tax revenues of the federal government. Unlike the C/QPP, the benefits received are not related to the contributions that an individual makes over the working lifecycle. This program has also had a substantial impact on poverty reduction among the elderly.
Employment Insurance (EI) and Social Assistance (SA) are designed to support, respectively, the unemployed and those with no other source of income. Welfare is the common term used to describe SA. Expenditures on EI and SA are strongly cyclical. At the trough of an economic cycle the real value of expenditures on these programs greatly exceeds expenditures at the peak of the cycle. Unemployment in Canada rose above 8% in 2009, and payments to the unemployed and those on welfare reflected this dire state. The strongly cyclical pattern of the cost of these programs reflects the importance of a healthy job market: Macroeconomic conditions have a major impact on social program expenditures.
EI is funded by contributions from employees and their employers. For each dollar contributed by the employee, the employer contributes \$1.4. Premiums are paid on earned income up to a maximum insurable earnings (MIE) of \$53,100 in 2019. The contribution rate for employees stood at 1.62% of MIE in 2017. EI contributions and pay-outs form part of the federal government's general revenues and expenditures. There is no separate 'fund' for this program. However it is expected to operate on a break-even basis over the longer term. To reflect this, the contribution rate fluctuates with a view to maintaining a balance between payouts and revenues over a seven-year planning period.
EI is called an insurance program, but in reality it is much more than that. Certain groups systematically use the program more than others – those in seasonal jobs, those in rural areas and those in the Atlantic Provinces, for example. Accordingly, using the terminology of Chapter 7, it is not everywhere an actuarially 'fair' insurance program. Benefits payable to unemployed individuals may also depend on their family size, in addition to their work history. While most payments go in the form of 'regular' benefits to unemployed individuals, the EI program also sponsors employee retraining, family benefits that cover maternity and paternity leave, and some other specific target programs for the unemployed.
Social Assistance is provided to individuals who are in serious need of financial support – having no income and few assets. Provincial governments administer SA, although the cost of the program is partly covered by federal transfers through the Canada Social Transfer. The nineteen nineties witnessed a substantial tightening of regulations virtually across the whole of Canada. Access to SA benefits is now more difficult, and benefits have fallen in real terms since the late nineteen eighties.
Welfare dependence peaked in Canada in 1994, when 3.1 million individuals were dependent upon support. As of 2019, the total is approximately half of this, on account of more stringent access conditions, reduced benefit levels and an improved job market. Some groups in Canada believe that benefits should be higher, others believe that making welfare too generous provides young individuals with the wrong incentives in life, and may lead them to neglect schooling and skill development.
Workers Compensation supports workers injured on the job. Worker/employer contributions and general tax revenue form the sources of program revenue, and the mix varies from province-to-province. In contrast to the macro-economy-induced swings in expenditures that characterize SA and EI since the early nineties, expenditures on Worker's Compensation have remained relatively constant.
Canada Child Benefit: The major remaining pillar in Canada's social safety net is the group of payments and tax credits aimed at supporting children: The Canada Child Tax Benefit (CCTB), the Universal Child Care Benefit and the National Child Benefit Supplement were repackaged in 2016 under the title Canada Child Benefit. Child support has evolved and been enriched over the last two decades, partly with the objective of reducing poverty among households with children, and partly with a view to helping parents receiving social assistance to transition back to the labour market. As of 2016, the federal government provides an annual payment to families with children. For each child under the age of 6 the payment is \$6,639 and for each child aged 6-17 the payment is \$5,602. Since these payment are primarily intended for households with low and middle incomes, the amounts are progressively clawed back once the household income reaches a threshold of \$30,000.
Application Box 14.2 Government debts and deficits
Canada's expenditure and tax policies in the nineteen seventies and eighties led to the accumulation of large government debts, as a result of running fiscal deficits. By the mid-nineties the combined federal and provincial debt reached 100% of GDP, with the federal debt accounting for the larger share. This ratio was perilously high: Interest payments absorbed a large fraction of annual government revenues, which in turn limited the ability of the government to embark on new programs or enrich existing ones. Canada's debt rating on international financial markets declined.
In 1995, Finance Minister Paul Martin addressed this problem, and over the following years program spending was pared back. Ultimately, the economy expanded and by the end of the decade the annual deficits at the federal level were eliminated.
As of 2007 the ratio of combined federal and provincial debts stood at just over 60% of GDP. However, the Great Recession of 2008 and following years saw all levels of government experience deficits, with the result that this ratio of combined debt to GDP rose again. Growth in recent years has seen that ratio fall. As of 2018-19, federal interest payments on its debt account for about 7% of its revenues (this figure stood at 28% in the early nineties). At the time of writing, interest rates are low in developed economies and so the interest costs of government debt are low. Low borrowing costs are a reason why some people favor large government spending in the form of infrastructure projects. Those who are fiscally more conservative fear rising rates in the future. The recessionary impacts of the coronavirus pandemic of 2020 will add greatly to accumulated debt, particularly at the federal level.
Debts can be measured in more than a single manner. One measure of debt is the value of all federal government bonds and financial liabilities outstanding. As of 2019-20 this value was approximately \$700b. In addition to this, the federal government has outstanding liabilities to the pensions of its retired employees, and not all of these liabilities have been covered by the contributions of those employees into their pension plans. The federal government also owns assets, both financial and physical - such as office buildings. Hence these assets offset the financial liabilities. To assess the total debt picture of the Canadian economy we need to add provincial and local government debts to the federal debts, and then consider the annual interest costs of this total. It turns out that the interest costs are just above 2% of GDP.
Source: Government of Canada, Fiscal Reference Tables: www.fin.gc.ca/frt-trf/2019/frt-trf-19-eng.asp
14.5 Regulation and competition policy
Goals and objectives
The goals of competition policy are relatively uniform across developed economies: The promotion of domestic competition; the development of new ideas, new products and new enterprises; the promotion of efficiency in the resource-allocation sense; the development of manufacturing and service industries that can compete internationally.
In addition to these economic objectives, governments and citizens frown upon monopolies or monopoly practices if they lead to an undue concentration of political power. Such power can lead to a concentration of wealth and influence in the hands of an elite.
Canada's regulatory body is the Competition Bureau, whose activity is governed primarily by the Competition Act of 1986. This act replaced the Combines Investigation Act. The Competition Tribunal acts as an adjudication body, and is composed of judges and non- judicial members. This tribunal can issue orders on the maintenance of competition in the marketplace. Canada has had anti-combines legislation since 1889, and the act of 1986 is the most recent form of such legislation and policy. The Competition Act does not forbid monopolies, but it does rule as unlawful the abuse of monopoly power. Canada's competition legislation is aimed at anti-competitive practices, and a full description of its activities is to be found on its website at www.competitionbureau.gc.ca. Let us examine some of these proscribed policies.
Anti-competitive practices
Anti-competitive practices may either limit entry into a sector of the economy or force existing competitors out. In either case they lead to a reduction in competition.
Mergers may turn competitive firms into a single organization with excessive market power. The customary justification for mergers is that they permit the merged firms to achieve scale economies that would otherwise be impossible. Such scale economies may in turn result in lower prices in the domestic or international market to the benefit of the consumer, but may alternatively reduce competition and result in higher prices. Equally important in this era of global competition is the impact of a merger on a firm's ability to compete internationally.
Mergers can be of the horizontal type (e.g. two manufacturers of pre-mixed concrete merge) or vertical type (a concrete manufacturer merges with a cement manufacturer). In a market with few suppliers mergers have the potential to reduce domestic competition.
Cartels aim to restrict output and thereby increase profits. These formations are almost universally illegal in individual national economies.
While cartels are one means of increasing prices, price discrimination is another, as we saw when studying monopoly behaviour. For example, if a concrete manufacturer makes her product available to large builders at a lower price than to small-scale builders – perhaps because the large builder has more bargaining power – then the small builder is at a competitive disadvantage in the construction business. If the small firm is forced out of the construction business as a consequence, then competition in this sector is reduced.
We introduced the concept of predatory pricing in Chapter 11. Predatory pricing is a practice that is aimed at driving out competition by artificially reducing the price of one product sold by a supplier. For example, a dominant nationwide transporter could reduce price on a particular route where competition comes from a strictly local competitor. By 'subsidizing' this route from profits on other routes, the dominant firm could undercut the local firm and drive it out of the market.
Predatory pricing is a practice that is aimed at driving out competition by artificially reducing the price of one product sold by a supplier.
Suppliers may also refuse to deal. If the local supplier of pre-mixed concrete refuses to sell the product to a local construction firm, then the ability of such a downstream firm to operate and compete may be compromised. This practice is similar to that of exclusive sales and tied sales. An exclusive sale might involve a large vegetable wholesaler forcing her retail clients to buy only from this supplier. Such a practice might hurt the local grower of aubergines or zucchini, and also may prevent the retailer from obtaining some of her vegetables at a lower price or at a higher quality elsewhere. A tied sale is one where the purchaser must agree to purchase a bundle of goods from a supplier.
Refusal to deal: an illegal practice where a supplier refuses to sell to a purchaser.
Exclusive sale: where a retailer is obliged (perhaps illegally) to purchase all wholesale products from a single supplier only.
Tied sale: one where the purchaser must agree to purchase a bundle of goods from a supplier.
Resale price maintenance involves the producer requiring a retailer to sell a product at a specified price. This practice can hurt consumers since they cannot 'shop around'. In Canada, we frequently encounter a 'manufacturer's suggested retail price' for autos and durable goods. But since these prices are not required, the practice conforms to the law.
Resale price maintenance is an illegal practice wherein a producer requires sellers to maintain a specified price.
Bid rigging is an illegal practice in which normally competitive bidders conspire to fix the awarding of contracts or sales. For example, two builders, who consider bidding on construction projects, may decide that one will bid seriously for project X and the other will bid seriously on project Y. In this way they conspire to reduce competition in order to make more profit.
Bid rigging is an illegal practice in which bidders (buyers) conspire to set prices in their own interest.
Deception and dishonesty in promoting products can either short-change the consumer or give one supplier an unfair advantage over other suppliers.
Enforcement
The Competition Act is enforced through the Competition Bureau in a variety of ways. Decisions on acceptable business practices are frequently reached through study and letters of agreement between the Bureau and businesses. In some cases, where laws appear to have been violated, criminal proceedings may follow.
Regulation, deregulation and privatization
The last three decades have witnessed a significant degree of privatization and deregulation in Canada, most notably in the transportation, communication and energy sectors. Modern deregulation in the US began with the passage of the Airline Deregulation Act of 1978, and was pursued with great energy under the Reagan administration in the eighties. The Economic Council of Canada produced an influential report in 1981, titled "Reforming Regulation," on the impact of regulation and possible deregulation of specific sectors. The Economic Council proposed that regulation in some sectors was inhibiting competition, entry and innovation. As a consequence, the interests of the consumer were in danger of becoming secondary to the interests of the suppliers.
Telecommunications provision, in the era when the telephone was the main form of such communication, was traditionally viewed as a natural monopoly. The Canadian Radio and Telecommunications Commission (CRTC) regulated its rates. The industry has developed dramatically in the last two decades with the introduction of satellite-facilitated communication, the internet, multi-purpose cable networks, cell phones and service integration.
Transportation, in virtually all forms, has been deregulated in Canada since the nineteen eighties. Railways were originally required to subsidize the transportation of grain under the Crow's Nest Pass rate structure. But the subsidization of particular markets requires an excessive rate elsewhere, and if the latter markets become subject to competition then a competitive system cannot function. This structure, along with many other anomalies, was changed with the passage of the Canada Transportation Act in 1996.
Trucking, historically, has been regulated by individual provinces. Entry was heavily controlled prior to the federal National Transportation Act of 1987, and subsequent legislation introduced by a number of provinces, have made for easier entry and a more competitive rate structure.
Deregulation of the airline industry in the US in the late seventies had a considerable influence on thinking and practice in Canada. The Economic Council report of 1981 recommended in favour of easier entry and greater fare competition. These policies were reflected in the 1987 National Transportation Act. Most economists are favourable to deregulation and freedom to enter, and the US experience indicated that cost reductions and increased efficiency could follow. In 1995 an agreement was reached between the US and Canada that provided full freedom for Canadian carriers to move passengers to any US city, and freedom for US carriers to do likewise, subject to a phase-in provision.
The National Energy Board regulates the development and transmission of oil and natural gas. But earlier powers of the Board, involving the regulation of product prices, were eliminated in 1986, and controls on oil exports were also eliminated.
Agriculture remains a highly controlled area of the economy. Supply 'management', which is really supply restriction, and therefore 'price maintenance', characterizes grain, dairy, poultry and other products. Management is primarily through provincial marketing boards.
The role of the sharing economy
The arrival of universal access to the internet has seen the emergence of what is known as the Sharing economy throughout the world. This expression is used to describe commercial activities that, in the first place, are internet-based. Second, suppliers in the sharing economy use resources in the market place that were initially aimed at a different purpose. Airbnb and Uber are good examples of companies in sectors of the economy where sharing is possible. In Uber's case, the 'ride-share' drivers initially purchased their vehicles for private use, and subsequently redirected them to commercial use. Airbnb is a communication corporation that enables the owners of spare home capacity to sell the use of that capacity to short-term renters. With the maturation of such corporations, the concept of 'initial' and 'secondary' use becomes blurred.
Sharing economy: involves enterprises that are internet based, and that use production resources that have use outside of the marketplace.
The importance of the sharing economy is that it provides an additional source of competition to established suppliers, and therefore limits the market power of the latter. At the same time, the emergence of the sharing economy poses a new set of regulatory challenges: If traditional taxis are required to purchase operating permits (medallions), and the ride-share drivers do not require such permits, is there a reasonable degree of competition in the market, and if not what is the appropriate solution? Should the medallion requirement be abolished, or should ride-share drivers be required to purchase one? In the case of Airbnb, the suppliers operate outside of the traditional 'hotel' market. In general they do not charge sales taxes or face any union labour agreements. What is the appropriate response from governments? And how should the sharing economy be taxed?
Price regulation
Regulating monopolistic sectors of the economy is one means of reducing their market power. In Chapter 11 it was proposed that indefinitely decreasing production costs in an industry means that the industry might be considered as a 'natural' monopoly: Higher output can be produced at lower cost with fewer firms. Hence, a single supplier has the potential to supply the market at a lower unit cost; unless, that is, such a single supplier uses his monopoly power. To illustrate how the consumer side may benefit from this production structure through regulation, consider Figure 14.2. For simplicity suppose that long-run marginal costs are constant and that average costs are downward sloping due to an initial fixed cost. The profit-maximizing (monopoly) output is where MR=MC at Qm and is sold at the price Pm. This output is inefficient because the willingness of buyers to pay for additional units of output exceeds the additional cost. On this criterion the efficient output is Q×. But LATC exceeds price at Q×, and therefore it is not feasible for a producer.
Figure 14.2 Regulating a decreasing-cost supplier
The profit-maximizing output is Qm, where MR=MC and price is Pm. This output is inefficient because marginal benefit is greater than MC. Q× is the efficient output, but results in losses because LATC>P at that output. A regulated price that covers costs is where LATC=DQr. This is closer to the efficient output Q× than the monopoly output Qm.
One solution is for the regulating body to set a price-quantity combination of Pr, and Qr, where price equals average cost and therefore generates a normal rate of profit. This output level is still lower than the efficient output level Q×, but is more efficient than the profit-maximizing output Qm. It is more efficient in the sense that it is closer to the efficient output Q×. A problem with such a strategy is that it may induce lax management: If producers are allowed to charge an average-cost price, then there is a reduced incentive for them to keep strict control of their costs in the absence of competition in the marketplace.
A second solution to the declining average cost phenomenon is to implement what is called a two-part tariff. This means that customers pay an 'entry fee' in order to be able to purchase the good. For example, in many jurisdictions hydro or natural gas subscribers may pay a fixed charge per month for their supply line and supply guarantee, and then pay an additional charge that varies with quantity. In this way it is possible for the supplier to charge a price per unit of output that is closer to marginal cost and still make a profit, than under an average cost pricing formula. In terms of Figure 14.2, the total value of entry fees, or fixed components of the pricing, would have to cover the difference between MC and LATC times the output supplied. In Figure 14.2 this implies that if the efficient output is purchased at a price equal to the MC the producer loses the amount (cMC) on each unit sold. The access fees would therefore have to cover at least this value.
Such a solution is appropriate when fixed costs are high and marginal costs are low. This situation is particularly relevant in the modern market for telecommunications: The cost to suppliers of marginal access to their networks, whether it be for internet, phone or TV, is negligible compared to the cost of maintaining the network and installing capacity.
Two-part tariff: involves an access fee and a per unit of quantity fee.
Finally, a word of caution: Nobel Laureate George Stigler has argued that there is a danger of regulators becoming too close to the regulated, and that the relationship can evolve to a point where the regulator may protect the regulated firms. In contrast, Professor Philippon of New York University argues that regulators are not regulating sufficiently in the US: they have permitted an excessive number of mergers that have, in turn, reduced competition.
Key Terms
Market failure defines outcomes in which the allocation of resources is not efficient.
Public goods are non-rivalrous, in that they can be consumed simultaneously by more than one individual; additionally they may have a non-excludability characteristic.
Efficient supply of public goods is where the marginal cost equals the sum of individual marginal valuations, and each individual consumes the same quantity.
Asymmetric information is where at least one party in an economic relationship has less than full information and has a different amount of information from another party.
Adverse selection occurs when incomplete or asymmetric information describes an economic relationship.
Moral hazard may characterize behaviour where the costs of certain activities are not incurred by those undertaking them.
Spending power of a federal government arises when the federal government can influence lower level governments due to its financial rather than constitutional power.
Predatory pricing is a practice that is aimed at driving out competition by artificially reducing the price of one product sold by a supplier.
Refusal to deal: an illegal practice where a supplier refuses to sell to a purchaser.
Exclusive sale: where a retailer is obliged (perhaps illegally) to purchase all wholesale products from a single supplier only.
Tied sale: one where the purchaser must agree to purchase a bundle of goods from the one supplier.
Resale price maintenance is an illegal practice wherein a producer requires sellers to maintain a specified price.
Bid rigging is an illegal practice in which bidders (buyers) conspire to set prices in their own interest.
Sharing economy: involves enterprises that are internet based, and that use production resources that have use outside of the marketplace.
Two-part tariff: involves an access fee and a per unit of quantity fee.
Exercises for Chapter 14
EXERCISE 14.1
An economy is composed of two individuals, whose demands for a public good – street lighting – are given by P=12–(1/2)Q and P=8–(1/3)Q.
1. Graph these demands on a diagram, for values of .
2. Graph the total demand for this public good by summing the demands vertically, specifying the numerical value of each intercept.
3. Let the marginal cost of providing the good be \$5 per unit. Illustrate graphically the efficient supply of the public good () in this economy.
4. Illustrate graphically the area that represents the total value to the consumers of the amount .
EXERCISE 14.2
In Exercise 14.1, suppose a new citizen joins the economy, and her demand for the public good is given by P=10–(5/12)Q.
1. Add this individual's demand curve to the graphic for the above question and graph the new total demand curve, specifying the intercept values.
2. Illustrate the area on your graph that represents the new total value to the three citizens of the optimal amount supplied.
3. Illustrate graphically the net value to society of the new – the total value minus the total cost.
EXERCISE 14.3
An industry that is characterized by a decreasing cost structure has a demand curve given by P=100–Q and the marginal revenue curve by MR=100–2Q. The marginal cost is MC=4, and average cost is AC=4+188/Q.
1. Graph this cost and demand structure. [Hint: This graph is similar to Figure 14.2.]
2. Illustrate the efficient output and the monopoly output for the industry.
3. Illustrate on the graph the price the monopolist would charge if he were unregulated.
EXERCISE 14.4
Optional: In Question 14.3, suppose the government decides to regulate the behaviour of the supplier, in the interests of the consumer.
1. Illustrate graphically the price and output that would emerge if the supplier were regulated so that his allowable price equalled average cost.
2. Is this greater or less than the efficient output?
3. Compute the AC and P that would be charged with this regulation.
4. Illustrate graphically the deadweight loss associated with the regulated price and compare it with the deadweight loss under monopoly.
EXERCISE 14.5
Optional: As an alternative to regulating the supplier such that price covers average total cost, suppose that a two part tariff were used to generate revenue. This scheme involves charging the MC for each unit that is purchased and in addition charging each buyer in the market a fixed cost that is independent of the amount he purchases. If an efficient output is supplied in the market, illustrate graphically the total revenue to be obtained from the component covering a price per unit of the good supplied, and the component covering fixed cost.
14: Government
Markets are fine institutions when all of the conditions for their efficient operation are in place. In Chapter 5 we explored the meaning of efficient resource allocation, by developing the concepts of consumer and producer surpluses. But, while we have emphasized the benefits of efficient resource allocation in a market economy, there are many situations where markets deliver inefficient outcomes. Several problems beset the operation of markets. The principal sources of market failure are: Externalities, public goods, asymmetric information, and the concentration of power. In addition markets may produce outcomes that are unfavourable to certain groups – perhaps those on low incomes. The circumstances described here lead to what is termed market failure.
Market failure defines outcomes in which the allocation of resources is not efficient.
Externalities
A negative externality is one resulting, perhaps, from the polluting activity of a producer, or the emission of greenhouse gases into the atmosphere. A positive externality is one where the activity of one individual confers a benefit on others. An example here is where individuals choose to get immunized against a particular illness. As more people become immune, the lower is the probability that the illness can propagate itself through hosts, and therefore the greater the benefits to those not immunized.
Solutions to these market failures come in several forms: Government taxes and subsidies, or quota systems that place limits on the production of products generating externalities. Such solutions were explored in Chapter 5. Taxes on gasoline discourage its use and therefore reduce the emission of poisons into the atmosphere. Taxes on cigarettes and alcohol lower the consumption of goods that may place an additional demand on our publicly-funded health system. The provision of free, or low-cost, immunization against specific diseases to children benefits the whole population.
These measures attempt to compensate for the absence of a market in certain activities. Producers may not wish to pay for the right to emit pollutants, and consequently if the government steps in to counter such an externality, the government is effectively implementing a solution to the missing market.
Public goods
Public goods are sometimes called collective consumption goods, on account of their non-rivalrous and non-excludability characteristics. For example, if the government meteorological office provides daily forecasts over the nation's airwaves, it is no more expensive to supply that information to one million than to one hundred individuals in the same region. Its provision to one is not rivalrous with its provision to others – in contrast to private goods that cannot be 'consumed' simultaneously by more than one individual. In addition, it may be difficult to exclude certain individuals from receiving the information.
Public goods are non-rivalrous, in that they can be consumed simultaneously by more than one individual; additionally they may have a non-excludability characteristic.
Examples of such goods and services abound: Highways (up to their congestion point), street lighting, information on trans-fats and tobacco, or public defence provision. Such goods pose a problem for private markets: If it is difficult to exclude individuals from their consumption, then potential private suppliers will likely be deterred from supplying them because the suppliers cannot generate revenue from free-riders. Governments therefore normally supply such goods and services. But how much should governments supply? An answer is provided with the help of Figure 14.1.
Figure 14.1 Optimal provision of a public good
The total demand for the public good D is the vertical sum of the individual demands DA and DB. The optimal provision is where the MC equals the aggregate marginal valuation, as defined by the demand curve D. At the optimum Q×, each individual is supplied the same amount of the public good.
This is a supply-demand diagram with a difference. The supply side is conventional, with the MC of production representing the supply curve. An efficient use of the economy's resources, we already know, dictates that an amount should be produced so that the cost at the margin equals the benefit to consumers at the margin. In contrast to the total market demand for private goods, which is obtained by summing individual demands horizontally, the demand for public goods is obtained by summing individual demands vertically.
Figure 14.1 depicts an economy with just two individuals whose demands for street lighting are given by DA and DB. These demands reveal the value each individual places on the various output levels of the public good, measured on the x-axis. However, since each individual can consume the public good simultaneously, the aggregate value of any output produced is the sum of each individual valuation. The valuation in the market of any quantity produced is therefore the vertical sum of the individual demands. D is the vertical sum of DA and DB, and the optimal output is Q×. At this equilibrium each individual consumes the same quantity of street lighting, and the MC of the last unit supplied equals the value placed upon it by society – both individuals. Note that this 'optimal' supply depends upon the income distribution, as we have stated several times to date. A different distribution of income may give rise to different demands DA and DB, and therefore a different 'optimal' output.
Efficient supply of public goods is where the marginal cost equals the sum of individual marginal valuations, and each individual consumes the same quantity.
Application Box 14.1 Are Wikipedia, Google and MOOCs public goods?
Wikipedia is one of the largest on-line sources of free information in the world. It is an encyclopedia that functions in multiple languages and that furnishes information on millions of topics. It is freely accessible, and is maintained and expanded by its users. Google is the most frequently used search engine on the World Wide Web. It provides information to millions of users simultaneously on every subject imaginable. But it is not quite free of charge; when the user searches she supplies information on herself that can be used profitably by Google in its advertising. MOOCs are 'monster open online courses' offered by numerous universities, frequently for no charge to the student. Are these services public goods in the sense we have described?
Very few goods and services are pure public goods, some have the major characteristics of public goods nonetheless. In this general sense, Google, Wikipedia and MOOCs have public good characteristics. Wikipedia is funded by philanthropic contributions, and its users expand its range by posting information on its servers. Google is funded from advertising revenue. MOOCs are funded by university budgets.
A pure public good is available to additional users at zero marginal cost. This condition is essentially met by these services since their server capacity rarely reaches its limit. Nonetheless, they are constantly adding server capacity, and in that sense cannot furnish their services to an unlimited number of additional users at no additional cost.
Knowledge is perhaps the ultimate public good; Wikipedia, Google and MOOCs all disseminate knowledge, knowledge which has been developed through the millennia by philosophers, scientists, artists, teachers, research laboratories and universities.
A challenge in providing the optimal amount of government-supplied public goods is to know the value that users may place upon them – how can the demand curves DA and DB, be ascertained, for example, in Figure 14.1? In contrast to markets for private goods, where consumer demands are essentially revealed through the process of purchase, the demands for public goods may have to be uncovered by means of surveys that are designed so as to elicit the true valuations that users place upon different amounts of a public good. A second challenge relates to the pricing and funding of public goods: For example, should highway lighting be funded from general tax revenue, or should drivers pay for it? These are complexities that are beyond our scope of our current inquiry.
Asymmetric information
Markets for information abound in the modern economy. Governments frequently supply information on account of its public good characteristics. But the problem of asymmetric information poses additional challenges. Asymmetric information is where at least one party in an economic relationship has less than full information. This situation characterizes many interactions: Life-insurance companies do not have perfect information on the lifestyle and health of their clients; used vehicle buyers may not know the history of the vehicles they are buying.
Asymmetric information is where at least one party in an economic relationship has less than full information and has a different amount of information from another party.
Asymmetric information can lead to two kinds of problems. The first is adverse selection. For example, can the life-insurance company be sure that it is not insuring only the lives of people who are high risk and likely to die young? If primarily high-risk people buy such insurance then the insurance company must set its premiums accordingly: The company is getting an adverse selection rather than a random selection of clients. Frequently governments decide to run universal compulsory-membership insurance plans (auto or health are examples in Canada) precisely because they may not wish to charge higher rates to higher-risk individuals.
Adverse selection occurs when incomplete or asymmetric information describes an economic relationship.
A related problem is moral hazard. If an individual does not face the full consequences of his actions, his behaviour may be influenced: if a homeowner has a fully insured home he may be less security conscious than an owner who does not.
In Chapter 7 we described how US mortgage providers lent large sums to borrowers with uncertain incomes in the early years of the new millennium. The individuals responsible for the lending were being rewarded on the basis of the amount lent, not the safety of the loan. Nor were the lenders responsible for loans that were not repaid. This 'sub-prime mortgage crisis' was certainly a case of moral hazard.
Moral hazard may characterize behaviour where the costs of certain activities are not incurred by those undertaking them.
Solutions to these problems do not always involve the government, but in critical situations do. For example, the government requires most professional societies and orders to ensure that their members are trained, accredited and capable. Whether for a medical doctor, a plumber or an engineer, a license or certificate of competence is a signal that the work and advice of these professionals is bona fide. Equally, the government sets standards so that individuals do not have to incur the cost of ascertaining the quality of their purchases – bicycle helmets must satisfy specific crash norms; so too must air-bags in automobiles.
These situations differ from those where solutions to the information problem can be dealt with reasonably well in the market place. For example, with the advent of buyer and seller rating on Airbnb, a potential renter can learn of the quality of the accommodation he is considering, and the letor can assess the potential renter.
Concentration of power
Monopolistic and imperfectly-competitive market structures can give rise to inefficient outcomes, in the sense that the value placed on the last unit of output does not equal the cost at the margin. This arises because the supplier uses his market power in order to maximize profits by limiting output and selling at a higher price.
What can governments do about such power concentrations? Every developed economy has a body similar to Canada's Competition Bureau. Such regulatory bodies are charged with seeing that the interests of the consumer, and the economy more broadly, are represented in the market place. Interventions, regulatory procedures and efforts to prevent the abuse of market power come in a variety of forms. These measures are examined in Section 14.5.
Unfavourable market outcomes
Even if governments successfully address the problems posed by the market failures described above, there is nothing to guarantee that market-driven outcomes will be 'fair', or accord with the prevailing notions of justice or equity. The marketplace generates many low-paying jobs, unemployment and poverty. The concentration of economic power has led to the growth in income and wealth inequality in many economies. Governments, to varying degrees, attempt to moderate these outcomes through a variety of social programs and transfers that are discussed in Section 14.4. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/14%3A_Government/14.01%3A_Market_Failure.txt |
Canada is a federal state, in which the federal, provincial and municipal governments exercise different powers and responsibilities. In contrast, most European states are unitary and power is not devolved to their regions to the same degree as in Canada or the US or Australia. Federalism confers several advantages over a unitary form of government where an economy is geographically extensive, or where identifiable differences distinguish one region from another: Regions can adopt different policies in response to the expression of different preferences by their respective voters; smaller governments may be better at experimentation and the introduction of new policies than large governments; political representatives are 'closer' to their constituents.
Despite these advantages, the existence of an additional level of government creates a tension between these levels. Such tension is evident in every federation, and federal and provincial governments argue over the appropriate division of taxation powers and revenue-raising power in general. For example, how should the royalties and taxes from oil and gas deposits offshore be distributed – to the federal government or a provincial government?
In Canada, the federal government collects more in tax revenue than it expends on its own programs. This is a feature of most federations. The provinces simultaneously face a shortfall in their own revenues relative to their program expenditure requirements. The federal government therefore redistributes, or transfers, funds to the provinces so that the latter can perform their constitutionally-assigned roles in the economy. The fact that the federal government bridges this fiscal gap gives it a degree of power over the provinces. This influence is commonly termed federal spending power.
Spending power of a federal government arises when the federal government can influence lower level governments due to its financial rather than constitutional power.
The principal revenue sources for financing federal government activity are given in Figure 14.1 for the fiscal year 2015-16, and the expenditure of these revenues is broken down in Figure 14.2. Further details are accessible in the Department of Finance's 'fiscal reference tables' at https://www.fin.gc.ca/frt-trf/2019/frt-trf-19-eng.asp. Total revenues for that fiscal year amounted to \$333.2b, and expenditures to \$346.2b.
The federal and provincial governments each transfer these revenues to individuals and other levels of government, supply goods and services directly, and also pay interest on accumulated borrowings – the national debt or provincial debt.
Provincial and local governments supply more goods and services than the federal government – health care, drug insurance, education and welfare are the responsibility of provincial and municipal governments. In contrast, national defence, the provision of main traffic arteries, Corrections Canada and a variety of transfer programs to individuals – such as Employment Insurance, Old Age Security and the Canada Pension Plan – are federally funded. The greater part of federal revenues goes towards transfers to individuals and provincial governments, as opposed to the supply of goods and services.
14.03: Federal-provincial fiscal relations
The federal government transfers revenue to the provinces using three main programs: Equalization, the Canada Social Transfer and the Canada Health Transfer. Each of these has a different objective. Equalization aims to reduce fiscal disparities among the provinces; The Canada Social Transfer (CST) is for educational and Social Assistance ('welfare') expenditures; The Canada Health Transfer (CHT) performs the same function for health.
Equalization and Territorial Funding
Canada's provinces receive unconditional funding through Canada's Equalization program, whereas the Territories receive federal funding through a separate mechanism - the Territorial Funding Formula.
"Parliament and the Government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public service at reasonably comparable levels of taxation."
This statement, from Section 36(2) of the Constitution Act of 1982, defines the purpose of Equalization. Equalization payments are unconditional – receiving provinces are free to spend the funds on public services according to their own priorities, or even use the revenue to reduce their provincial taxes. Payments are calculated according to a formula that ensures those provinces with revenue-raising ability, or fiscal capacity, below a threshold or 'standard' receive payments from the federal government to bring their capacity up to that standard.
Equalization has gone through very many changes in the several decades of its existence. Its current rules and regulations reflect the 2006 recommendations of a federal Expert Panel. The fiscal capacity of a province is measured by its ability to raise revenues from five major sources: Personal and business income taxes, sales taxes, property taxes, and natural resources. This ability is then compared to the ability of all of the provinces combined to raise revenue; if a difference or shortfall exists, the federal government transfers revenue accordingly, with the amount determined by both the population of the province and the magnitude of its per-person shortfall. Data on annual transfers for Equalization, the Territorial Funding Formula, and the CHT and CST are available at fin.gc.ca/fedprov/mtp-eng.asp
The program transferred \$19.8b to the provinces in 2019-20. The recipiency status of some provinces varies from year to year. Variation in energy prices and energy-based government revenues are the principal cause of this. British Columbia, Alberta, Saskatchewan and Ontario tend to receive little or zero. Manitoba, Quebec and the Atlantic Provinces have been the major recipient provinces. Quebec receives the largest single amount – approximately two thirds of the total allocation, both on account of its population size and the fact that it has a lower than average fiscal capacity. The Territories received a total of \$3.9b in 2019-20 through the Territorial Funding Formula.
The Canada Social Transfer and the Canada Health Transfer
The CST is a block transfer to provinces in support of post-secondary education, Social Assistance and social services more generally. The CST came into effect in 2004. Prior to that date it was integrated with the health component of federal transfers in a program titled the Canada Health and Social Transfer (CHST). The objective of the separation was to increase the transparency and accountability of federal support for health while continuing to provide funding for other objectives. The CHT is the other part of the unbundled CHST: It provides funding to the provinces for their health expenditures.
The CST and CHT funding comes in two parts: A cash transfer and tax transfer. A tax transfer essentially provides the same support as a cash transfer of equal value, but comes in a different form. In 1977 the federal government agreed with provincial governments to reduce federal personal and corporate tax rates in order to permit the provincial governments to increase the corresponding provincial rates. The net effect was that the federal government got less tax revenue and the provinces got more. And to this day, the federal and provincial governments keep a record of the implied tax transfers that arise from this long-ago agreement. This is the tax transfer component of the CST and the CHT.
The CST support is allocated to provinces and territories on an equal per-capita basis to ensure equal support for all Canadians regardless of their place of residence. The CHT is distributed likewise, and it requires the provinces to abide by the federally-legislated Canada Health Act, which demands that provincial health coverage be comprehensive, universal, portable, accessible and publicly administered.
The CHT transfer amounted to \$40.4b and the CST amounted to \$14.6b, in cash, for the year 2019-20. Health care and health expenditures are a core issue of policy at all levels of government on account of the envisaged growth in these expenditures that will inevitably accompany the aging of the baby-boomers. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/14%3A_Government/14.02%3A_Fiscal_federalism-_Taxing_and_spending.txt |
Many Canadians take pride in Canada's extensive 'social safety net' that aims to protect individuals from misfortune and the reduction of income in old age. Others believe it is too generous. While it is more supportive than the safety net in the US, the Canadian safety net is no more protective than the nets of the developed economies of the European Union. The extent of such support depends in large measure upon the degree to which governments are willing to impose, and individuals are willing to pay, higher or lower tax rates. The major elements of this umbrella of programs are the following.
The Canada and Quebec Pension Plans (C/QPP) are funded from the contributions of workers and their employers. Contributions form 9.9% of an individual's earnings up to the maximum pensionable earnings (MPE) figure of \$57,400 in 2019. The contributions are shared equally by employer and employee. The Canada and Quebec components of the plan operate similarly, but are managed separately. The contribution rate to the QPP stands at 10.65%. Contributions to the plans from workers and their employers are largely transferred immediately to retired workers. Part of the contributions is invested in a fund. The objective of the plans is to ensure that some income is saved for retirement. Many individuals are not very good at planning – they constantly postpone the decision to save, so the state steps in and requires them to save. An individual contributing throughout a full-time working lifecycle can expect an annual pension of about \$14,000 in 2019. The Plans provide a maximum payout of 25% of maximum insurable earnings. The objective is to provide a minimum level of retirement income, not an income that will see individuals live in great comfort.
The C/QPP plans have contributed greatly to the reduction of poverty among the elderly since their introduction in the mid-sixties. The aging of the baby-boom generation – that very large cohort born in the late forties through to the early sixties – means that the percentage of the population in the post-65 age group has begun to increase. To meet this changing demographic, the federal and provincial governments reshaped the plans in the late nineties in order to put them on a sound financial footing – primarily by increasing contributions, that in turn will enable the build-up of a CPP 'fund' that will support the aged in the following decades.
A number of recent studies in Canada on the retirement savings practices of Canadians have proposed that households on average are not saving a sufficient amount for their retirement; many households may thus see a notable decline in their incomes upon retirement. In response to this finding, the federal government agreed with the provinces in June 2016, to add a supplement to the CPP. The new federal provisions, which will be phased in over the period 2019-2025, envisage an increase in contributions that will ultimately lead to a maximum replacement rate of 33% of MPE as opposed to the current goal of 25%. However, full benefits will be experienced only by individuals contributing for their complete lifecycle, meaning that full implementation will take about four decades.
Details of the CPP and the 2016 enhancements are to be found at http://www.fin.gc.ca/n16/data/16-113_3-eng.asp.
Old Age Security (OAS), the Guaranteed Income Supplement (GIS) and the Spousal Allowance (SPA) together form the second support leg for the retired. OAS is a payment made automatically to individuals once they attain the age of 65. The GIS is an additional payment made only to those on very low incomes – for example, individuals who have little income from their C/QPP or private pension plans. The SPA, which is payable to the spouse or survivor of an OAS recipient, accounts for a small part of the sums disbursed. As of 2019 the maximum annual OAS payment stood at \$7,360. The federal government in 2016 reversed a plan that would have seen the eligible age for receipt of OAS move to 67.
The payments for these plans come from the general tax revenues of the federal government. Unlike the C/QPP, the benefits received are not related to the contributions that an individual makes over the working lifecycle. This program has also had a substantial impact on poverty reduction among the elderly.
Employment Insurance (EI) and Social Assistance (SA) are designed to support, respectively, the unemployed and those with no other source of income. Welfare is the common term used to describe SA. Expenditures on EI and SA are strongly cyclical. At the trough of an economic cycle the real value of expenditures on these programs greatly exceeds expenditures at the peak of the cycle. Unemployment in Canada rose above 8% in 2009, and payments to the unemployed and those on welfare reflected this dire state. The strongly cyclical pattern of the cost of these programs reflects the importance of a healthy job market: Macroeconomic conditions have a major impact on social program expenditures.
EI is funded by contributions from employees and their employers. For each dollar contributed by the employee, the employer contributes \$1.4. Premiums are paid on earned income up to a maximum insurable earnings (MIE) of \$53,100 in 2019. The contribution rate for employees stood at 1.62% of MIE in 2017. EI contributions and pay-outs form part of the federal government's general revenues and expenditures. There is no separate 'fund' for this program. However it is expected to operate on a break-even basis over the longer term. To reflect this, the contribution rate fluctuates with a view to maintaining a balance between payouts and revenues over a seven-year planning period.
EI is called an insurance program, but in reality it is much more than that. Certain groups systematically use the program more than others – those in seasonal jobs, those in rural areas and those in the Atlantic Provinces, for example. Accordingly, using the terminology of Chapter 7, it is not everywhere an actuarially 'fair' insurance program. Benefits payable to unemployed individuals may also depend on their family size, in addition to their work history. While most payments go in the form of 'regular' benefits to unemployed individuals, the EI program also sponsors employee retraining, family benefits that cover maternity and paternity leave, and some other specific target programs for the unemployed.
Social Assistance is provided to individuals who are in serious need of financial support – having no income and few assets. Provincial governments administer SA, although the cost of the program is partly covered by federal transfers through the Canada Social Transfer. The nineteen nineties witnessed a substantial tightening of regulations virtually across the whole of Canada. Access to SA benefits is now more difficult, and benefits have fallen in real terms since the late nineteen eighties.
Welfare dependence peaked in Canada in 1994, when 3.1 million individuals were dependent upon support. As of 2019, the total is approximately half of this, on account of more stringent access conditions, reduced benefit levels and an improved job market. Some groups in Canada believe that benefits should be higher, others believe that making welfare too generous provides young individuals with the wrong incentives in life, and may lead them to neglect schooling and skill development.
Workers Compensation supports workers injured on the job. Worker/employer contributions and general tax revenue form the sources of program revenue, and the mix varies from province-to-province. In contrast to the macro-economy-induced swings in expenditures that characterize SA and EI since the early nineties, expenditures on Worker's Compensation have remained relatively constant.
Canada Child Benefit: The major remaining pillar in Canada's social safety net is the group of payments and tax credits aimed at supporting children: The Canada Child Tax Benefit (CCTB), the Universal Child Care Benefit and the National Child Benefit Supplement were repackaged in 2016 under the title Canada Child Benefit. Child support has evolved and been enriched over the last two decades, partly with the objective of reducing poverty among households with children, and partly with a view to helping parents receiving social assistance to transition back to the labour market. As of 2016, the federal government provides an annual payment to families with children. For each child under the age of 6 the payment is \$6,639 and for each child aged 6-17 the payment is \$5,602. Since these payment are primarily intended for households with low and middle incomes, the amounts are progressively clawed back once the household income reaches a threshold of \$30,000.
Application Box 14.2 Government debts and deficits
Canada's expenditure and tax policies in the nineteen seventies and eighties led to the accumulation of large government debts, as a result of running fiscal deficits. By the mid-nineties the combined federal and provincial debt reached 100% of GDP, with the federal debt accounting for the larger share. This ratio was perilously high: Interest payments absorbed a large fraction of annual government revenues, which in turn limited the ability of the government to embark on new programs or enrich existing ones. Canada's debt rating on international financial markets declined.
In 1995, Finance Minister Paul Martin addressed this problem, and over the following years program spending was pared back. Ultimately, the economy expanded and by the end of the decade the annual deficits at the federal level were eliminated.
As of 2007 the ratio of combined federal and provincial debts stood at just over 60% of GDP. However, the Great Recession of 2008 and following years saw all levels of government experience deficits, with the result that this ratio of combined debt to GDP rose again. Growth in recent years has seen that ratio fall. As of 2018-19, federal interest payments on its debt account for about 7% of its revenues (this figure stood at 28% in the early nineties). At the time of writing, interest rates are low in developed economies and so the interest costs of government debt are low. Low borrowing costs are a reason why some people favor large government spending in the form of infrastructure projects. Those who are fiscally more conservative fear rising rates in the future. The recessionary impacts of the coronavirus pandemic of 2020 will add greatly to accumulated debt, particularly at the federal level.
Debts can be measured in more than a single manner. One measure of debt is the value of all federal government bonds and financial liabilities outstanding. As of 2019-20 this value was approximately \$700b. In addition to this, the federal government has outstanding liabilities to the pensions of its retired employees, and not all of these liabilities have been covered by the contributions of those employees into their pension plans. The federal government also owns assets, both financial and physical - such as office buildings. Hence these assets offset the financial liabilities. To assess the total debt picture of the Canadian economy we need to add provincial and local government debts to the federal debts, and then consider the annual interest costs of this total. It turns out that the interest costs are just above 2% of GDP.
Source: Government of Canada, Fiscal Reference Tables: https://www.fin.gc.ca/frt-trf/2019/frt-trf-19-eng.asp | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/14%3A_Government/14.04%3A_Government-to-individual_transfers.txt |
Goals and objectives
The goals of competition policy are relatively uniform across developed economies: The promotion of domestic competition; the development of new ideas, new products and new enterprises; the promotion of efficiency in the resource-allocation sense; the development of manufacturing and service industries that can compete internationally.
In addition to these economic objectives, governments and citizens frown upon monopolies or monopoly practices if they lead to an undue concentration of political power. Such power can lead to a concentration of wealth and influence in the hands of an elite.
Canada's regulatory body is the Competition Bureau, whose activity is governed primarily by the Competition Act of 1986. This act replaced the Combines Investigation Act. The Competition Tribunal acts as an adjudication body, and is composed of judges and non- judicial members. This tribunal can issue orders on the maintenance of competition in the marketplace. Canada has had anti-combines legislation since 1889, and the act of 1986 is the most recent form of such legislation and policy. The Competition Act does not forbid monopolies, but it does rule as unlawful the abuse of monopoly power. Canada's competition legislation is aimed at anti-competitive practices, and a full description of its activities is to be found on its website at www.competitionbureau.gc.ca. Let us examine some of these proscribed policies.
Anti-competitive practices
Anti-competitive practices may either limit entry into a sector of the economy or force existing competitors out. In either case they lead to a reduction in competition.
Mergers may turn competitive firms into a single organization with excessive market power. The customary justification for mergers is that they permit the merged firms to achieve scale economies that would otherwise be impossible. Such scale economies may in turn result in lower prices in the domestic or international market to the benefit of the consumer, but may alternatively reduce competition and result in higher prices. Equally important in this era of global competition is the impact of a merger on a firm's ability to compete internationally.
Mergers can be of the horizontal type (e.g. two manufacturers of pre-mixed concrete merge) or vertical type (a concrete manufacturer merges with a cement manufacturer). In a market with few suppliers mergers have the potential to reduce domestic competition.
Cartels aim to restrict output and thereby increase profits. These formations are almost universally illegal in individual national economies.
While cartels are one means of increasing prices, price discrimination is another, as we saw when studying monopoly behaviour. For example, if a concrete manufacturer makes her product available to large builders at a lower price than to small-scale builders – perhaps because the large builder has more bargaining power – then the small builder is at a competitive disadvantage in the construction business. If the small firm is forced out of the construction business as a consequence, then competition in this sector is reduced.
We introduced the concept of predatory pricing in Chapter 11. Predatory pricing is a practice that is aimed at driving out competition by artificially reducing the price of one product sold by a supplier. For example, a dominant nationwide transporter could reduce price on a particular route where competition comes from a strictly local competitor. By 'subsidizing' this route from profits on other routes, the dominant firm could undercut the local firm and drive it out of the market.
Predatory pricing is a practice that is aimed at driving out competition by artificially reducing the price of one product sold by a supplier.
Suppliers may also refuse to deal. If the local supplier of pre-mixed concrete refuses to sell the product to a local construction firm, then the ability of such a downstream firm to operate and compete may be compromised. This practice is similar to that of exclusive sales and tied sales. An exclusive sale might involve a large vegetable wholesaler forcing her retail clients to buy only from this supplier. Such a practice might hurt the local grower of aubergines or zucchini, and also may prevent the retailer from obtaining some of her vegetables at a lower price or at a higher quality elsewhere. A tied sale is one where the purchaser must agree to purchase a bundle of goods from a supplier.
Refusal to deal: an illegal practice where a supplier refuses to sell to a purchaser.
Exclusive sale: where a retailer is obliged (perhaps illegally) to purchase all wholesale products from a single supplier only.
Tied sale: one where the purchaser must agree to purchase a bundle of goods from a supplier.
Resale price maintenance involves the producer requiring a retailer to sell a product at a specified price. This practice can hurt consumers since they cannot 'shop around'. In Canada, we frequently encounter a 'manufacturer's suggested retail price' for autos and durable goods. But since these prices are not required, the practice conforms to the law.
Resale price maintenance is an illegal practice wherein a producer requires sellers to maintain a specified price.
Bid rigging is an illegal practice in which normally competitive bidders conspire to fix the awarding of contracts or sales. For example, two builders, who consider bidding on construction projects, may decide that one will bid seriously for project X and the other will bid seriously on project Y. In this way they conspire to reduce competition in order to make more profit.
Bid rigging is an illegal practice in which bidders (buyers) conspire to set prices in their own interest.
Deception and dishonesty in promoting products can either short-change the consumer or give one supplier an unfair advantage over other suppliers.
Enforcement
The Competition Act is enforced through the Competition Bureau in a variety of ways. Decisions on acceptable business practices are frequently reached through study and letters of agreement between the Bureau and businesses. In some cases, where laws appear to have been violated, criminal proceedings may follow.
Regulation, deregulation and privatization
The last three decades have witnessed a significant degree of privatization and deregulation in Canada, most notably in the transportation, communication and energy sectors. Modern deregulation in the US began with the passage of the Airline Deregulation Act of 1978, and was pursued with great energy under the Reagan administration in the eighties. The Economic Council of Canada produced an influential report in 1981, titled "Reforming Regulation," on the impact of regulation and possible deregulation of specific sectors. The Economic Council proposed that regulation in some sectors was inhibiting competition, entry and innovation. As a consequence, the interests of the consumer were in danger of becoming secondary to the interests of the suppliers.
Telecommunications provision, in the era when the telephone was the main form of such communication, was traditionally viewed as a natural monopoly. The Canadian Radio and Telecommunications Commission (CRTC) regulated its rates. The industry has developed dramatically in the last two decades with the introduction of satellite-facilitated communication, the internet, multi-purpose cable networks, cell phones and service integration.
Transportation, in virtually all forms, has been deregulated in Canada since the nineteen eighties. Railways were originally required to subsidize the transportation of grain under the Crow's Nest Pass rate structure. But the subsidization of particular markets requires an excessive rate elsewhere, and if the latter markets become subject to competition then a competitive system cannot function. This structure, along with many other anomalies, was changed with the passage of the Canada Transportation Act in 1996.
Trucking, historically, has been regulated by individual provinces. Entry was heavily controlled prior to the federal National Transportation Act of 1987, and subsequent legislation introduced by a number of provinces, have made for easier entry and a more competitive rate structure.
Deregulation of the airline industry in the US in the late seventies had a considerable influence on thinking and practice in Canada. The Economic Council report of 1981 recommended in favour of easier entry and greater fare competition. These policies were reflected in the 1987 National Transportation Act. Most economists are favourable to deregulation and freedom to enter, and the US experience indicated that cost reductions and increased efficiency could follow. In 1995 an agreement was reached between the US and Canada that provided full freedom for Canadian carriers to move passengers to any US city, and freedom for US carriers to do likewise, subject to a phase-in provision.
The National Energy Board regulates the development and transmission of oil and natural gas. But earlier powers of the Board, involving the regulation of product prices, were eliminated in 1986, and controls on oil exports were also eliminated.
Agriculture remains a highly controlled area of the economy. Supply 'management', which is really supply restriction, and therefore 'price maintenance', characterizes grain, dairy, poultry and other products. Management is primarily through provincial marketing boards.
The role of the sharing economy
The arrival of universal access to the internet has seen the emergence of what is known as the Sharing economy throughout the world. This expression is used to describe commercial activities that, in the first place, are internet-based. Second, suppliers in the sharing economy use resources in the market place that were initially aimed at a different purpose. Airbnb and Uber are good examples of companies in sectors of the economy where sharing is possible. In Uber's case, the 'ride-share' drivers initially purchased their vehicles for private use, and subsequently redirected them to commercial use. Airbnb is a communication corporation that enables the owners of spare home capacity to sell the use of that capacity to short-term renters. With the maturation of such corporations, the concept of 'initial' and 'secondary' use becomes blurred.
Sharing economy: involves enterprises that are internet based, and that use production resources that have use outside of the marketplace.
The importance of the sharing economy is that it provides an additional source of competition to established suppliers, and therefore limits the market power of the latter. At the same time, the emergence of the sharing economy poses a new set of regulatory challenges: If traditional taxis are required to purchase operating permits (medallions), and the ride-share drivers do not require such permits, is there a reasonable degree of competition in the market, and if not what is the appropriate solution? Should the medallion requirement be abolished, or should ride-share drivers be required to purchase one? In the case of Airbnb, the suppliers operate outside of the traditional 'hotel' market. In general they do not charge sales taxes or face any union labour agreements. What is the appropriate response from governments? And how should the sharing economy be taxed?
Price regulation
Regulating monopolistic sectors of the economy is one means of reducing their market power. In Chapter 11 it was proposed that indefinitely decreasing production costs in an industry means that the industry might be considered as a 'natural' monopoly: Higher output can be produced at lower cost with fewer firms. Hence, a single supplier has the potential to supply the market at a lower unit cost; unless, that is, such a single supplier uses his monopoly power. To illustrate how the consumer side may benefit from this production structure through regulation, consider Figure 14.2. For simplicity suppose that long-run marginal costs are constant and that average costs are downward sloping due to an initial fixed cost. The profit-maximizing (monopoly) output is where MR=MC at Qm and is sold at the price Pm. This output is inefficient because the willingness of buyers to pay for additional units of output exceeds the additional cost. On this criterion the efficient output is Q×. But LATC exceeds price at Q×, and therefore it is not feasible for a producer.
Figure 14.2 Regulating a decreasing-cost supplier
The profit-maximizing output is Qm, where MR=MC and price is Pm. This output is inefficient because marginal benefit is greater than MC. Q× is the efficient output, but results in losses because LATC>P at that output. A regulated price that covers costs is where LATC=DQr. This is closer to the efficient output Q× than the monopoly output Qm.
One solution is for the regulating body to set a price-quantity combination of Pr, and Qr, where price equals average cost and therefore generates a normal rate of profit. This output level is still lower than the efficient output level Q×, but is more efficient than the profit-maximizing output Qm. It is more efficient in the sense that it is closer to the efficient output Q×. A problem with such a strategy is that it may induce lax management: If producers are allowed to charge an average-cost price, then there is a reduced incentive for them to keep strict control of their costs in the absence of competition in the marketplace.
A second solution to the declining average cost phenomenon is to implement what is called a two-part tariff. This means that customers pay an 'entry fee' in order to be able to purchase the good. For example, in many jurisdictions hydro or natural gas subscribers may pay a fixed charge per month for their supply line and supply guarantee, and then pay an additional charge that varies with quantity. In this way it is possible for the supplier to charge a price per unit of output that is closer to marginal cost and still make a profit, than under an average cost pricing formula. In terms of Figure 14.2, the total value of entry fees, or fixed components of the pricing, would have to cover the difference between MC and LATC times the output supplied. In Figure 14.2 this implies that if the efficient output is purchased at a price equal to the MC the producer loses the amount (cMC) on each unit sold. The access fees would therefore have to cover at least this value.
Such a solution is appropriate when fixed costs are high and marginal costs are low. This situation is particularly relevant in the modern market for telecommunications: The cost to suppliers of marginal access to their networks, whether it be for internet, phone or TV, is negligible compared to the cost of maintaining the network and installing capacity.
Two-part tariff: involves an access fee and a per unit of quantity fee.
Finally, a word of caution: Nobel Laureate George Stigler has argued that there is a danger of regulators becoming too close to the regulated, and that the relationship can evolve to a point where the regulator may protect the regulated firms. In contrast, Professor Philippon of New York University argues that regulators are not regulating sufficiently in the US: they have permitted an excessive number of mergers that have, in turn, reduced competition. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/14%3A_Government/14.05%3A_Regulation_and_competition_policy.txt |
Market failure defines outcomes in which the allocation of resources is not efficient.
Public goods are non-rivalrous, in that they can be consumed simultaneously by more than one individual; additionally they may have a non-excludability characteristic.
Efficient supply of public goods is where the marginal cost equals the sum of individual marginal valuations, and each individual consumes the same quantity.
Asymmetric information is where at least one party in an economic relationship has less than full information and has a different amount of information from another party.
Adverse selection occurs when incomplete or asymmetric information describes an economic relationship.
Moral hazard may characterize behaviour where the costs of certain activities are not incurred by those undertaking them.
Spending power of a federal government arises when the federal government can influence lower level governments due to its financial rather than constitutional power.
Predatory pricing is a practice that is aimed at driving out competition by artificially reducing the price of one product sold by a supplier.
Refusal to deal: an illegal practice where a supplier refuses to sell to a purchaser.
Exclusive sale: where a retailer is obliged (perhaps illegally) to purchase all wholesale products from a single supplier only.
Tied sale: one where the purchaser must agree to purchase a bundle of goods from the one supplier.
Resale price maintenance is an illegal practice wherein a producer requires sellers to maintain a specified price.
Bid rigging is an illegal practice in which bidders (buyers) conspire to set prices in their own interest.
Sharing economy: involves enterprises that are internet based, and that use production resources that have use outside of the marketplace.
Two-part tariff: involves an access fee and a per unit of quantity fee.
14.07: Exercises for Chapter 14
EXERCISE 14.1
An economy is composed of two individuals, whose demands for a public good – street lighting – are given by P=12–(1/2)Q and P=8–(1/3)Q.
1. Graph these demands on a diagram, for values of .
2. Graph the total demand for this public good by summing the demands vertically, specifying the numerical value of each intercept.
3. Let the marginal cost of providing the good be \$5 per unit. Illustrate graphically the efficient supply of the public good () in this economy.
4. Illustrate graphically the area that represents the total value to the consumers of the amount .
EXERCISE 14.2
In Exercise 14.1, suppose a new citizen joins the economy, and her demand for the public good is given by P=10–(5/12)Q.
1. Add this individual's demand curve to the graphic for the above question and graph the new total demand curve, specifying the intercept values.
2. Illustrate the area on your graph that represents the new total value to the three citizens of the optimal amount supplied.
3. Illustrate graphically the net value to society of the new – the total value minus the total cost.
EXERCISE 14.3
An industry that is characterized by a decreasing cost structure has a demand curve given by P=100–Q and the marginal revenue curve by MR=100–2Q. The marginal cost is MC=4, and average cost is AC=4+188/Q.
1. Graph this cost and demand structure. [Hint: This graph is similar to Figure 14.2.]
2. Illustrate the efficient output and the monopoly output for the industry.
3. Illustrate on the graph the price the monopolist would charge if he were unregulated.
EXERCISE 14.4
Optional: In Question 14.3, suppose the government decides to regulate the behaviour of the supplier, in the interests of the consumer.
1. Illustrate graphically the price and output that would emerge if the supplier were regulated so that his allowable price equalled average cost.
2. Is this greater or less than the efficient output?
3. Compute the AC and P that would be charged with this regulation.
4. Illustrate graphically the deadweight loss associated with the regulated price and compare it with the deadweight loss under monopoly.
EXERCISE 14.5
Optional: As an alternative to regulating the supplier such that price covers average total cost, suppose that a two part tariff were used to generate revenue. This scheme involves charging the MC for each unit that is purchased and in addition charging each buyer in the market a fixed cost that is independent of the amount he purchases. If an efficient output is supplied in the market, illustrate graphically the total revenue to be obtained from the component covering a price per unit of the good supplied, and the component covering fixed cost. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/14%3A_Government/14.06%3A_Key_Terms.txt |
Chapter 15: International trade
In this chapter we will explore:
15.1
Trade in our daily lives
15.2
Canada in the world economy
15.3
Gains from trade: Comparative advantage
15.4
Returns to scale and dynamic gains
15.5
Trade barriers: Tariffs, subsidies and quotas
15.6
The politics of protection
15.7
Institutions governing trade
15.1 Trade in our daily lives
Virtually every economy in the modern world trades with other economies – they are what we call 'open' economies. Evidence of such openness is everywhere evident in our daily life. The world eats Canadian wheat; China exports manufactured goods to almost anywhere we can think of; and Canadians take their holidays in Florida.
As consumers we value the choice and variety of products that trade offers. We benefit from lower prices than would prevail in a world of protectionism. At the same time there is a constant chorus of voices calling for protection from international competition: Manufacturers are threatened by production in Asia; farmers fight against the imports of poultry, beef, and dairy products; even the service sector is concerned about offshore competition from call centres and designers. In this world of competing views it is vital to understand how trade has the potential to improve the well-being of economies.
This chapter examines the theory of international trade, trade flows, and trade policy: Who trades with whom, in what commodities, and why. In general, countries trade with one another because they can buy foreign products at a lower price than it costs to make them at home. International trade reflects specialization and exchange, which in turn improve living standards. It is cost differences between countries rather than technological differences that drive trade: In principle, Canada could supply Toronto with olives and oranges grown in Nunavut greenhouses, but it makes more sense to import them from Greece, Florida or Mexico.
Trade between Canada and other countries differs from trade between provinces. By definition, international trade involves jumping a border, whereas most trade within Canada does not. Internal borders are present in some instances – for example when it comes to recognizing professional qualifications acquired out-of-province. In the second instance, international trade may involve different currencies. When Canadians trade with Europeans the trade is accompanied by financial transactions involving Canadian dollars and Euros. A Canadian buyer of French wine pays in Canadian dollars, but the French vineyard worker is paid in euros. Exchange rates are one factor in determining national competitiveness in international markets. Evidently, not every international trade requires currency trades at the same time – most members of the European Union use the Euro. Indeed a common currency was seen as a means of facilitating trade between member nations of the EU, and thus a means of integrating the constituent economies more effectively.
It is important at the outset to emphasize that while trade has the potential to improve aggregate well being in the trading economies, this does not mean that every citizen will benefit; some will gain others will lose out. Buyers usually gain as a result of having a wider array of products to purchase at lower prices. Successful producers may benefit from production efficiencies associated with accessing a global supply chain, while others may be squeezed by international competition. The former may export more and employ more workers, the latter may contract and lay off employees.
15.2 Canada in the world economy
World trade has grown rapidly since the end of World War II, indicating that trade has become ever more important to national economies. Canada has been no exception. Canada signed the Free Trade Agreement with the US in 1989, and this agreement was expanded in 1994 when Mexico was included under the North America Free Trade Agreement (NAFTA). Imports and exports rose dramatically, from approximately one quarter to forty percent of GDP. Canada is now what is termed a very 'open' economy – one where trade forms a large fraction of total production. In early 2017, Canada and the EU signed a trade agreement - the Comprehensive Economic and Trade Agreement (CETA). Under this agreement tariffs will be phased out or reduced in most areas of trade over a several-year period. Canada also signed the Comprehensive and Progressive Agreement on Trans-Pacific Trade in 2018 that has the same objective of reducing trade barriers between 11 Pacific-Rim member states.
Smaller economies are typically more open than large economies—Belgium and the Netherlands depend upon trade more than the United States. This is because large economies tend to have a sufficient variety of resources to supply much of an individual country's needs. The European Union is similar, in population terms, to the United States, but it is composed of many distinct economies. Some European economies are equal in size to individual American states. But trade between California and New York is not international, whereas trade between Italy and the Spain is.
Because our economy is increasingly open to international trade, events in the world economy affect our daily lives much more than in the past. The conditions in international markets for basic commodities and energy affect all nations, both importers and exporters. For example, the prices of primary commodities on world markets increased dramatically in the latter part of the 2000s. Higher prices for grains, oil, and fertilizers on world markets brought enormous benefits to Canada, particularly the Western provinces, which produce these commodities. In contrast, by early 2015, many of these prices dropped dramatically and Canadian producers suffered as a consequence.
The service sector accounts for more of our GDP than the manufacturing sector. As incomes grow, the demand for health, education, leisure, financial services, tourism, etc., dominates the demand for physical products. Technically, the income elasticity demand for the former group exceeds the income elasticity of demand for the latter. Internationally, while trade in services is growing rapidly, it still forms a relatively small part of total world trade. Trade in goods—merchandise trade—remains dominant, partly because many countries import unfinished goods, add some value, and re-export them. Even though the value added from such import-export activity may make just a small contribution to GDP, the gross flows of imports and exports can still be large relative to GDP. The transition from agriculture to manufacturing and then to services has been underway in developed economies for over a century. This transition has been facilitated in recent decades by the communications revolution and globalization. Globalization has seen a rapid shift in merchandise production from the developed to the developing world.
Table 15.1 shows the patterns of Canadian merchandise trade in 2018. The US is Canada's major trading partner, buying almost three quarters of our exports and supplying almost two thirds of imports. Table 15.2 details exports and imports by type. Although exports of resource-based products account for only about 40 percent of total merchandise exports, Canada is still viewed as a resource-based economy. This is in part because manufactures account for almost 80 percent of US and European merchandise exports and about 60 percent of Canadian exports. Nevertheless, Canada has important strength in machinery, equipment, and automotive products.
Table 15.1 Canada's Merchandise Trade Patterns 2018
Country Exports to Imports from
United States 73.9 64.4
European Union 7.9 10.5
China 5.0 7.6
Mexico 1.6 3.4
Others 11.6 14.1
Total 100 100
Dollar Total 585,255.7 607,205.4
Source: Adapted from Statistics Canada Table 12-10-0011-01
Table 15.2 Canadian Trade by Merchandise Type 2017
Sector Exports Imports
Farm, fishing, and intermediate food products 6.5 3.0
Energy products 20.5 5.5
Metal ores and non-metallic minerals 3.8 2.3
Metal and non-metallic mineral products 11.9 7.6
Basic and industrial chemical, plastic and rubber products 6.6 8.5
Forestry products and building and packaging materials 8.5 4.4
Industrial machinery, equipment and parts 5.3 9.7
Electronic and electrical equipment and parts 3.5 11.8
Motor vehicles and parts 16.3 20.0
Aircraft and other transportation equipment and parts 3.7 3.7
Consumer Goods 12.3 21.9
Special transactions trade 1.1 1.6
Total 100 100
Total dollar value in millions 500,892.6 561,425.9
Source: Adapted from Statistics Canada Table 12-10-0002-01
15.3 The gains from trade: Comparative advantage
In the opening chapter of this text we emphasized the importance of opportunity cost and differing efficiencies in the production process as a means of generating benefits to individuals through trade in the marketplace. The simple example we developed illustrated that, where individuals differ in their efficiency levels, benefits can accrue to each individual as a result of specializing and trading. In that example it was assumed that individual A had an absolute advantage in producing one product and that individual Z had an absolute advantage in producing the second good. This set-up could equally well be applied to two economies that have different efficiencies and are considering trade, with the objective of increasing their consumption possibilities. Technically, we could replace Amanda and Zoe with Argentina and Zambia, and nothing in the analysis would have to change in order to illustrate that consumption gains could be attained by both Argentina and Zambia as a result of specialization and trade.
Remember: The opportunity cost of a good is the quantity of another good or service given up in order to have one more unit of the good in question.
So, let us now consider two economies with differing production capabilities, as illustrated in Figures 15.1 and 15.2. In this instance it is assumed that one economy has an absolute advantage in both goods, but the degree of that advantage is greater in one good than the other. In international trade language, there exists a comparative advantage as well as an absolute advantage. It is frequently a surprise to students that this situation has the capacity to yield consumption advantages to each economy, even though one is absolutely more efficient in producing both of the goods. This is termed the principle of comparative advantage, and it states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies. This is a remarkable result, and much less intuitive than the principle of absolute advantage. We explore it with the help of the example developed in Figures 15.1 and 15.2.
Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.
We will name these two imaginary economies the US and Canada. Their production possibilities are defined by the PPFs in Figure 15.1. Canada can produce 5 units of V or 35 units of F, or any combination defined by the line joining these points. With the same resources the US can produce 8V or 40F, or any combination defined by its PPF1. With no trade, Canadians and Americans consume a combination of the goods defined by some point on their respective PPFs. The opportunity cost of a unit of V in Canada is 7F (the slope of Canada's PPF is 5/35=1/7). In the US the opportunity cost of one unit of V is 5F (slope is 8/40=1/5). In this set-up the US is more efficient in producing V than F relative to Canada, as reflected by the opportunity costs. Hence we say that the US has a comparative advantage in the production of V and that Canada has therefore a comparative advantage in producing F.
Figure 15.1 Comparative advantage – production
Canada specializes completely in Fish at 35, where it has a comparative advantage. Similarly, the US specializes in Vegetable at 8. They trade at a rate of 1:6. The US trades 3V to Canada in return for 18F.
Prior to trade each economy is producing all of the goods it consumes. This no-trade state is termed autarky.
Autarky denotes the no-trade situation.
The gains from trade
We now permit each economy to specialize in producing where it has a comparative advantage. So Canada specializes completely by producing 35F and the US produces 8V. Having done this the economies must now agree on the terms of trade. The terms of trade define the rate at which the two goods will trade post-specialization. Let us suppose that a bargaining process leads to agreement that one unit of V will trade for six units of F. Such a trading rate, one that lies between the opportunity costs of each economy, benefits both economies. This exchange rate lies between Canada's opportunity cost of 1:7 and the US opportunity cost of 1:5. By specializing in F, Canada can now obtain an additional unit of V by sacrificing six units of F, whereas pre-trade it had to sacrifice seven units of F for a unit of V. Technically, by specializing in F and trading at a rate of 1:6 Canada's consumption possibilities have expanded and are given by the consumption possibility frontier (CPF) illustrated in Figure 15.2. The consumption possibility frontier defines what an economy can consume after production specialization and trade.
Figure 15.2 Comparative advantage – consumption
Post specialization the economies trade 1V for 6F. Total production is 35F plus 8V. Hence one consumption possibility would be (18,5) for the US and (17,3) for Canada. Here Canada exchanges 18F in return for 3V.
The US also experiences an improved set of consumption possibilities. By specializing in V and trading at a rate of 1:6 its CPF lies outside its PPF and this enables it to consume more than in the pre-specialization state, where its CPF was defined by its PPF.
Evidently, the US and Canada CPFs are parallel since they trade with each other at the same rate: If Canada exports six units of F for every unit of V that it imports from the US, then the US must import the same six units of F for each unit of V it exports to Canada. The remarkable outcome here is that, even though one economy is more efficient in producing each good, specialization still leads to gains for both economies. The gain is illustrated by the fact that each economy's consumption possibilities lie outside of its production possibilities2.
Terms of trade define the rate at which the goods trade internationally.
Consumption possibility frontier defines what an economy can consume after production specialization and trade.
Comparative advantage and factor endowments
A traditional statement of why comparative advantage arises is that economies have different endowments of the factors of production – land, capital and labour endowments differ. A land endowment that facilitates the harvesting of grain (Saskatchewan) or the growing of fruit (California) may be innate to an economy. We say that wheat production is land intensive, that aluminum production is power intensive, that research and development is skill intensive, that auto manufacture is capital intensive, that apparel is labour intensive. Consequently, if a country is well endowed with some particular factors of production, it is to be expected that it will specialize in producing goods that use those inputs. A relatively abundant supply or endowment of one factor of production tends to make the cost of using that factor relatively cheap: It is relatively less expensive to produce clothing in China and wheat in Canada than the other way around. This explains why Canada's Prairies produce wheat, why Quebec produces aluminum, why Asia produces apparel. But endowments can evolve.
How can we explain why Switzerland specializes in watches, precision instruments, and medical equipment, while Vietnam specializes in rice, tourism and manufactured goods and components? Evidently, Switzerland made a decision to educate its population and invest in the capital required to produce these goods. It was not naturally endowed with these skills, in the same way that Greece is endowed with sun or Saskatchewan is endowed with fertile flat land.
While we have demonstrated the principle of comparative advantage using a two-good example (since we are constrained by the geometry of two dimensions), the conclusions carry over to the case of many goods. Furthermore, the principle has many applications. For example, if one person in the household is more efficient at doing all household chores than another, there are still gains to specialization provided the efficiency differences are not all identical. This is the principle of comparative advantage at work in a microcosm.
Application Box 15.1 The one hundred mile diet
In 2005 two young British Columbians embarked on what has famously become known as the 'one hundred mile diet'—a challenge to eat and drink only products grown within this distance of their home. They succeeded in doing this for a whole year, wrote a book on their experience and went on to produce a TV series. They were convinced that such a project is good for humanity, partly because they wrapped up ideas on organic farming and environmentally friendly practices in the same message.
Reflect now on the implications of this superficially attractive program: If North Americans were to espouse this diet, it would effectively result in the closing down of the midwest of the Continent. From Saskatchewan to Kansas, we are endowed with grain-producing land that is the envy of the planet. But since most of this terrain is not within 100 miles of any big cities, these deluded advocates are proposing that we close up the production of grains and cereals exactly in those locations where such production is extraordinarily efficient. Should we sacrifice grains and cereals completely in this hemisphere, or just cultivate them on a hillside close to home, even if the resulting cultivation were to be more labour and fuel intensive? Should we produce olives in greenhouses in Edmonton rather than importing them from the Mediterranean, or simply stop eating them? Should we sacrifice wine and beer in North Battleford because insufficient grapes and hops are grown locally?
Would production in temperate climates really save more energy than the current practice of shipping vegetables and fruits from a distance—particularly when there are returns to scale associated with their distribution? The 'one hundred mile diet' is based on precepts that are contrary to the norms of the gains from trade. In its extreme the philosophy proposes that food exports be halted and that the world's great natural endowments of land, water, and sun be allowed to lie fallow. Where would that leave a hungry world?
Table 15.1 shows the patterns of Canadian merchandise trade in 2008. The United States was and still is Canada's major trading partner, buying almost three quarters of our exports and supplying almost two thirds of Canadian imports. Table 15.2 details exports by type. Although exports of resource-based products account for only about 40 percent of total exports, Canada is now viewed as a resource-based economy. This is in part because manufactured products account for almost 80 percent of US and European exports but only about 60 percent of Canadian exports. Nevertheless, Canada has important export strength in machinery, equipment, and automotive products.
15.4 Returns to scale and dynamic gains from trade
The theory of comparative advantage explains why economies should wish to trade. The theory is based upon the view that economies are 'inherently' different in their production capabilities. But trade is influenced by more than these differences. We will explore how returns to scale may be exploited to generate benefits from trade, and also how economies might gain from one-another by learning as a result of trading. This learning can increase domestic productivity.
Returns to scale
One of the reasons Canada signed the North America Free trade Agreement (NAFTA) was that economists convinced the Canadian government that a larger market would enable Canadian producers to be even more efficient than in the presence of trade barriers. Rather than opening up trade in order to take advantage of existing comparative advantage, it was proposed that efficiencies would actually increase with market size. This argument is easily understood in terms of increasing returns to scale concepts that we developed in Chapter 8. Essentially, economists suggested that there were several sectors of the Canadian economy that were operating on the downward sloping section of their long-run average cost curve.
Increasing returns are evident in the world market place as well as the domestic marketplace. Witness the small number of aircraft manufacturers—Airbus and Boeing are the world's two major manufacturers of large aircraft. Enormous fixed costs—in the form of research, design, and development—or capital outlays frequently result in decreasing unit costs, and the world marketplace can be supplied at a lower cost if some specialization can take place. Facebook is the giant in social media. Entertainment streaming companies like Netflix, Amazon, Disney and Hulu are few in number because of scale economies. Consider the specific example of automotive trade. In North America, Canadian auto plants produce different vehicle models than their counterparts in the US. Canada exports some models of a given manufacturer to the United States and imports other models. This is the phenomenon of intra-industry trade and intra-firm trade. How can we explain these patterns?
Intra-industry trade is two-way international trade in products produced within the same industry.
Intra-firm trade is two-way trade in international products produced within the same firm.
In the first instance, intra-industry trade reflects the preference of consumers for a choice of brands; consumers do not all want the same vehicle, or the same software, or the same furnishings. The second element to intra-industry trade is that increasing returns to scale characterize many production processes. Let us see if we can transform the returns to scale ideas developed in earlier chapters into a production possibility framework.
Figure 15.3 Intra industry trade
Hunda can produce either 100,000 of each vehicle or 40,000 of both in each plant. Hence production possibilities are given by the points A, Z, and B. Pre-trade it produces at Z in each economy due to trade barriers. Post-trade it produces at A in one economy and B in the other, and ships the vehicles internationally. Total production increases from 160,000 to 200,000 using the same resources.
Consider the example presented in Figure 15.3, where the hypothetical company Hunda Motor Corporation currently has a large assembly plant in each of Canada and the US where it produces two types of vehicles; sedans and sports utility vehicles (SUVs). Intially, restrictions on trade in automobiles, in the form of tariffs, between the two countries make it too costly to ship models across the border. Hence Hunda produces both sedans and SUVs in each plant. But for several reasons, switching between model production is costly and results in reduced output. Hunda can produce 40,000 vehicles of each type per annum in its plants, but could produce 100,000 of a single model in each plant, using the same amount of capital and labour. This is a situation of increasing returns to scale, and in this instance the scale economies are what make gains from trade possible - as opposed to any innate comparative advantage between the economies. If trade barriers against the shipment of autos across national boundaries can be eliminated, then Hunda can take advantage of scale economies in each plant and increase its total production without using more capital and labour.
As this example implies, an opening up of trade increases the potential market size, and producers who experience increasing returns to scale stand to benefit from an enlarged market because their potential unit costs fall. Returns to scale are not limited to finished goods. Returns to scale characterize the production of many intermediate goods, which are goods used to produce other final goods or services. Manufacturers rarely produce all of the components entering their final products; they have supply chains for components that comprise numerous suppliers. In the automotive industry transmissions, gearboxes and seats are such intermediate goods. If either returns to scale, or comparative advantage, characterize their supply then there are gains to trade in these goods. In the context of the North American Free Trade Agreement (NAFTA). and its most recent form (the US Mexico and Canada Agreement - USMCA), automotive parts as well as automobiles can be shipped free of tariffs across borders provided that they satisfy regional value content (RVC) rules. We observe, for example, transmissions being produced in Ontario and seats in Mexico, and these goods are also shipped freely within North America provided they satisfy the RVC rules. Scale economies characterize transmission manufacture, and comparative advantage characterizes seat production – labour costs are lower in Mexico, and seats are labor intensive.
Content requirements apply to some goods under the NAFTA/USMCA. In the case of vehicles and their components, NAFTA required a 62.5% regional value content - that is, to be imported into one of the NAFTA signatories free of tariffs, 62.5% of the vehicle value had to be attributable to production in one of the three economies. This requirement was designed to prevent the members from using an excessive amount of components from low-wage economies and thereby undermine production of parts and vehicles in North America. The USMCA raises (by the year 2023) the regional value component (RVC) to 75% for most vehicles (70% for heavy trucks), and the RVC to between 65% and 75% on vehicle parts.
Supply chain: denotes the numerous sources for intermediate goods used in producing a final product
Intermediate good: one that is used in the production of final output
Regional value content: requires that a specified percentage of the final value of a product originate in the economies covered in the Agreement.
Dynamic gains from trade
The term dynamic gains denotes the potential for domestic producers to increase productivity as a result of competing with, and learning from, foreign producers.
Dynamic gains: the potential for domestic producers to increase productivity by competing with, and learning from, foreign producers.
Production processes in reality are seldom static. Innovation is constant in the modern world, and innovation is manifested in the form of productivity improvements. An economy's production possibility frontier is determined by its endowments of capital and labour and also the efficiency with which it uses those productive factors. Total factor productivity defines how efficiently the factors of production are combined. Research suggests that in developed economies this productivity increases by about 1% per annum. This means that more output can be produced using the same amounts of capital and labour because production is being carried out more efficiently. In graphical terms, such productivity improvements effectively push out an economy's production possibility frontier by 1% per annum. For economies in the process of development, this productivity growth may be as high as 3% or 4% per annum – for the reason that these economies can observe and learn from economies that are ahead of it technologically.
Freer trade forces domestic firms to compete with foreign firms that may be more productive. Domestic firms that can learn and adapt to competition by becoming more efficient will survive, firms that cannot adapt will not. Inevitably, there will be winners and losers in the production sector of the economy, whereas in the consumption sector most consumers should be winners.
Total factor productivity: a measure of how efficiently the factors of production are combined.
15.5 Trade barriers: Tariffs, subsidies and quotas
Despite the many good arguments favoring free or relatively free trade, we observe numerous trade barriers. These barriers come in several forms. A tariff is a tax on an imported product that is designed to limit trade and generate tax revenue. It is a barrier to trade. An import quota is a limitation on imports; other non-tariff barriers take the form of product content requirements, and subsidies. By raising the domestic price of imports, a tariff helps domestic producers but hurts domestic consumers. Quotas and other non-tariff barriers have similar impacts.
A tariff is a tax on an imported product that is designed to limit trade in addition to generating tax revenue.
A quota is a quantitative limit on an imported product.
A trade subsidy to a domestic manufacturer reduces the domestic cost and limits imports.
Non-tariff barriers, such as product content requirements, limit the gains from trade.
Application Box 15.2 Tariffs – the national policy of J.A. MacDonald
In Canada, tariffs were the main source of government revenues, both before and after Confederation in 1867 and up to World War I. They provided 'incidental protection' for domestic manufacturing. After the 1878 federal election, tariffs were an important part of the National Policy introduced by the government of Sir John A. MacDonald. The broad objective was to create a Canadian nation based on east-west trade and growth.
This National Policy had several dimensions. Initially, to support domestic manufacturing, it increased tariff protection on foreign manufactured goods, but lowered tariffs on raw materials and intermediate goods used in local manufacturing activity. The profitability of domestic manufacturing improved. But on a broader scale, tariff protection, railway promotion, Western settlement, harbour development, and transport subsidies to support the export of Canadian products were intended to support national economic development. Although reciprocity agreements with the United States removed duties on commodities for a time, tariff protection for manufactures was maintained until the GATT negotiations of the post-World War II era.
Tariffs
Figure 15.4 describes how tariffs operate. We can think of this as the Canadian wine market—a market that is heavily taxed in Canada. The world price of Cabernet Sauvignon is, let us say, \$10 per bottle, and this is shown by the horizontal world supply curve at that price. To maintain simplicity, we will neglect any taxes on alcohol here other than the tax represented by the tariff. The international supply curve is horizontal because the domestic market accounts for only a small part of the world demand for wine: we are sufficiently small that international producers can supply us with any amount we wish to buy at the world price. The Canadian demand for this wine is given by the demand curve D, and Canadian suppliers have a supply curve given by S (Canadian Cabernet is assumed to be of the same quality as the imported variety in this example). The effective supply curve in the Canadian market is now BCM. At a price of \$10, Canadian consumers wish to buy litres, and domestic producers wish to supply litres. The gap between domestic supply and domestic demand is filled by imports. This is the free trade equilibrium.
Figure 15.4 Tariffs and trade
At a world price of \$10 the domestic quantity demanded is QD. Of this amount Qs is supplied by domestic producers and the remainder by foreign producers. A tariff increases the world price to \$12. This reduces demand to ; the domestic component of supply increases to . Of the total loss in consumer surplus (LFGJ), tariff revenue equals EFHI, increased surplus for domestic suppliers equals LECJ, and the deadweight loss is therefore the sum of the triangular areas CEI and HFG.
If the government now imposes a 20 percent tariff on imported wines (or a \$2 per bottle tax), foreign wine sells for \$12 a bottle, inclusive of the tariff. The effective supply curve in the Canadian market becomes BEK. The tariff raises the domestic 'tariff-inclusive' price above the world price, and this shifts the international supply curve of this wine upwards. By raising wine prices in the domestic market, the tariff protects domestic producers by raising the domestic price at which imports become competitive. Those domestic suppliers who were previously not quite competitive at a global price of \$10 are now competitive. The total quantity demanded falls from QD to at the new equilibrium F. Domestic producers supply the amount and imports fall to the amount . Reduced imports are partly displaced by those domestic producers who can supply at prices between \$10 and \$12. Hence, imports fall both because total consumption falls and because domestic suppliers can displace some imports under the protective tariff; the amount .
Since the tariff is a type of tax, its impact in the market depends upon the elasticities of supply and demand, (as illustrated in Chapters 4 and 5). The more elastic is the demand curve, the more a given tariff reduces imports. In contrast, if it is inelastic the quantity of imports declines less.
Costs and benefits of a tariff
The costs of a tariff come from the higher price to consumers, but this is partly offset by the tariff revenue that goes to the government. This tariff revenue is a benefit and can be redistributed to consumers or spent on goods from which consumers derive a benefit. But there are also efficiency costs associated with tariffs—deadweight losses, as we call them. These are the real costs of the tariff, and they arise because the marginal cost of production does not equal the marginal benefit to the consumer. Let us see how these concepts apply with the help of Figure 15.4.
Consumer surplus is the area under the demand curve and above the equilibrium market price. It represents the total amount consumers would have been willing to pay for the product, but did not have to pay, at the equilibrium price. It is a measure of consumer welfare. The tariff raises the market price and reduces this consumer surplus by the amount LFGJ. This area measures by how much domestic consumers are worse off as a result of the price increase caused by the tariff. But this is not the net loss for the whole domestic economy, because the government obtains some tax revenue and domestic producers get more revenue and profit.
Government revenue accrues from the domestic sales of imports. On imports of , tax revenue is EFHI. Then, domestic producers obtain an additional profit of LECJ—the excess of additional revenue over their cost per additional bottle. If we are not concerned about who gains and who loses, then there is a net loss to the domestic economy equal to the areas CEI and HFG.
The area HFG is the consumer side measure of deadweight loss. At the quantity , the production cost of an additional bottle is less than the value placed on it by consumers; and, by not having those additional bottles supplied, consumers forgo a potential gain. The area CEI tells us that when supply by domestic higher-cost producers is increased, and supply of lower-cost foreign producers is reduced, the corresponding resources are not being used efficiently. The sum of the areas CEI and HFG is therefore the total deadweight loss of the tariff.
In the real world we should also be interested in the magnitude of the financial amounts involved here: In particular, how much more do consumers pay with the tariff in place, relative to the additional amounts going to domestic suppliers/corporations? How much tax revenue is generated? How many jobs are created domestically as a result of 'distorting' the market? Regardless of the magnitude of the two deadweight loss areas, which represent the net cost of the tariff, we should be interested in whether the owners of capital gain at the expense of consumers.
Tariffs by country of origin - trade diversion
The imposition of tariffs is governed by the World Trade Organization (WTO). Tariffs are permitted under the WTO rules in specific circumstances: if a particular economy is deemed to be subsidizing exports, and those exports have employment impacts on the destination economy, then a 'retaliatory' tariff may be imposed. A related justification is dumping. It is frequently difficult to prove subsidization or dumping by an exporting economy. An example of such a tariff was one placed by the US on washing machines originating in China in 2016, on the basis of a dumping claim by the United States. The immediate result of this was that the manufacturers located in China switched most of their production to other plants they owned in Vietnam and Thailand. In this particular instance there was virtually no impact on the retail price of washing machines in the US.
Dumping is a predatory practice, based on artificially low costs aimed at driving out domestic producers.
The traditional theory of tariffs described in 15.4 implicitly assumes that production and employment increase in the importing economy as a result of domestic production displacing imported goods. This analysis assumes that the tariff is imposed on a particular commodity, regardless of its economy of origin.
Production subsidies
Figure 15.5 illustrates the effect of a subsidy to a domestic supplier. As in Figure 15.4, the amount QD is demanded in the free trade equilibrium and, of this, QS is supplied domestically. With a subsidy per unit of output sold, the government can reduce the supply cost of the domestic supplier, thereby shifting the supply curve downward from S to . In this illustration, the total quantity demanded remains at QD, but the domestic share increases to .
Figure 15.5 Subsidies and trade
With a world supply price of P, a domestic supply curve S, and a domestic demand D, the amount QD is purchased. Of this, Qs is supplied domestically and (QDQs) by foreign suppliers. A per-unit subsidy to domestic suppliers shifts their supply curve to , and increases their market share to .
The new equilibrium represents a misallocation of resources. When domestic output increases from QS to , a low-cost international producer is being replaced by a higher cost domestic supplier; the domestic supply curve S lies above the international supply curve P in this range of output.
Note that this example deals with a subsidy to domestic suppliers who are selling in the domestic market. It is not a subsidy to domestic producers who are selling in the international market – an export subsidy.
This subsidy comes with a cost to the domestic economy: Taxpayers-at-large must pay higher taxes to support this policy; and each dollar raised in tax itself has a deadweight loss, as we examined in Chapter 5.
Quotas
A quota is a limit placed upon the amount of a good that can be imported. Consider Figure 15.6, where again there is a domestic supply curve coupled with a world price of P. Rather than imposing a tariff, the government imposes a quota that restricts imports to a physical amount denoted by the distance quota on the quantity axis. The supply curve facing domestic consumers then has several segments to it. First it has the segment RC, reflecting the fact that domestic suppliers are competitive with world suppliers up to the amount C. Beyond this output, world suppliers can supply at a price of P, whereas domestic suppliers cannot compete at this price. Therefore the supply curve becomes horizontal, but only up to the amount permitted under the quota—the quantity CU corresponding to quota. Beyond this amount, international supply is not permitted and therefore additional amounts are supplied by the (higher cost) domestic suppliers. Hence the supply curve to domestic buyers becomes the supply curve from the domestic suppliers once again.
Figure 15.6 Quotas and trade
At the world price P, plus a quota, the supply curve becomes RCUV. This has three segments: (i) domestic suppliers who can supply below P; (ii) quota; and (iii) domestic suppliers who can only supply at a price above P. The quota equilibrium is at T, with price and quantity ; the free-trade equilibrium is at G. Of the amount , quota is supplied by foreign suppliers and the remainder by domestic suppliers. The quota increases the price in the domestic market.
The resulting supply curve yields an equilibrium quantity . There are several features to note about this equilibrium. First, the quota pushes the domestic price above the world price ( is greater than P) because low-cost international suppliers are partially supplanted by higher-cost domestic suppliers. Second, if the quota is chosen 'appropriately', the same domestic market price could exist under the quota as under the tariff in Figure 15.4. Third, in contrast to the tariff case, the government obtains no tax revenue from the quotas. The higher market price under a quota means that the price per unit received by foreign suppliers is now rather than P. De facto, instead of tax revenue being generated in the importing economy, the foreign supplier benefits from a higher price. Fourth, inefficiencies are associated with the equilibrium at . These inefficiencies arise because the lower-cost international suppliers are not permitted to supply the amount they would be willing to supply at the quota-induced market equilibrium. In other words, more efficient producers are being squeezed out of the market by quotas that make space for less-efficient producers.
Application Box 15.3 Cheese quota in Canada
In 1978 the federal government set a cheese import quota for Canada at just over 20,000 tonnes. This quota was implemented initially to protect the interests of domestic suppliers. Despite a strong growth in population and income in the intervening decades, the import quota has remained unchanged. The result is a price for cheese that is considerably higher than it would otherwise be. The quotas are owned by individuals and companies who have the right to import cheese. The quotas are also traded among importers, at a price. Importers wishing to import cheese beyond their available quota pay a tariff of about 250 percent. So, while the consumer is the undoubted loser in this game, who gains?
First the suppliers gain, as illustrated in Figure 15.6. Canadian consumers are required to pay high-cost domestic producers who displace lower-cost producers from overseas. Second, the holders of the quotas gain. With the increase in demand for cheese that comes with higher incomes, the domestic cheese price increases over time and this in turn makes an individual quota more valuable.
In the 2018 United States Mexico Canada Agreement, a slight increase in access to Canadian markets was granted in return for a corresponding increase in access to the US market.
15.6 The politics of protection
Objections to imports are frequent and come from many different sectors of the economy. In the face of the gains from trade which we have illustrated in this chapter, why do we observe such strong opposition to imported goods and services?
Structural change and technology
In a nutshell the answer is that, while consumers in the aggregate gain from the reduction of trade barriers, and there is a net gain to the economy at large, some individual sectors of the economy lose out. Not surprisingly the sectors that will be adversely affected are vociferous in lodging their objections. Sectors of the economy that cannot compete with overseas suppliers generally see a reduction in jobs. This has been the case in the manufacturing sector of the Canadian and US economies in recent decades, as manufacturing and assembly has flown off-shore to Asia and Mexico where labour costs are lower. Domestic job losses are painful, and frequently workers who have spent decades in a particular job find reemployment difficult, and rarely get as high a wage as in their displaced job.
Such job losses are reflected in calls for tariffs on imports from China, for example, in order to 'level the playing field' – that is, to counter the impact of lower wages in China. Of course it is precisely because of lower labour costs in China that the Canadian consumer benefits.
In Canada we deal with such dislocation first by providing unemployment payments to workers, and by furnishing retraining allowances, both coming from Canada's Employment Insurance program. While such support does not guarantee an equally good alternative job, structural changes in the economy, due to both internal and external developments, must be confronted. For example, the information technology revolution made tens of thousands of 'data entry' workers redundant. Should producers have shunned the technological developments which increased their productivity dramatically? If they did, would they be able to compete in world markets?
While job losses feature heavily in protests against technological development and freer trade, most modern economies continue to grow and create more jobs in the service sector than are lost in the manufacturing sector. Developed economies now have many more workers in service than manufacture. Service jobs are not just composed of low-wage jobs in fast food establishments – 'Mcjobs', they are high paying jobs in the health, education, legal, financial and communications sectors of the economy.
Successful lobbying and concentration
While efforts to protect manufacture have not resulted in significant barriers to imports of manufactures, objections in some specific sectors of the economy seem to be effective worldwide. One sector that stands out is agriculture, where political conditions are conducive to the continuance of protection and what is called 'supply management' – domestic production quotas. The reason for 'successful' supply limitation appears to rest in the geographic concentration of potential beneficiaries of such protection and the scattered beneficiaries of freer trade on the one hand, and the costs and benefits of political organization on the other: Farmers tend to be concentrated in a limited number of rural electoral ridings and hence they can collectively have a major impact on electoral outcomes. Second, the benefits that accrue to trade restriction are heavily concentrated in the economy – keep in mind that about two percent of the population lives on farms, or relies on farming for its income. By contrast the costs on a per person scale are small, and are spread over the whole population. Thus, in terms of the costs of political organization, the incentives for consumers are small, but the incentives for producers are high.
In addition to the differing patterns of costs and benefits, rural communities tend to be more successful in pushing trade restrictions based on a 'way-of-life' argument. By permitting imports that might displace local supply, lobbyists are frequently successful in convincing politicians that long-standing way-of-life traditions would be endangered, even if such 'traditions' are accompanied by monopolies and exceptionally high tariffs.
Valid trade barriers: Infant industries and dumping?
An argument that carries both intellectual and emotional appeal to voters is the 'infant industry' argument. It goes as follows: New ventures and sectors of the economy may require time before that can compete internationally. Scale economies may be involved, for example, and time may be required for producers to expand their scale of operation, at which time costs will have fallen to international (i.e. competitive) levels. In addition, learning-by-doing may be critical in more high-tech sectors and, once again, with the passage of time costs should decline for this reason also.
The problem with this stance is that these 'infants' have insufficient incentive to 'grow up' and become competitive. A protection measure that is initially intended to be temporary can become permanent because of the potential job losses associated with a cessation of the protection to an industry that fails to become internationally competitive. Furthermore, employees and managers in protected sectors have insufficient incentive to make their production competitive if they realize that their government will always be there to protect them.
In contrast to the infant industry argument, economists are more favourable to restrictions that are aimed at preventing dumping.
Dumping may occur either because foreign suppliers choose to sell at artificially low prices (prices below their break-even price for example), or because of surpluses in foreign markets resulting from oversupply. For example, if, as a result of price support in its own market, a foreign government induced oversupply in butter and it chose to sell such butter on world markets at a price well below the going ('competitive') world supply price, such a sale would constitute dumping. Alternatively, an established foreign supplier might choose to enter our domestic market by selling its products at artificially low prices, with a view to driving domestic competition out of the domestic market. Having driven out the domestic competition it would then be in a position to raise prices. This is predatory pricing as explored in the last chapter. Such behaviour differs from a permanently lower price on the part of foreign suppliers. This latter may be welcomed as a gain from trade, whereas the former may generate no gains and serve only to displace domestic labour and capital.
Protectionism in the age of pandemics
The year 2020 will be remembered in history as the year of the coronavirus pandemic. An uncountable number of men and women died all across the globe as a result of contracting COVID-19, the respiratory disorder brought on by an attack of the coronavirus. In the absence of a vaccine, health authorities the world over implemented a twin policy of social distancing and quarantining (or self-isolation). The world economy went into a tailspin, as huge fractions of the labor force were laid off. Trade patterns were disrupted and serious shortages of personal protection equipment (PPE - masks, visors, gowns), ventilators and drugs emerged. The world demand for PPE and ventilators skyrocketed. But the production of PPE was concentrated in China; most western economies did not have the necessary productive capacity to supply even non-pandemic requirements. Bidding wars erupted amongst countries and hospitals as they vied for supply, while domestic producers of some products added to their production capacity.
Following this chaos, we ask if self-sufficiency would not be a better model than open trade. Would a world where each country ensured it had the production capacity to produce these necessities in times of emergency not be superior to one where global supply chains characterize everything from computers to generic drugs? India is a major producer of generic drugs and the components for such drugs. The demand for anti-biotics and pain killers also rocketed upwards with the pandemic.
There is more than one way to plan for a pandemic, and such planning should not involve a generalized move to self-sufficiency on the part of the global economy. One strategy is to build up inventories of PPE and ventilators domestically. This is costly, but for the most part feasible. It does not represent a complete solution because technology changes will make 30-year old ventilators sitting in inventory redundant for the next pandemic. In addition, most medications have a limited shelf life. Hence one solution is to maintain and rotate substantial inventories of emergency equipment using existing supply chains, and benefit from the efficiencies that are built into these chains.
A second option is to maintain excess production capacity on the part of domestic manufacturers of critical pandemic products. Maintaining such capacity should be considered at least partially as a social cost; pandemics ravage societies, not just individuals, and therefore society should undertake part of the cost of insuring against them.
A more general argument against global trade comes in the form of protecting food supplies. In the early 2000s an increase in global cereal prices led some economies to limit exports of specific crops on account of the fact that global demand was pushing prices to a level that low-income consumers could not afford. But such a policy may threaten consumers in other low-income economies whose demands have not changed in a context of reduced supplies. The reality is that world food supply is adequate for world consumption, even in the presence of disruptions. It is also the case that certain economies have huge advantages in producing specific kinds of food. For example, Canada, the US and the Ukraine produce cereals very economically. Mountainous regions are unsuitable for this production. It would benefit no economy for these economies to lower their production of grains to the point where they produced only enough for their own production. By the same reasoning, warmer climates produce fruits, coffee beans, olives etc that cannot easily be produced in many regions suited to wheat. The gains to specialization in the world economy are enormous. Where food shortages occur we frequently encounter the scourges of drought or war or political upheaval, and these conditions inhibit the distribution of foodstuffs.
What about supply chains? If motherboards produced in China are not being exported in sufficient quantities then indeed production of computers in North America will suffer. But to infer from this that North America should decide to produce all of its computer components in North America is illogical. First, in the time of a pandemic, if certain economies in the supply chain are on lockdown, we cannot be sure that the domestic economy would not be on lockdown simultaneously. Second, the cost to moving the production of all computer parts to North America would likely double the cost of computer hardware - including cell-phones. Perhaps a disruption to our supply chains is something we need to bear in extraordinary times. In case it requires emphasis, most producers in supply chains have incentives to produce and sell. If they do not they will die economically.
The energy sector of every economy is impacted with the outbreak of a pandemic. This is because the demand for fuel (primarily oil) declines following policies of social distancing, limits on permissible travel, and the closure of some production facilities that depend upon oil. In North America, as we saw in Chapter 4 earlier, the price of oil declined from US \$60 per barrel to US \$20 in the space of two months in early 2020. Since production costs are higher in both Canada and much of the US than in Saudi Arabia, the North Sea and Russia, producers in North America were squeezed. Many were no longer able to cover their full production costs, and forced to cease drilling and recovering oil. Inevitably there was a clamor for protection. Producers sought tariffs on competing oil: Tariffs would increase the price of cheaper-to-produce foreign oil and enable domestic producers to survive.
While protection might seem like a 'sensible' policy in this instance, the fact is that unilateral tariffs usually invite reprisals, and raise the danger of a trade war with ever-expanding counter protectionism. In contrast to the case of a shortage of medical supplies, the energy sector in Canada suffered from a glut of world oil supply. The domestic issue is not about the health of consumers (as in the case of medical supplies), it is about the health of producers.
To conclude: a pandemic is a profoundly serious event and such events inflict major costs on all societies. There are no magic bullets in the form of low-cost ideal economic policies to counter viral warfare. The key to policy making is to recognize constraints and recognize an attack as soon as possible. A wholesale move to insulate the domestic economy is ill-conceived. Comparative advantage confers enormous benefits to all nations. Specific policies should take the form of inventory management and excess production capacity in specific sectors of the economy.
15.7 Institutions governing trade
In the nineteenth century, world trade grew rapidly, in part because the leading trading nation at the time—the United Kingdom—pursued a vigorous policy of free trade. In contrast, US tariffs averaged about 50 percent, although they had fallen to around 30 percent by the early 1920s. As the industrial economies went into the Great Depression of the late 1920s and 1930s, there was pressure to protect domestic jobs by keeping out imports. Tariffs in the United States returned to around 50 percent, and the United Kingdom abandoned the policy of free trade that had been pursued for nearly a century. The combination of world recession and increasing tariffs led to a disastrous slump in the volume of world trade, further exacerbated by World War II.
The WTO and GATT
After World War II, there was a collective determination to see world trade restored. Bodies such as the International Monetary Fund and the World Bank were set up, and many countries signed the General Agreement on Tariffs and Trade (GATT), a commitment to reduce tariffs progressively and dismantle trade restrictions.
Under successive rounds of GATT, tariffs fell steadily. By 1960, United States tariffs were only one-fifth of their level at the outbreak of the War. In the United Kingdom, the system of wartime quotas on imports had been dismantled by the mid-1950s, after which tariffs were reduced by nearly half in the ensuing 25 years. Europe as a whole moved toward an enlarged European Union in which tariffs between member countries have been abolished. By the late 1980s, Canada's tariffs had been reduced to about one-quarter of their immediate post-World War II level.
The GATT Secretariat, now called the World Trade Organization (WTO), aims both to dismantle existing protection that reduces efficiency and to extend trade liberalization to more and more countries. Tariff levels throughout the world are now as low as they have ever been, and trade liberalization has been an engine of growth for many economies. The consequence has been a substantial growth in world trade.
NAFTA, the USMCA, the EU, the CETA, and the TPP
In North America, policy since the 1980s has led to a free trade area that covers the flow of trade between Canada, the United States, and Mexico. The Canada/United States free trade agreement (FTA) of 1989 expanded in 1994 to include Mexico in the North American Free Trade Agreement (NAFTA). The objective in both cases was to institute freer trade between these countries in most goods and services. This meant the elimination or reduction of tariffs and non-tariff barriers over a period of years, with a few exceptions in specific products and cultural industries. A critical component of the Agreement was the establishment of a dispute-resolution mechanism, under which disputes would be resolved by a panel of 'judges' nominated from the member economies. Evidence of the success of these agreements is reflected in the fact that Canadian exports have grown to more than 30 percent of GDP, and trade with the United States accounts for the lion's share of Canadian trade flows. NAFTA was updated and replaced in 2018 and the new agreement is termed the United States Mexico Canada Agreement.
The European Union was formed after World War II, with the prime objective of bringing about a greater degree of political integration in Europe. Two world wars had laid waste to their economies and social fabric. Closer economic ties and greater trade were seen as the means of achieving this integration. The Union was called the "Common Market" for much of its existence. The Union originally had six member states, and as of 2019 the number is 28, with several other candidate countries in the process of application, most notably Turkey. The European Union (EU) has a secretariat and parliament in Bruxelles. The UK intends to exit the EU as of late 2019.
Canada has concluded a free trade agreement with the European Union that is termed the Comprehensive Economic and Trade Agreement (CETA). It has the objective of implementing free trade between the two negotiating parties, though there remain some exceptions, for example agriculture.
The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) is a trading agreement between Canada and ten other Pacific-Rim economies that came into being in 2018. Negotiations for a Trans Pacific Partnership treaty were complete by 2016. Those negotiations involved 12 Pacific Rim economies including Canada and the United States, but excluding China. The Obama presidency appeared ready to sign the treaty, however the Trump presidency (and also the Democratic candidate for president of the US, Hillary Clinton) decided that the Partnership was not in the interests of the United States and withdrew its affiliation. The remaining 11 economies reached an agreement to implement the partnership in December 2018.
Key Terms
Autarky denotes the no-trade situation.
Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.
Terms of trade define the rate at which goods trade internationally.
Consumption possibility frontier defines what an economy can consume after production specialization and trade.
Intra-industry trade is two-way international trade in products produced within the same industry.
Intra-firm trade is two-way trade in international products produced within the same firm.
Supply chain: denotes the numerous sources for intermediate goods used in producing a final product.
Intermediate good: one that is used in the production of final output.
Content requirement: requires that a specified percentage of the final value of a product originate in the producing economy.
Dynamic gains: the potential for domestic producers to increase productivity by competing with, and learning from, foreign producers.
Total factor productivity: how efficiently the factors of production are combined.
Tariff is a tax on an imported product that is designed to limit trade in addition to generating tax revenue. It is a barrier to trade.
Quota is a quantitative limit on an imported product.
Trade subsidy to a domestic manufacturer reduces the domestic cost and limits imports.
Non-tariff barriers, such as product content requirements, limits the gains from trade.
Dumping is a predatory practice, based on artificial costs aimed at driving out domestic producers.
Exercises for Chapter 15
EXERCISE 15.1
The following table shows the labour input requirements to produce a bushel of wheat and a litre of wine in two countries, Northland and Southland, on the assumption of constant cost production technology – meaning that the production possibility curves in each are straight lines. You can answer this question either by analyzing the table or developing a graph similar to Figure 15.1, assuming each economy has 4 units of labour.
Labour requirements per unit produced
Northland Southland
Per bushel of wheat 1 3
Per litre of wine 2 4
1. Which country has an absolute advantage in the production of both wheat and wine?
2. What is the opportunity cost of wheat in each economy? Of wine?
3. What is the pattern of comparative advantage here?
4. Suppose the country with a comparative advantage in wine reduces wheat production by one bushel and reallocates the labour involved to wine production. How much additional wine does it produce?
EXERCISE 15.2
Canada and the United States can produce two goods, xylophones and yogurt. Each good can be produced with labour alone. Canada requires 60 hours to produce a ton of yogurt and 6 hours to produce a xylophone. The United States requires 40 hours to produce the ton of yogurt and 5 hours to produce a xylophone.
1. Describe the state of absolute advantage between these economies in producing goods.
2. In which good does Canada have a comparative advantage? Does this mean the United States has a comparative advantage in the other good?
3. Draw the production possibility frontier for each economy to scale on a diagram, assuming that each economy has an endowment of 240 hours of labour, and that the PPFs are linear.
4. On the same diagram, draw Canada's consumption possibility frontier on the assumption that it can trade with the United States at the United States' rate of transformation.
5. Draw the US consumption possibility frontier under the assumption that it can trade at Canada's rate of transformation.
EXERCISE 15.3
The domestic demand for bicycles is given by P=36–0.3Q. The foreign supply is given by P=18 and domestic supply by P=16+0.4Q.
1. Illustrate the market equilibrium on a diagram, and illustrate the amounts supplied by domestic and foreign suppliers in equilibrium.
2. If the government now imposes a tariff of \$6 per unit on the foreign good, illustrate the impact geometrically.
3. In the diagram, illustrate the area representing tariff revenue.
4. Optional: Compute the price and quantity in equilibrium with free trade, and again in the presence of the tariff.
EXERCISE 15.4
1. In Exercise 15.3, illustrate graphically the deadweight losses associated with the imposition of the tariff.
2. Illustrate on your diagram the additional amount of profit made by the domestic producer as a result of the tariff. [Hint: Refer to Figure 15.4 in the text.]
EXERCISE 15.5
The domestic demand for office printers is given by P=40–0.2Q. The supply of domestic producers is given by P=12+0.1Q, and international supply by P=20.
1. Illustrate this market geometrically.
2. If the government gives a production subsidy of \$2 per unit to domestic suppliers in order to increase their competitiveness, illustrate the impact of this on the domestic supply curve.
3. Illustrate geometrically the cost to the government of this scheme.
EXERCISE 15.6
Consider the data underlying Figure 15.1. Suppose, from the initial state of comparative advantage, where Canada specializes in fish and the US in vegetable, we have a technological change in fishing. The US invents the multi-hook fishing line, and as a result can now produce 64 units of fish with the same amount of labour, rather than the 40 units it could produce before the technological change. This technology does not spread to Canada however.
1. Illustrate the new PPF for the US in addition to the PPF for Canada.
2. What is the new opportunity cost (number of fish) associated with one unit of V?
3. Has comparative advantage changed here – which economy should specialize in the production of each good?
EXERCISE 15.7
The following are hypothetical (straight line) production possibilities tables for Canada and the United States. For each line required, plot any two or more points on the line.
Canada United States
A B C D A B C D
Peaches 0 5 10 15 Peaches 0 10 20 30
Apples 30 20 10 0 Apples 15 10 5 0
1. Plot Canada's production possibilities curve.
2. Plot the United States' production possibilities curve.
3. What is each country's cost ratio of producing peaches and apples?
4. Which economy should specialize in which product?
5. Plot the United States' trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.
6. Plot the Canada' trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.
7. Suppose that the optimum product mixes before specialization and trade were B in the United States and C in Canada. What are the gains from specialization and trade?
15: International trade
Virtually every economy in the modern world trades with other economies – they are what we call 'open' economies. Evidence of such openness is everywhere evident in our daily life. The world eats Canadian wheat; China exports manufactured goods to almost anywhere we can think of; and Canadians take their holidays in Florida.
As consumers we value the choice and variety of products that trade offers. We benefit from lower prices than would prevail in a world of protectionism. At the same time there is a constant chorus of voices calling for protection from international competition: Manufacturers are threatened by production in Asia; farmers fight against the imports of poultry, beef, and dairy products; even the service sector is concerned about offshore competition from call centres and designers. In this world of competing views it is vital to understand how trade has the potential to improve the well-being of economies.
This chapter examines the theory of international trade, trade flows, and trade policy: Who trades with whom, in what commodities, and why. In general, countries trade with one another because they can buy foreign products at a lower price than it costs to make them at home. International trade reflects specialization and exchange, which in turn improve living standards. It is cost differences between countries rather than technological differences that drive trade: In principle, Canada could supply Toronto with olives and oranges grown in Nunavut greenhouses, but it makes more sense to import them from Greece, Florida or Mexico.
Trade between Canada and other countries differs from trade between provinces. By definition, international trade involves jumping a border, whereas most trade within Canada does not. Internal borders are present in some instances – for example when it comes to recognizing professional qualifications acquired out-of-province. In the second instance, international trade may involve different currencies. When Canadians trade with Europeans the trade is accompanied by financial transactions involving Canadian dollars and Euros. A Canadian buyer of French wine pays in Canadian dollars, but the French vineyard worker is paid in euros. Exchange rates are one factor in determining national competitiveness in international markets. Evidently, not every international trade requires currency trades at the same time – most members of the European Union use the Euro. Indeed a common currency was seen as a means of facilitating trade between member nations of the EU, and thus a means of integrating the constituent economies more effectively.
It is important at the outset to emphasize that while trade has the potential to improve aggregate well being in the trading economies, this does not mean that every citizen will benefit; some will gain others will lose out. Buyers usually gain as a result of having a wider array of products to purchase at lower prices. Successful producers may benefit from production efficiencies associated with accessing a global supply chain, while others may be squeezed by international competition. The former may export more and employ more workers, the latter may contract and lay off employees. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.01%3A_Trade_in_our_daily_lives.txt |
World trade has grown rapidly since the end of World War II, indicating that trade has become ever more important to national economies. Canada has been no exception. Canada signed the Free Trade Agreement with the US in 1989, and this agreement was expanded in 1994 when Mexico was included under the North America Free Trade Agreement (NAFTA). Imports and exports rose dramatically, from approximately one quarter to forty percent of GDP. Canada is now what is termed a very 'open' economy – one where trade forms a large fraction of total production. In early 2017, Canada and the EU signed a trade agreement - the Comprehensive Economic and Trade Agreement (CETA). Under this agreement tariffs will be phased out or reduced in most areas of trade over a several-year period. Canada also signed the Comprehensive and Progressive Agreement on Trans-Pacific Trade in 2018 that has the same objective of reducing trade barriers between 11 Pacific-Rim member states.
Smaller economies are typically more open than large economies—Belgium and the Netherlands depend upon trade more than the United States. This is because large economies tend to have a sufficient variety of resources to supply much of an individual country's needs. The European Union is similar, in population terms, to the United States, but it is composed of many distinct economies. Some European economies are equal in size to individual American states. But trade between California and New York is not international, whereas trade between Italy and the Spain is.
Because our economy is increasingly open to international trade, events in the world economy affect our daily lives much more than in the past. The conditions in international markets for basic commodities and energy affect all nations, both importers and exporters. For example, the prices of primary commodities on world markets increased dramatically in the latter part of the 2000s. Higher prices for grains, oil, and fertilizers on world markets brought enormous benefits to Canada, particularly the Western provinces, which produce these commodities. In contrast, by early 2015, many of these prices dropped dramatically and Canadian producers suffered as a consequence.
The service sector accounts for more of our GDP than the manufacturing sector. As incomes grow, the demand for health, education, leisure, financial services, tourism, etc., dominates the demand for physical products. Technically, the income elasticity demand for the former group exceeds the income elasticity of demand for the latter. Internationally, while trade in services is growing rapidly, it still forms a relatively small part of total world trade. Trade in goods—merchandise trade—remains dominant, partly because many countries import unfinished goods, add some value, and re-export them. Even though the value added from such import-export activity may make just a small contribution to GDP, the gross flows of imports and exports can still be large relative to GDP. The transition from agriculture to manufacturing and then to services has been underway in developed economies for over a century. This transition has been facilitated in recent decades by the communications revolution and globalization. Globalization has seen a rapid shift in merchandise production from the developed to the developing world.
Table 15.1 shows the patterns of Canadian merchandise trade in 2018. The US is Canada's major trading partner, buying almost three quarters of our exports and supplying almost two thirds of imports. Table 15.2 details exports and imports by type. Although exports of resource-based products account for only about 40 percent of total merchandise exports, Canada is still viewed as a resource-based economy. This is in part because manufactures account for almost 80 percent of US and European merchandise exports and about 60 percent of Canadian exports. Nevertheless, Canada has important strength in machinery, equipment, and automotive products.
Table 15.1 Canada's Merchandise Trade Patterns 2018
Country Exports to Imports from
United States 73.9 64.4
European Union 7.9 10.5
China 5.0 7.6
Mexico 1.6 3.4
Others 11.6 14.1
Total 100 100
Dollar Total 585,255.7 607,205.4
Source: Adapted from Statistics Canada Table 12-10-0011-01
Table 15.2 Canadian Trade by Merchandise Type 2017
Sector Exports Imports
Farm, fishing, and intermediate food products 6.5 3.0
Energy products 20.5 5.5
Metal ores and non-metallic minerals 3.8 2.3
Metal and non-metallic mineral products 11.9 7.6
Basic and industrial chemical, plastic and rubber products 6.6 8.5
Forestry products and building and packaging materials 8.5 4.4
Industrial machinery, equipment and parts 5.3 9.7
Electronic and electrical equipment and parts 3.5 11.8
Motor vehicles and parts 16.3 20.0
Aircraft and other transportation equipment and parts 3.7 3.7
Consumer Goods 12.3 21.9
Special transactions trade 1.1 1.6
Total 100 100
Total dollar value in millions 500,892.6 561,425.9
Source: Adapted from Statistics Canada Table 12-10-0002-01 | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.02%3A_Canada_in_the_world_economy.txt |
In the opening chapter of this text we emphasized the importance of opportunity cost and differing efficiencies in the production process as a means of generating benefits to individuals through trade in the marketplace. The simple example we developed illustrated that, where individuals differ in their efficiency levels, benefits can accrue to each individual as a result of specializing and trading. In that example it was assumed that individual A had an absolute advantage in producing one product and that individual Z had an absolute advantage in producing the second good. This set-up could equally well be applied to two economies that have different efficiencies and are considering trade, with the objective of increasing their consumption possibilities. Technically, we could replace Amanda and Zoe with Argentina and Zambia, and nothing in the analysis would have to change in order to illustrate that consumption gains could be attained by both Argentina and Zambia as a result of specialization and trade.
Remember: The opportunity cost of a good is the quantity of another good or service given up in order to have one more unit of the good in question.
So, let us now consider two economies with differing production capabilities, as illustrated in Figures 15.1 and 15.2. In this instance it is assumed that one economy has an absolute advantage in both goods, but the degree of that advantage is greater in one good than the other. In international trade language, there exists a comparative advantage as well as an absolute advantage. It is frequently a surprise to students that this situation has the capacity to yield consumption advantages to each economy, even though one is absolutely more efficient in producing both of the goods. This is termed the principle of comparative advantage, and it states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies. This is a remarkable result, and much less intuitive than the principle of absolute advantage. We explore it with the help of the example developed in Figures 15.1 and 15.2.
Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.
We will name these two imaginary economies the US and Canada. Their production possibilities are defined by the PPFs in Figure 15.1. Canada can produce 5 units of V or 35 units of F, or any combination defined by the line joining these points. With the same resources the US can produce 8V or 40F, or any combination defined by its PPF1. With no trade, Canadians and Americans consume a combination of the goods defined by some point on their respective PPFs. The opportunity cost of a unit of V in Canada is 7F (the slope of Canada's PPF is 5/35=1/7). In the US the opportunity cost of one unit of V is 5F (slope is 8/40=1/5). In this set-up the US is more efficient in producing V than F relative to Canada, as reflected by the opportunity costs. Hence we say that the US has a comparative advantage in the production of V and that Canada has therefore a comparative advantage in producing F.
Figure 15.1 Comparative advantage – production
Canada specializes completely in Fish at 35, where it has a comparative advantage. Similarly, the US specializes in Vegetable at 8. They trade at a rate of 1:6. The US trades 3V to Canada in return for 18F.
Prior to trade each economy is producing all of the goods it consumes. This no-trade state is termed autarky.
Autarky denotes the no-trade situation.
The gains from trade
We now permit each economy to specialize in producing where it has a comparative advantage. So Canada specializes completely by producing 35F and the US produces 8V. Having done this the economies must now agree on the terms of trade. The terms of trade define the rate at which the two goods will trade post-specialization. Let us suppose that a bargaining process leads to agreement that one unit of V will trade for six units of F. Such a trading rate, one that lies between the opportunity costs of each economy, benefits both economies. This exchange rate lies between Canada's opportunity cost of 1:7 and the US opportunity cost of 1:5. By specializing in F, Canada can now obtain an additional unit of V by sacrificing six units of F, whereas pre-trade it had to sacrifice seven units of F for a unit of V. Technically, by specializing in F and trading at a rate of 1:6 Canada's consumption possibilities have expanded and are given by the consumption possibility frontier (CPF) illustrated in Figure 15.2. The consumption possibility frontier defines what an economy can consume after production specialization and trade.
Figure 15.2 Comparative advantage – consumption
Post specialization the economies trade 1V for 6F. Total production is 35F plus 8V. Hence one consumption possibility would be (18,5) for the US and (17,3) for Canada. Here Canada exchanges 18F in return for 3V.
The US also experiences an improved set of consumption possibilities. By specializing in V and trading at a rate of 1:6 its CPF lies outside its PPF and this enables it to consume more than in the pre-specialization state, where its CPF was defined by its PPF.
Evidently, the US and Canada CPFs are parallel since they trade with each other at the same rate: If Canada exports six units of F for every unit of V that it imports from the US, then the US must import the same six units of F for each unit of V it exports to Canada. The remarkable outcome here is that, even though one economy is more efficient in producing each good, specialization still leads to gains for both economies. The gain is illustrated by the fact that each economy's consumption possibilities lie outside of its production possibilities2.
Terms of trade define the rate at which the goods trade internationally.
Consumption possibility frontier defines what an economy can consume after production specialization and trade.
Comparative advantage and factor endowments
A traditional statement of why comparative advantage arises is that economies have different endowments of the factors of production – land, capital and labour endowments differ. A land endowment that facilitates the harvesting of grain (Saskatchewan) or the growing of fruit (California) may be innate to an economy. We say that wheat production is land intensive, that aluminum production is power intensive, that research and development is skill intensive, that auto manufacture is capital intensive, that apparel is labour intensive. Consequently, if a country is well endowed with some particular factors of production, it is to be expected that it will specialize in producing goods that use those inputs. A relatively abundant supply or endowment of one factor of production tends to make the cost of using that factor relatively cheap: It is relatively less expensive to produce clothing in China and wheat in Canada than the other way around. This explains why Canada's Prairies produce wheat, why Quebec produces aluminum, why Asia produces apparel. But endowments can evolve.
How can we explain why Switzerland specializes in watches, precision instruments, and medical equipment, while Vietnam specializes in rice, tourism and manufactured goods and components? Evidently, Switzerland made a decision to educate its population and invest in the capital required to produce these goods. It was not naturally endowed with these skills, in the same way that Greece is endowed with sun or Saskatchewan is endowed with fertile flat land.
While we have demonstrated the principle of comparative advantage using a two-good example (since we are constrained by the geometry of two dimensions), the conclusions carry over to the case of many goods. Furthermore, the principle has many applications. For example, if one person in the household is more efficient at doing all household chores than another, there are still gains to specialization provided the efficiency differences are not all identical. This is the principle of comparative advantage at work in a microcosm.
Application Box 15.1 The one hundred mile diet
In 2005 two young British Columbians embarked on what has famously become known as the 'one hundred mile diet'—a challenge to eat and drink only products grown within this distance of their home. They succeeded in doing this for a whole year, wrote a book on their experience and went on to produce a TV series. They were convinced that such a project is good for humanity, partly because they wrapped up ideas on organic farming and environmentally friendly practices in the same message.
Reflect now on the implications of this superficially attractive program: If North Americans were to espouse this diet, it would effectively result in the closing down of the midwest of the Continent. From Saskatchewan to Kansas, we are endowed with grain-producing land that is the envy of the planet. But since most of this terrain is not within 100 miles of any big cities, these deluded advocates are proposing that we close up the production of grains and cereals exactly in those locations where such production is extraordinarily efficient. Should we sacrifice grains and cereals completely in this hemisphere, or just cultivate them on a hillside close to home, even if the resulting cultivation were to be more labour and fuel intensive? Should we produce olives in greenhouses in Edmonton rather than importing them from the Mediterranean, or simply stop eating them? Should we sacrifice wine and beer in North Battleford because insufficient grapes and hops are grown locally?
Would production in temperate climates really save more energy than the current practice of shipping vegetables and fruits from a distance—particularly when there are returns to scale associated with their distribution? The 'one hundred mile diet' is based on precepts that are contrary to the norms of the gains from trade. In its extreme the philosophy proposes that food exports be halted and that the world's great natural endowments of land, water, and sun be allowed to lie fallow. Where would that leave a hungry world?
Table 15.1 shows the patterns of Canadian merchandise trade in 2008. The United States was and still is Canada's major trading partner, buying almost three quarters of our exports and supplying almost two thirds of Canadian imports. Table 15.2 details exports by type. Although exports of resource-based products account for only about 40 percent of total exports, Canada is now viewed as a resource-based economy. This is in part because manufactured products account for almost 80 percent of US and European exports but only about 60 percent of Canadian exports. Nevertheless, Canada has important export strength in machinery, equipment, and automotive products. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.03%3A_The_gains_from_trade-_Comparative_advantage.txt |
The theory of comparative advantage explains why economies should wish to trade. The theory is based upon the view that economies are 'inherently' different in their production capabilities. But trade is influenced by more than these differences. We will explore how returns to scale may be exploited to generate benefits from trade, and also how economies might gain from one-another by learning as a result of trading. This learning can increase domestic productivity.
Returns to scale
One of the reasons Canada signed the North America Free trade Agreement (NAFTA) was that economists convinced the Canadian government that a larger market would enable Canadian producers to be even more efficient than in the presence of trade barriers. Rather than opening up trade in order to take advantage of existing comparative advantage, it was proposed that efficiencies would actually increase with market size. This argument is easily understood in terms of increasing returns to scale concepts that we developed in Chapter 8. Essentially, economists suggested that there were several sectors of the Canadian economy that were operating on the downward sloping section of their long-run average cost curve.
Increasing returns are evident in the world market place as well as the domestic marketplace. Witness the small number of aircraft manufacturers—Airbus and Boeing are the world's two major manufacturers of large aircraft. Enormous fixed costs—in the form of research, design, and development—or capital outlays frequently result in decreasing unit costs, and the world marketplace can be supplied at a lower cost if some specialization can take place. Facebook is the giant in social media. Entertainment streaming companies like Netflix, Amazon, Disney and Hulu are few in number because of scale economies. Consider the specific example of automotive trade. In North America, Canadian auto plants produce different vehicle models than their counterparts in the US. Canada exports some models of a given manufacturer to the United States and imports other models. This is the phenomenon of intra-industry trade and intra-firm trade. How can we explain these patterns?
Intra-industry trade is two-way international trade in products produced within the same industry.
Intra-firm trade is two-way trade in international products produced within the same firm.
In the first instance, intra-industry trade reflects the preference of consumers for a choice of brands; consumers do not all want the same vehicle, or the same software, or the same furnishings. The second element to intra-industry trade is that increasing returns to scale characterize many production processes. Let us see if we can transform the returns to scale ideas developed in earlier chapters into a production possibility framework.
Figure 15.3 Intra industry trade
Hunda can produce either 100,000 of each vehicle or 40,000 of both in each plant. Hence production possibilities are given by the points A, Z, and B. Pre-trade it produces at Z in each economy due to trade barriers. Post-trade it produces at A in one economy and B in the other, and ships the vehicles internationally. Total production increases from 160,000 to 200,000 using the same resources.
Consider the example presented in Figure 15.3, where the hypothetical company Hunda Motor Corporation currently has a large assembly plant in each of Canada and the US where it produces two types of vehicles; sedans and sports utility vehicles (SUVs). Intially, restrictions on trade in automobiles, in the form of tariffs, between the two countries make it too costly to ship models across the border. Hence Hunda produces both sedans and SUVs in each plant. But for several reasons, switching between model production is costly and results in reduced output. Hunda can produce 40,000 vehicles of each type per annum in its plants, but could produce 100,000 of a single model in each plant, using the same amount of capital and labour. This is a situation of increasing returns to scale, and in this instance the scale economies are what make gains from trade possible - as opposed to any innate comparative advantage between the economies. If trade barriers against the shipment of autos across national boundaries can be eliminated, then Hunda can take advantage of scale economies in each plant and increase its total production without using more capital and labour.
As this example implies, an opening up of trade increases the potential market size, and producers who experience increasing returns to scale stand to benefit from an enlarged market because their potential unit costs fall. Returns to scale are not limited to finished goods. Returns to scale characterize the production of many intermediate goods, which are goods used to produce other final goods or services. Manufacturers rarely produce all of the components entering their final products; they have supply chains for components that comprise numerous suppliers. In the automotive industry transmissions, gearboxes and seats are such intermediate goods. If either returns to scale, or comparative advantage, characterize their supply then there are gains to trade in these goods. In the context of the North American Free Trade Agreement (NAFTA). and its most recent form (the US Mexico and Canada Agreement - USMCA), automotive parts as well as automobiles can be shipped free of tariffs across borders provided that they satisfy regional value content (RVC) rules. We observe, for example, transmissions being produced in Ontario and seats in Mexico, and these goods are also shipped freely within North America provided they satisfy the RVC rules. Scale economies characterize transmission manufacture, and comparative advantage characterizes seat production – labour costs are lower in Mexico, and seats are labor intensive.
Content requirements apply to some goods under the NAFTA/USMCA. In the case of vehicles and their components, NAFTA required a 62.5% regional value content - that is, to be imported into one of the NAFTA signatories free of tariffs, 62.5% of the vehicle value had to be attributable to production in one of the three economies. This requirement was designed to prevent the members from using an excessive amount of components from low-wage economies and thereby undermine production of parts and vehicles in North America. The USMCA raises (by the year 2023) the regional value component (RVC) to 75% for most vehicles (70% for heavy trucks), and the RVC to between 65% and 75% on vehicle parts.
Supply chain: denotes the numerous sources for intermediate goods used in producing a final product
Intermediate good: one that is used in the production of final output
Regional value content: requires that a specified percentage of the final value of a product originate in the economies covered in the Agreement.
Dynamic gains from trade
The term dynamic gains denotes the potential for domestic producers to increase productivity as a result of competing with, and learning from, foreign producers.
Dynamic gains: the potential for domestic producers to increase productivity by competing with, and learning from, foreign producers.
Production processes in reality are seldom static. Innovation is constant in the modern world, and innovation is manifested in the form of productivity improvements. An economy's production possibility frontier is determined by its endowments of capital and labour and also the efficiency with which it uses those productive factors. Total factor productivity defines how efficiently the factors of production are combined. Research suggests that in developed economies this productivity increases by about 1% per annum. This means that more output can be produced using the same amounts of capital and labour because production is being carried out more efficiently. In graphical terms, such productivity improvements effectively push out an economy's production possibility frontier by 1% per annum. For economies in the process of development, this productivity growth may be as high as 3% or 4% per annum – for the reason that these economies can observe and learn from economies that are ahead of it technologically.
Freer trade forces domestic firms to compete with foreign firms that may be more productive. Domestic firms that can learn and adapt to competition by becoming more efficient will survive, firms that cannot adapt will not. Inevitably, there will be winners and losers in the production sector of the economy, whereas in the consumption sector most consumers should be winners.
Total factor productivity: a measure of how efficiently the factors of production are combined. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.04%3A_Returns_to_scale_and_dynamic_gains_from_trade.txt |
Despite the many good arguments favoring free or relatively free trade, we observe numerous trade barriers. These barriers come in several forms. A tariff is a tax on an imported product that is designed to limit trade and generate tax revenue. It is a barrier to trade. An import quota is a limitation on imports; other non-tariff barriers take the form of product content requirements, and subsidies. By raising the domestic price of imports, a tariff helps domestic producers but hurts domestic consumers. Quotas and other non-tariff barriers have similar impacts.
A tariff is a tax on an imported product that is designed to limit trade in addition to generating tax revenue.
A quota is a quantitative limit on an imported product.
A trade subsidy to a domestic manufacturer reduces the domestic cost and limits imports.
Non-tariff barriers, such as product content requirements, limit the gains from trade.
Application Box 15.2 Tariffs – the national policy of J.A. MacDonald
In Canada, tariffs were the main source of government revenues, both before and after Confederation in 1867 and up to World War I. They provided 'incidental protection' for domestic manufacturing. After the 1878 federal election, tariffs were an important part of the National Policy introduced by the government of Sir John A. MacDonald. The broad objective was to create a Canadian nation based on east-west trade and growth.
This National Policy had several dimensions. Initially, to support domestic manufacturing, it increased tariff protection on foreign manufactured goods, but lowered tariffs on raw materials and intermediate goods used in local manufacturing activity. The profitability of domestic manufacturing improved. But on a broader scale, tariff protection, railway promotion, Western settlement, harbour development, and transport subsidies to support the export of Canadian products were intended to support national economic development. Although reciprocity agreements with the United States removed duties on commodities for a time, tariff protection for manufactures was maintained until the GATT negotiations of the post-World War II era.
Tariffs
Figure 15.4 describes how tariffs operate. We can think of this as the Canadian wine market—a market that is heavily taxed in Canada. The world price of Cabernet Sauvignon is, let us say, \$10 per bottle, and this is shown by the horizontal world supply curve at that price. To maintain simplicity, we will neglect any taxes on alcohol here other than the tax represented by the tariff. The international supply curve is horizontal because the domestic market accounts for only a small part of the world demand for wine: we are sufficiently small that international producers can supply us with any amount we wish to buy at the world price. The Canadian demand for this wine is given by the demand curve D, and Canadian suppliers have a supply curve given by S (Canadian Cabernet is assumed to be of the same quality as the imported variety in this example). The effective supply curve in the Canadian market is now BCM. At a price of \$10, Canadian consumers wish to buy litres, and domestic producers wish to supply litres. The gap between domestic supply and domestic demand is filled by imports. This is the free trade equilibrium.
Figure 15.4 Tariffs and trade
At a world price of \$10 the domestic quantity demanded is QD. Of this amount Qs is supplied by domestic producers and the remainder by foreign producers. A tariff increases the world price to \$12. This reduces demand to ; the domestic component of supply increases to . Of the total loss in consumer surplus (LFGJ), tariff revenue equals EFHI, increased surplus for domestic suppliers equals LECJ, and the deadweight loss is therefore the sum of the triangular areas CEI and HFG.
If the government now imposes a 20 percent tariff on imported wines (or a \$2 per bottle tax), foreign wine sells for \$12 a bottle, inclusive of the tariff. The effective supply curve in the Canadian market becomes BEK. The tariff raises the domestic 'tariff-inclusive' price above the world price, and this shifts the international supply curve of this wine upwards. By raising wine prices in the domestic market, the tariff protects domestic producers by raising the domestic price at which imports become competitive. Those domestic suppliers who were previously not quite competitive at a global price of \$10 are now competitive. The total quantity demanded falls from QD to at the new equilibrium F. Domestic producers supply the amount and imports fall to the amount . Reduced imports are partly displaced by those domestic producers who can supply at prices between \$10 and \$12. Hence, imports fall both because total consumption falls and because domestic suppliers can displace some imports under the protective tariff; the amount .
Since the tariff is a type of tax, its impact in the market depends upon the elasticities of supply and demand, (as illustrated in Chapters 4 and 5). The more elastic is the demand curve, the more a given tariff reduces imports. In contrast, if it is inelastic the quantity of imports declines less.
Costs and benefits of a tariff
The costs of a tariff come from the higher price to consumers, but this is partly offset by the tariff revenue that goes to the government. This tariff revenue is a benefit and can be redistributed to consumers or spent on goods from which consumers derive a benefit. But there are also efficiency costs associated with tariffs—deadweight losses, as we call them. These are the real costs of the tariff, and they arise because the marginal cost of production does not equal the marginal benefit to the consumer. Let us see how these concepts apply with the help of Figure 15.4.
Consumer surplus is the area under the demand curve and above the equilibrium market price. It represents the total amount consumers would have been willing to pay for the product, but did not have to pay, at the equilibrium price. It is a measure of consumer welfare. The tariff raises the market price and reduces this consumer surplus by the amount LFGJ. This area measures by how much domestic consumers are worse off as a result of the price increase caused by the tariff. But this is not the net loss for the whole domestic economy, because the government obtains some tax revenue and domestic producers get more revenue and profit.
Government revenue accrues from the domestic sales of imports. On imports of , tax revenue is EFHI. Then, domestic producers obtain an additional profit of LECJ—the excess of additional revenue over their cost per additional bottle. If we are not concerned about who gains and who loses, then there is a net loss to the domestic economy equal to the areas CEI and HFG.
The area HFG is the consumer side measure of deadweight loss. At the quantity , the production cost of an additional bottle is less than the value placed on it by consumers; and, by not having those additional bottles supplied, consumers forgo a potential gain. The area CEI tells us that when supply by domestic higher-cost producers is increased, and supply of lower-cost foreign producers is reduced, the corresponding resources are not being used efficiently. The sum of the areas CEI and HFG is therefore the total deadweight loss of the tariff.
In the real world we should also be interested in the magnitude of the financial amounts involved here: In particular, how much more do consumers pay with the tariff in place, relative to the additional amounts going to domestic suppliers/corporations? How much tax revenue is generated? How many jobs are created domestically as a result of 'distorting' the market? Regardless of the magnitude of the two deadweight loss areas, which represent the net cost of the tariff, we should be interested in whether the owners of capital gain at the expense of consumers.
Tariffs by country of origin - trade diversion
The imposition of tariffs is governed by the World Trade Organization (WTO). Tariffs are permitted under the WTO rules in specific circumstances: if a particular economy is deemed to be subsidizing exports, and those exports have employment impacts on the destination economy, then a 'retaliatory' tariff may be imposed. A related justification is dumping. It is frequently difficult to prove subsidization or dumping by an exporting economy. An example of such a tariff was one placed by the US on washing machines originating in China in 2016, on the basis of a dumping claim by the United States. The immediate result of this was that the manufacturers located in China switched most of their production to other plants they owned in Vietnam and Thailand. In this particular instance there was virtually no impact on the retail price of washing machines in the US.
Dumping is a predatory practice, based on artificially low costs aimed at driving out domestic producers.
The traditional theory of tariffs described in 15.4 implicitly assumes that production and employment increase in the importing economy as a result of domestic production displacing imported goods. This analysis assumes that the tariff is imposed on a particular commodity, regardless of its economy of origin.
Production subsidies
Figure 15.5 illustrates the effect of a subsidy to a domestic supplier. As in Figure 15.4, the amount QD is demanded in the free trade equilibrium and, of this, QS is supplied domestically. With a subsidy per unit of output sold, the government can reduce the supply cost of the domestic supplier, thereby shifting the supply curve downward from S to . In this illustration, the total quantity demanded remains at QD, but the domestic share increases to .
Figure 15.5 Subsidies and trade
With a world supply price of P, a domestic supply curve S, and a domestic demand D, the amount QD is purchased. Of this, Qs is supplied domestically and (QDQs) by foreign suppliers. A per-unit subsidy to domestic suppliers shifts their supply curve to , and increases their market share to .
The new equilibrium represents a misallocation of resources. When domestic output increases from QS to , a low-cost international producer is being replaced by a higher cost domestic supplier; the domestic supply curve S lies above the international supply curve P in this range of output.
Note that this example deals with a subsidy to domestic suppliers who are selling in the domestic market. It is not a subsidy to domestic producers who are selling in the international market – an export subsidy.
This subsidy comes with a cost to the domestic economy: Taxpayers-at-large must pay higher taxes to support this policy; and each dollar raised in tax itself has a deadweight loss, as we examined in Chapter 5.
Quotas
A quota is a limit placed upon the amount of a good that can be imported. Consider Figure 15.6, where again there is a domestic supply curve coupled with a world price of P. Rather than imposing a tariff, the government imposes a quota that restricts imports to a physical amount denoted by the distance quota on the quantity axis. The supply curve facing domestic consumers then has several segments to it. First it has the segment RC, reflecting the fact that domestic suppliers are competitive with world suppliers up to the amount C. Beyond this output, world suppliers can supply at a price of P, whereas domestic suppliers cannot compete at this price. Therefore the supply curve becomes horizontal, but only up to the amount permitted under the quota—the quantity CU corresponding to quota. Beyond this amount, international supply is not permitted and therefore additional amounts are supplied by the (higher cost) domestic suppliers. Hence the supply curve to domestic buyers becomes the supply curve from the domestic suppliers once again.
Figure 15.6 Quotas and trade
At the world price P, plus a quota, the supply curve becomes RCUV. This has three segments: (i) domestic suppliers who can supply below P; (ii) quota; and (iii) domestic suppliers who can only supply at a price above P. The quota equilibrium is at T, with price and quantity ; the free-trade equilibrium is at G. Of the amount , quota is supplied by foreign suppliers and the remainder by domestic suppliers. The quota increases the price in the domestic market.
The resulting supply curve yields an equilibrium quantity . There are several features to note about this equilibrium. First, the quota pushes the domestic price above the world price ( is greater than P) because low-cost international suppliers are partially supplanted by higher-cost domestic suppliers. Second, if the quota is chosen 'appropriately', the same domestic market price could exist under the quota as under the tariff in Figure 15.4. Third, in contrast to the tariff case, the government obtains no tax revenue from the quotas. The higher market price under a quota means that the price per unit received by foreign suppliers is now rather than P. De facto, instead of tax revenue being generated in the importing economy, the foreign supplier benefits from a higher price. Fourth, inefficiencies are associated with the equilibrium at . These inefficiencies arise because the lower-cost international suppliers are not permitted to supply the amount they would be willing to supply at the quota-induced market equilibrium. In other words, more efficient producers are being squeezed out of the market by quotas that make space for less-efficient producers.
Application Box 15.3 Cheese quota in Canada
In 1978 the federal government set a cheese import quota for Canada at just over 20,000 tonnes. This quota was implemented initially to protect the interests of domestic suppliers. Despite a strong growth in population and income in the intervening decades, the import quota has remained unchanged. The result is a price for cheese that is considerably higher than it would otherwise be. The quotas are owned by individuals and companies who have the right to import cheese. The quotas are also traded among importers, at a price. Importers wishing to import cheese beyond their available quota pay a tariff of about 250 percent. So, while the consumer is the undoubted loser in this game, who gains?
First the suppliers gain, as illustrated in Figure 15.6. Canadian consumers are required to pay high-cost domestic producers who displace lower-cost producers from overseas. Second, the holders of the quotas gain. With the increase in demand for cheese that comes with higher incomes, the domestic cheese price increases over time and this in turn makes an individual quota more valuable.
In the 2018 United States Mexico Canada Agreement, a slight increase in access to Canadian markets was granted in return for a corresponding increase in access to the US market. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.05%3A_Trade_barriers-_Tariffs_subsidies_and_quotas.txt |
Objections to imports are frequent and come from many different sectors of the economy. In the face of the gains from trade which we have illustrated in this chapter, why do we observe such strong opposition to imported goods and services?
Structural change and technology
In a nutshell the answer is that, while consumers in the aggregate gain from the reduction of trade barriers, and there is a net gain to the economy at large, some individual sectors of the economy lose out. Not surprisingly the sectors that will be adversely affected are vociferous in lodging their objections. Sectors of the economy that cannot compete with overseas suppliers generally see a reduction in jobs. This has been the case in the manufacturing sector of the Canadian and US economies in recent decades, as manufacturing and assembly has flown off-shore to Asia and Mexico where labour costs are lower. Domestic job losses are painful, and frequently workers who have spent decades in a particular job find reemployment difficult, and rarely get as high a wage as in their displaced job.
Such job losses are reflected in calls for tariffs on imports from China, for example, in order to 'level the playing field' – that is, to counter the impact of lower wages in China. Of course it is precisely because of lower labour costs in China that the Canadian consumer benefits.
In Canada we deal with such dislocation first by providing unemployment payments to workers, and by furnishing retraining allowances, both coming from Canada's Employment Insurance program. While such support does not guarantee an equally good alternative job, structural changes in the economy, due to both internal and external developments, must be confronted. For example, the information technology revolution made tens of thousands of 'data entry' workers redundant. Should producers have shunned the technological developments which increased their productivity dramatically? If they did, would they be able to compete in world markets?
While job losses feature heavily in protests against technological development and freer trade, most modern economies continue to grow and create more jobs in the service sector than are lost in the manufacturing sector. Developed economies now have many more workers in service than manufacture. Service jobs are not just composed of low-wage jobs in fast food establishments – 'Mcjobs', they are high paying jobs in the health, education, legal, financial and communications sectors of the economy.
Successful lobbying and concentration
While efforts to protect manufacture have not resulted in significant barriers to imports of manufactures, objections in some specific sectors of the economy seem to be effective worldwide. One sector that stands out is agriculture, where political conditions are conducive to the continuance of protection and what is called 'supply management' – domestic production quotas. The reason for 'successful' supply limitation appears to rest in the geographic concentration of potential beneficiaries of such protection and the scattered beneficiaries of freer trade on the one hand, and the costs and benefits of political organization on the other: Farmers tend to be concentrated in a limited number of rural electoral ridings and hence they can collectively have a major impact on electoral outcomes. Second, the benefits that accrue to trade restriction are heavily concentrated in the economy – keep in mind that about two percent of the population lives on farms, or relies on farming for its income. By contrast the costs on a per person scale are small, and are spread over the whole population. Thus, in terms of the costs of political organization, the incentives for consumers are small, but the incentives for producers are high.
In addition to the differing patterns of costs and benefits, rural communities tend to be more successful in pushing trade restrictions based on a 'way-of-life' argument. By permitting imports that might displace local supply, lobbyists are frequently successful in convincing politicians that long-standing way-of-life traditions would be endangered, even if such 'traditions' are accompanied by monopolies and exceptionally high tariffs.
Valid trade barriers: Infant industries and dumping?
An argument that carries both intellectual and emotional appeal to voters is the 'infant industry' argument. It goes as follows: New ventures and sectors of the economy may require time before that can compete internationally. Scale economies may be involved, for example, and time may be required for producers to expand their scale of operation, at which time costs will have fallen to international (i.e. competitive) levels. In addition, learning-by-doing may be critical in more high-tech sectors and, once again, with the passage of time costs should decline for this reason also.
The problem with this stance is that these 'infants' have insufficient incentive to 'grow up' and become competitive. A protection measure that is initially intended to be temporary can become permanent because of the potential job losses associated with a cessation of the protection to an industry that fails to become internationally competitive. Furthermore, employees and managers in protected sectors have insufficient incentive to make their production competitive if they realize that their government will always be there to protect them.
In contrast to the infant industry argument, economists are more favourable to restrictions that are aimed at preventing dumping.
Dumping may occur either because foreign suppliers choose to sell at artificially low prices (prices below their break-even price for example), or because of surpluses in foreign markets resulting from oversupply. For example, if, as a result of price support in its own market, a foreign government induced oversupply in butter and it chose to sell such butter on world markets at a price well below the going ('competitive') world supply price, such a sale would constitute dumping. Alternatively, an established foreign supplier might choose to enter our domestic market by selling its products at artificially low prices, with a view to driving domestic competition out of the domestic market. Having driven out the domestic competition it would then be in a position to raise prices. This is predatory pricing as explored in the last chapter. Such behaviour differs from a permanently lower price on the part of foreign suppliers. This latter may be welcomed as a gain from trade, whereas the former may generate no gains and serve only to displace domestic labour and capital.
Protectionism in the age of pandemics
The year 2020 will be remembered in history as the year of the coronavirus pandemic. An uncountable number of men and women died all across the globe as a result of contracting COVID-19, the respiratory disorder brought on by an attack of the coronavirus. In the absence of a vaccine, health authorities the world over implemented a twin policy of social distancing and quarantining (or self-isolation). The world economy went into a tailspin, as huge fractions of the labor force were laid off. Trade patterns were disrupted and serious shortages of personal protection equipment (PPE - masks, visors, gowns), ventilators and drugs emerged. The world demand for PPE and ventilators skyrocketed. But the production of PPE was concentrated in China; most western economies did not have the necessary productive capacity to supply even non-pandemic requirements. Bidding wars erupted amongst countries and hospitals as they vied for supply, while domestic producers of some products added to their production capacity.
Following this chaos, we ask if self-sufficiency would not be a better model than open trade. Would a world where each country ensured it had the production capacity to produce these necessities in times of emergency not be superior to one where global supply chains characterize everything from computers to generic drugs? India is a major producer of generic drugs and the components for such drugs. The demand for anti-biotics and pain killers also rocketed upwards with the pandemic.
There is more than one way to plan for a pandemic, and such planning should not involve a generalized move to self-sufficiency on the part of the global economy. One strategy is to build up inventories of PPE and ventilators domestically. This is costly, but for the most part feasible. It does not represent a complete solution because technology changes will make 30-year old ventilators sitting in inventory redundant for the next pandemic. In addition, most medications have a limited shelf life. Hence one solution is to maintain and rotate substantial inventories of emergency equipment using existing supply chains, and benefit from the efficiencies that are built into these chains.
A second option is to maintain excess production capacity on the part of domestic manufacturers of critical pandemic products. Maintaining such capacity should be considered at least partially as a social cost; pandemics ravage societies, not just individuals, and therefore society should undertake part of the cost of insuring against them.
A more general argument against global trade comes in the form of protecting food supplies. In the early 2000s an increase in global cereal prices led some economies to limit exports of specific crops on account of the fact that global demand was pushing prices to a level that low-income consumers could not afford. But such a policy may threaten consumers in other low-income economies whose demands have not changed in a context of reduced supplies. The reality is that world food supply is adequate for world consumption, even in the presence of disruptions. It is also the case that certain economies have huge advantages in producing specific kinds of food. For example, Canada, the US and the Ukraine produce cereals very economically. Mountainous regions are unsuitable for this production. It would benefit no economy for these economies to lower their production of grains to the point where they produced only enough for their own production. By the same reasoning, warmer climates produce fruits, coffee beans, olives etc that cannot easily be produced in many regions suited to wheat. The gains to specialization in the world economy are enormous. Where food shortages occur we frequently encounter the scourges of drought or war or political upheaval, and these conditions inhibit the distribution of foodstuffs.
What about supply chains? If motherboards produced in China are not being exported in sufficient quantities then indeed production of computers in North America will suffer. But to infer from this that North America should decide to produce all of its computer components in North America is illogical. First, in the time of a pandemic, if certain economies in the supply chain are on lockdown, we cannot be sure that the domestic economy would not be on lockdown simultaneously. Second, the cost to moving the production of all computer parts to North America would likely double the cost of computer hardware - including cell-phones. Perhaps a disruption to our supply chains is something we need to bear in extraordinary times. In case it requires emphasis, most producers in supply chains have incentives to produce and sell. If they do not they will die economically.
The energy sector of every economy is impacted with the outbreak of a pandemic. This is because the demand for fuel (primarily oil) declines following policies of social distancing, limits on permissible travel, and the closure of some production facilities that depend upon oil. In North America, as we saw in Chapter 4 earlier, the price of oil declined from US \$60 per barrel to US \$20 in the space of two months in early 2020. Since production costs are higher in both Canada and much of the US than in Saudi Arabia, the North Sea and Russia, producers in North America were squeezed. Many were no longer able to cover their full production costs, and forced to cease drilling and recovering oil. Inevitably there was a clamor for protection. Producers sought tariffs on competing oil: Tariffs would increase the price of cheaper-to-produce foreign oil and enable domestic producers to survive.
While protection might seem like a 'sensible' policy in this instance, the fact is that unilateral tariffs usually invite reprisals, and raise the danger of a trade war with ever-expanding counter protectionism. In contrast to the case of a shortage of medical supplies, the energy sector in Canada suffered from a glut of world oil supply. The domestic issue is not about the health of consumers (as in the case of medical supplies), it is about the health of producers.
To conclude: a pandemic is a profoundly serious event and such events inflict major costs on all societies. There are no magic bullets in the form of low-cost ideal economic policies to counter viral warfare. The key to policy making is to recognize constraints and recognize an attack as soon as possible. A wholesale move to insulate the domestic economy is ill-conceived. Comparative advantage confers enormous benefits to all nations. Specific policies should take the form of inventory management and excess production capacity in specific sectors of the economy. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.06%3A_The_politics_of_protection.txt |
In the nineteenth century, world trade grew rapidly, in part because the leading trading nation at the time—the United Kingdom—pursued a vigorous policy of free trade. In contrast, US tariffs averaged about 50 percent, although they had fallen to around 30 percent by the early 1920s. As the industrial economies went into the Great Depression of the late 1920s and 1930s, there was pressure to protect domestic jobs by keeping out imports. Tariffs in the United States returned to around 50 percent, and the United Kingdom abandoned the policy of free trade that had been pursued for nearly a century. The combination of world recession and increasing tariffs led to a disastrous slump in the volume of world trade, further exacerbated by World War II.
The WTO and GATT
After World War II, there was a collective determination to see world trade restored. Bodies such as the International Monetary Fund and the World Bank were set up, and many countries signed the General Agreement on Tariffs and Trade (GATT), a commitment to reduce tariffs progressively and dismantle trade restrictions.
Under successive rounds of GATT, tariffs fell steadily. By 1960, United States tariffs were only one-fifth of their level at the outbreak of the War. In the United Kingdom, the system of wartime quotas on imports had been dismantled by the mid-1950s, after which tariffs were reduced by nearly half in the ensuing 25 years. Europe as a whole moved toward an enlarged European Union in which tariffs between member countries have been abolished. By the late 1980s, Canada's tariffs had been reduced to about one-quarter of their immediate post-World War II level.
The GATT Secretariat, now called the World Trade Organization (WTO), aims both to dismantle existing protection that reduces efficiency and to extend trade liberalization to more and more countries. Tariff levels throughout the world are now as low as they have ever been, and trade liberalization has been an engine of growth for many economies. The consequence has been a substantial growth in world trade.
NAFTA, the USMCA, the EU, the CETA, and the TPP
In North America, policy since the 1980s has led to a free trade area that covers the flow of trade between Canada, the United States, and Mexico. The Canada/United States free trade agreement (FTA) of 1989 expanded in 1994 to include Mexico in the North American Free Trade Agreement (NAFTA). The objective in both cases was to institute freer trade between these countries in most goods and services. This meant the elimination or reduction of tariffs and non-tariff barriers over a period of years, with a few exceptions in specific products and cultural industries. A critical component of the Agreement was the establishment of a dispute-resolution mechanism, under which disputes would be resolved by a panel of 'judges' nominated from the member economies. Evidence of the success of these agreements is reflected in the fact that Canadian exports have grown to more than 30 percent of GDP, and trade with the United States accounts for the lion's share of Canadian trade flows. NAFTA was updated and replaced in 2018 and the new agreement is termed the United States Mexico Canada Agreement.
The European Union was formed after World War II, with the prime objective of bringing about a greater degree of political integration in Europe. Two world wars had laid waste to their economies and social fabric. Closer economic ties and greater trade were seen as the means of achieving this integration. The Union was called the "Common Market" for much of its existence. The Union originally had six member states, and as of 2019 the number is 28, with several other candidate countries in the process of application, most notably Turkey. The European Union (EU) has a secretariat and parliament in Bruxelles. The UK intends to exit the EU as of late 2019.
Canada has concluded a free trade agreement with the European Union that is termed the Comprehensive Economic and Trade Agreement (CETA). It has the objective of implementing free trade between the two negotiating parties, though there remain some exceptions, for example agriculture.
The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) is a trading agreement between Canada and ten other Pacific-Rim economies that came into being in 2018. Negotiations for a Trans Pacific Partnership treaty were complete by 2016. Those negotiations involved 12 Pacific Rim economies including Canada and the United States, but excluding China. The Obama presidency appeared ready to sign the treaty, however the Trump presidency (and also the Democratic candidate for president of the US, Hillary Clinton) decided that the Partnership was not in the interests of the United States and withdrew its affiliation. The remaining 11 economies reached an agreement to implement the partnership in December 2018.
15.08: Key Terms
Autarky denotes the no-trade situation.
Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.
Terms of trade define the rate at which goods trade internationally.
Consumption possibility frontier defines what an economy can consume after production specialization and trade.
Intra-industry trade is two-way international trade in products produced within the same industry.
Intra-firm trade is two-way trade in international products produced within the same firm.
Supply chain: denotes the numerous sources for intermediate goods used in producing a final product.
Intermediate good: one that is used in the production of final output.
Content requirement: requires that a specified percentage of the final value of a product originate in the producing economy.
Dynamic gains: the potential for domestic producers to increase productivity by competing with, and learning from, foreign producers.
Total factor productivity: how efficiently the factors of production are combined.
Tariff is a tax on an imported product that is designed to limit trade in addition to generating tax revenue. It is a barrier to trade.
Quota is a quantitative limit on an imported product.
Trade subsidy to a domestic manufacturer reduces the domestic cost and limits imports.
Non-tariff barriers, such as product content requirements, limits the gains from trade.
Dumping is a predatory practice, based on artificial costs aimed at driving out domestic producers. | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.07%3A_Institutions_governing_trade.txt |
EXERCISE 15.1
The following table shows the labour input requirements to produce a bushel of wheat and a litre of wine in two countries, Northland and Southland, on the assumption of constant cost production technology – meaning that the production possibility curves in each are straight lines. You can answer this question either by analyzing the table or developing a graph similar to Figure 15.1, assuming each economy has 4 units of labour.
Labour requirements per unit produced
Northland Southland
Per bushel of wheat 1 3
Per litre of wine 2 4
1. Which country has an absolute advantage in the production of both wheat and wine?
2. What is the opportunity cost of wheat in each economy? Of wine?
3. What is the pattern of comparative advantage here?
4. Suppose the country with a comparative advantage in wine reduces wheat production by one bushel and reallocates the labour involved to wine production. How much additional wine does it produce?
EXERCISE 15.2
Canada and the United States can produce two goods, xylophones and yogurt. Each good can be produced with labour alone. Canada requires 60 hours to produce a ton of yogurt and 6 hours to produce a xylophone. The United States requires 40 hours to produce the ton of yogurt and 5 hours to produce a xylophone.
1. Describe the state of absolute advantage between these economies in producing goods.
2. In which good does Canada have a comparative advantage? Does this mean the United States has a comparative advantage in the other good?
3. Draw the production possibility frontier for each economy to scale on a diagram, assuming that each economy has an endowment of 240 hours of labour, and that the PPFs are linear.
4. On the same diagram, draw Canada's consumption possibility frontier on the assumption that it can trade with the United States at the United States' rate of transformation.
5. Draw the US consumption possibility frontier under the assumption that it can trade at Canada's rate of transformation.
EXERCISE 15.3
The domestic demand for bicycles is given by P=36–0.3Q. The foreign supply is given by P=18 and domestic supply by P=16+0.4Q.
1. Illustrate the market equilibrium on a diagram, and illustrate the amounts supplied by domestic and foreign suppliers in equilibrium.
2. If the government now imposes a tariff of \$6 per unit on the foreign good, illustrate the impact geometrically.
3. In the diagram, illustrate the area representing tariff revenue.
4. Optional: Compute the price and quantity in equilibrium with free trade, and again in the presence of the tariff.
EXERCISE 15.4
1. In Exercise 15.3, illustrate graphically the deadweight losses associated with the imposition of the tariff.
2. Illustrate on your diagram the additional amount of profit made by the domestic producer as a result of the tariff. [Hint: Refer to Figure 15.4 in the text.]
EXERCISE 15.5
The domestic demand for office printers is given by P=40–0.2Q. The supply of domestic producers is given by P=12+0.1Q, and international supply by P=20.
1. Illustrate this market geometrically.
2. If the government gives a production subsidy of \$2 per unit to domestic suppliers in order to increase their competitiveness, illustrate the impact of this on the domestic supply curve.
3. Illustrate geometrically the cost to the government of this scheme.
EXERCISE 15.6
Consider the data underlying Figure 15.1. Suppose, from the initial state of comparative advantage, where Canada specializes in fish and the US in vegetable, we have a technological change in fishing. The US invents the multi-hook fishing line, and as a result can now produce 64 units of fish with the same amount of labour, rather than the 40 units it could produce before the technological change. This technology does not spread to Canada however.
1. Illustrate the new PPF for the US in addition to the PPF for Canada.
2. What is the new opportunity cost (number of fish) associated with one unit of V?
3. Has comparative advantage changed here – which economy should specialize in the production of each good?
EXERCISE 15.7
The following are hypothetical (straight line) production possibilities tables for Canada and the United States. For each line required, plot any two or more points on the line.
Canada United States
A B C D A B C D
Peaches 0 5 10 15 Peaches 0 10 20 30
Apples 30 20 10 0 Apples 15 10 5 0
1. Plot Canada's production possibilities curve.
2. Plot the United States' production possibilities curve.
3. What is each country's cost ratio of producing peaches and apples?
4. Which economy should specialize in which product?
5. Plot the United States' trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.
6. Plot the Canada' trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.
7. Suppose that the optimum product mixes before specialization and trade were B in the United States and C in Canada. What are the gains from specialization and trade? | textbooks/socialsci/Economics/Principles_of_Microeconomics_(Curtis_and_Irvine)/06%3A_Government_and_Trade/15%3A_International_trade/15.09%3A_Exercises_for_Chapter_15.txt |
Figure 1.1 Do You Use Facebook? Economics is greatly impacted by how well information travels through society. Today, social media giants Twitter, Facebook, and Instagram are major forces on the information super highway. (Credit: modification of "Social Media Mixed Icons - Banner" by Blogtrepreneur/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• What Is Economics, and Why Is It Important?
• Microeconomics and Macroeconomics
• How Economists Use Theories and Models to Understand Economic Issues
• How Economies Can Be Organized: An Overview of Economic Systems
Bring It Home
Information Overload in the Information Age
To post or not to post? Every day we are faced with a myriad of decisions, from what to have for breakfast, to which show to stream, to the more complex—“Should I double major and add possibly another semester of study to my education?” Our response to these choices depends on the information we have available at any given moment. Economists call this “imperfect” because we rarely have all the data we need to make perfect decisions. Despite the lack of perfect information, we still make hundreds of decisions a day.
Streams, sponsors, and social media are altering the process by which we make choices, how we spend our time, which movies we see, which products we buy, and more. Whether they read the reviews or just check the ratings, it's unlikely for Americans to make many significant decisions without these information streams.
As you will see in this course, what happens in economics is affected by how well and how fast information disseminates through a society, such as how quickly information travels through Facebook. “Economists love nothing better than when deep and liquid markets operate under conditions of perfect information,” says Jessica Irvine, National Economics Editor for News Corp Australia.
This leads us to the topic of this chapter, an introduction to the world of making decisions, processing information, and understanding behavior in markets —the world of economics. Each chapter in this book will start with a discussion about current (or sometimes past) events and revisit it at chapter’s end—to “bring home” the concepts in play.
What is economics and why should you spend your time learning it? After all, there are other disciplines you could be studying, and other ways you could be spending your time. As the Bring it Home feature just mentioned, making choices is at the heart of what economists study, and your decision to take this course is as much as economic decision as anything else.
Economics is probably not what you think. It is not primarily about money or finance. It is not primarily about business. It is not mathematics. What is it then? It is both a subject area and a way of viewing the world.
1.02: What Is Economics and Why Is It Important
Learning Objectives
By the end of this section, you will be able to:
• Discuss the importance of studying economics
• Explain the relationship between production and division of labor
• Evaluate the significance of scarcity
Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 expendable hours in the day to earn income to acquire goods and services, for leisure time, or for sleep. At any point in time, there is only a finite amount of resources available.
Think about it this way: In 2015 the labor force in the United States contained over 158 million workers, according to the U.S. Bureau of Labor Statistics. The total land area was 3,794,101 square miles. While these are certainly large numbers, they are not infinite. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem.
Introduction to FRED
Data is very important in economics because it describes and measures the issues and problems that economics seek to understand. A variety of government agencies publish economic and social data. For this course, we will generally use data from the St. Louis Federal Reserve Bank's FRED database. FRED is very user friendly. It allows you to display data in tables or charts, and you can easily download it into spreadsheet form if you want to use the data for other purposes. The FRED website includes data on nearly 400,000 domestic and international variables over time, in the following broad categories:
• Money, Banking & Finance
• Population, Employment, & Labor Markets (including Income Distribution)
• National Accounts (Gross Domestic Product & its components), Flow of Funds, and International Accounts
• Production & Business Activity (including Business Cycles)
• Prices & Inflation (including the Consumer Price Index, the Producer Price Index, and the Employment Cost Index)
• International Data from other nations
• U.S. Regional Data
• Academic Data (including Penn World Tables & NBER Macrohistory database)
For more information about how to use FRED, see the variety of videos on YouTube starting with this introduction.
Figure 1.2 Scarcity of Resources People experiencing homelessness are a stark reminder that scarcity of resources is real. (Credit: "Pittsburgh Homeless" by "daveyinn"/Flickr Creative Commons, CC BY 2.0)
If you still do not believe that scarcity is a problem, consider the following: Does everyone require food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as Figure 1.2 shows), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics.
The Problem of Scarcity
Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy all the things we want. This is because of scarcity. So how do we solve it?
Link It Up
Visit this website to read about how the United States is dealing with scarcity in resources.
Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. How do we use our limited resources the best way possible, that is, to obtain the most goods and services we can? There are a couple of options. First, we could each produce everything we each consume. Alternatively, we could each produce some of what we want to consume, and “trade” for the rest of what we want. Let’s explore these options. Why do we not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things, but it is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith (Figure 1.3) in his book, The Wealth of Nations.
Figure 1.3 Adam Smith Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: "Adam Smith" by Cadell and Davies (1811), John Horsburgh (1828), or R.C. Bell (1872)/Wikimedia Commons, Public Domain)
The Division of and Specialization of Labor
The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which means that the way one produces a good or service is divided into a number of tasks that different workers perform, instead of all the tasks being done by the same person.
To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that different people performed—all for a pin, believe it or not!
Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory (Figure 1.4), or a hospital can have hundreds of job classifications.
Figure 1.4 Division of Labor Workers on an assembly line are an example of the divisions of labor. (Credit: "Red Wing Shoe Factory Tour" by Nina Hale/Flickr Creative Commons, CC BY 2.0)
Why the Division of Labor Increases Production
When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons.
First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more effective than if they produce a combination of things, some of which they are good at and some of which they are not.
Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better.
A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products.
Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of their own goods and services. The division and specialization of labor has been a force against the problem of scarcity.
Trade and Markets
Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade.
You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy.
Why Study Economics?
Figure 1.5 Esther Duflo, Abhijit Banerjee, and Michael Kremer Esther Duflo, Abhijit Banerjee (both from Massachusetts Institute of Technology), and Michael Kremer (University of Chicago) were awarded the Nobel Prize for groundbreaking work in which they established experimental methods to understand poverty and outcomes of initiatives to address it. (Credit: modification of work by U.S. Embassy Sweden/Wikimedia Commons, CC BY 2.0; Financial Times/Wikimedia Commons, CC BY 2.0; U.S. Embassy Sweden/Flickr Creative Commons, CC BY 2.0)
Now that you have an overview on what economics studies, let’s quickly discuss why you are right to study it. Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn. Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics provides the tools to solve those puzzles.
Consider the complex and critical issue of education barriers on national and regional levels, which affect millions of people and result in widespread poverty and inequality. Governments, aid organizations, and wealthy individuals spend billions of dollars each year trying to address these issues. Nations announce the revitalization of their education programs; tech companies donate devices and infrastructure, and celebrities and charities build schools and sponsor students. Yet the problems remain, sometimes almost as pronounced as they were before the intervention. Why is that the case? In 2019, three economists—Esther Duflo, Abhijit Banerjee, and Michael Kremer—were awarded the Nobel Prize for their work to answer those questions. They worked diligently to break the widespread problems into smaller pieces, and experimented with small interventions to test success. The award citation credited their work with giving the world better tools and information to address poverty and improve education. Esther Duflo, who is the youngest person and second woman to win the Nobel Prize in Economics, said, "We believed that like the war on cancer, the war on poverty was not going to be won in one major battle, but in a series of small triumphs. . . . This work and the culture of learning that it fostered in governments has led to real improvement in the lives of hundreds of millions of poor people.”
As you can see, economics affects far more than business. For example:
• Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial.
• It is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues? Did you know?
• A basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will understand and be able to evaluate the writer’s argument. When you hear classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics.
The study of economics does not dictate the answers, but it can illuminate the different choices. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/01%3A_Welcome_to_Economics/1.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe microeconomics
• Describe macroeconomics
• Contrast monetary policy and fiscal policy
Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption.
It should be clear by now that economics covers considerable ground. We can divide that ground into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy.
To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the lake's ecosystem from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint.
Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live.
In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy. For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy's performance ultimately depends on the microeconomic decisions that individual households and businesses make.
Microeconomics
What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means?
What determines the products, and how many of each, a firm will produce and sell? What determines the prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how markets for labor and other resources work, and how markets sometimes fail to work properly.
Macroeconomics
What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay them off? Finally, what causes the economy to grow over the long term?
We can determine an economy's macroeconomic health by examining a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can we use government macroeconomic policy to pursue these goals? A nation's central bank conducts monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets. For the United States, this is the Federal Reserve. A nation's legislative body determines fiscal policy, which involves government spending and taxes. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the government's main tools. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the macroeconomic chapters of this book. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/01%3A_Welcome_to_Economics/1.03%3A_Microeconomics_and_Macroeconomics.txt |
Learning Objectives
By the end of this section, you will be able to:
• Interpret a circular flow diagram
• Explain the importance of economic theories and models
• Describe goods and services markets and labor markets
Figure 1.6 John Maynard Keynes One of the most influential economists in modern times was John Maynard Keynes. (Credit: “John Maynard Keynes” by IMF/Wikimedia Commons, Public Domain)
John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes (Figure 1.6) famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.
Link It Up
Watch this video about John Maynard Keynes and his influence on economics.
Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.
Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. We use models to test theories, but for this course we will use the terms interchangeably.
For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.
A good model to start with in economics is the circular flow diagram (Figure 1.7). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.
Figure 1.7 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.
Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g., land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrows “C” and “D” represent the two sides of the factor market.
Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand.
This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).
Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/01%3A_Welcome_to_Economics/1.04%3A_How_Economists_Use_Theories_and_Models_to_Understand_Economic_Issues.txt |
Learning Objectives
By the end of this section, you will be able to:
• Contrast traditional economies, command economies, and market economies
• Explain gross domestic product (GDP)
• Assess the importance and effects of globalization
Think about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who ensures that, for example, the number of televisions a society provides is the same as the amount it needs and wants? Who ensures that the right number of employees work in the electronics industry? Who ensures that televisions are produced in the best way possible? How does it all get done?
There are at least three ways that societies organize an economy. The first is the traditional economy, which is the oldest economic system and is used in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops using traditional methods. What you produce is what you consume. Because tradition drives the way of life, there is little economic progress or development.
Figure 1.8 A Command Economy Ancient Egypt was an example of a command economy. (Credit: "Pyramids at Giza" by Jay Bergesen/Flickr Creative Commons, CC BY 2.0)
Command economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those in Figure 1.8, for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.
In a command economy, the government decides what goods and services will be produced and what prices it will charge for them. The government decides what methods of production to use and sets wages for workers. The government provides many necessities like healthcare and education for free. Currently, Cuba and North Korea have command economies.
Figure 1.9 A Market Economy Nothing says “market” more than The New York Stock Exchange. (Credit: work by Erik Drost/Flickr Creative Commons, CC BY 2.0)
Although command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange (Figure 1.9) is a prime example of a market which brings buyers and sellers together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the private individuals or groups of private individuals own and operate the means of production (resources and businesses). Businesses supply goods and services based on demand. (In a command economy, by contrast, the government owns resources and businesses.) Supply of goods and services depends on what the demands are. A person’s income is based on their ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income (think Lady Gaga or LeBron James). In this scenario, market forces, not governments, determine economic decisions.
Most economies in the real world are mixed. They combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy. China and Russia, while over the past several decades have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum. The Heritage Foundation provides perspective on countries’ economic freedom, as the following Clear It Up feature discusses.
Clear It Up
What countries are considered economically free?
Who is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans, or does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category. Note that while the Heritage Foundation/WSJ index is widely cited by an array of scholars and publications, it should be regarded as only one viewpoint. Some experts indicate that the index’s category choices and scores are politically biased. However, the index and others like it provide a useful resource for critical discussion of economic freedom.
The 2016 Heritage Foundation’s Index of Economic Freedom report ranked 178 countries around the world: Table 1.1 lists some examples of the most free and the least free countries. Although technically not a separate country, Hong Kong has been granted a degree of autonomy such that, for purposes of measuring economic statistics, it is often treated as a separate country. Several additional countries were not ranked because of extreme instability that made judgments about economic freedom impossible. These countries include Afghanistan, Iraq, Libya, Syria, Somalia, and Yemen.
The assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77 of the countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of economic freedom around the world.
Most Economic Freedom Least Economic Freedom
1. Hong Kong 167. Timor-Leste
2. Singapore 168. Democratic Republic of Congo
3. New Zealand 169. Argentina
4. Switzerland 170. Equatorial Guinea
5. Australia 171. Iran
6. Canada 172. Republic of Congo
7. Chile 173. Eritrea
8. Ireland 174. Turkmenistan
9. Estonia 175. Zimbabwe
10. United Kingdom 176. Venezuela
11. United States 177. Cuba
12. Denmark 178. North Korea
Table 1.1 Economic Freedoms, 2016 (Source: The Heritage Foundation, 2016 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking)
Regulations: The Rules of the Game
Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? The government heavily regulates decisions of what to produce and prices to charge. Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the government’s approval.
The question of how to organize economic institutions is typically not a straightforward choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules.
Figure 1.10 Globalization Cargo ships are one mode of transportation for shipping goods in the global economy. (Credit: "Cargo Ship" by Raul Valdez/Flickr Creative Commons, CC BY 2.0)
The Rise of Globalization
Recent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows.
Globalization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container ship in Figure 1.10, and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of information—for example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade.
Table 1.2 presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2015, according to an entity known as The World Bank. Exports are the goods and services that one produces domestically and sells abroad. Imports are the goods and services that one produces abroad and then sells domestically. Gross domestic product (GDP) measures the size of total production in an economy. Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries.
Country 2010 2011 2012 2013 2014 2015
Higher Income Countries
United States 12.4 13.6 13.6 13.5 13.5 12.6
Belgium 76.2 81.4 82.2 82.8 84.0 84.4
Canada 29.1 30.7 30.0 30.1 31.7 31.5
France 26.0 27.8 28.1 28.3 29.0 30.0
Middle Income Countries
Brazil 10.9 11.9 12.6 12.6 11.2 13.0
Mexico 29.9 31.2 32.6 31.7 32.3 35.3
South Korea 49.4 55.7 56.3 53.9 50.3 45.9
Lower Income Countries
Chad 36.8 38.9 36.9 32.2 34.2 29.8
China 29.4 28.5 27.3 26.4 23.9 22.4
India 22.0 23.9 24.0 24.8 22.9 -
Nigeria 25.3 31.3 31.4 18.0 18.4 -
Table 1.2 The Extent of Globalization (exports/GDP) (Source: http://databank.worldbank.org/data/)
In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries.
Table 1.2 indicates that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections.
Despite the rise in globalization over the last few decades, in recent years we've seen significant pushback against globalization from people across the world concerned about loss of jobs, loss of political sovereignty, and increased economic inequality. Prominent examples of this pushback include the 2016 vote in Great Britain to exit the European Union (i.e. Brexit), and the election of Donald J. Trump for President of the United States.
Hopefully, you now have an idea about economics. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called The Use of Mathematics in Principles of Economics. It is essential that you learn more about how to read and use models in economics.
Bring It Home
Information Overload in the Information Age
The world provides nearly instant access to a wealth of information. Consider that as recently as the late 1970s, the Farmer’s Almanac, along with the Weather Bureau of the U.S. Department of Agriculture, were the primary sources American farmers used to determine when to plant and harvest their crops. Today, these decisions are driven by data. Farmers access detailed data streams driven by global positioning systems, historical rainfall patterns, and complex weather monitoring services. They combine this information with crop yield data and soil quality measurements from prior years. Maximizing production efficiently can mean the difference between a farm that remains profitable and one that may need to sell its land, and data helps eliminate guesswork.
Information helps us make decisions as simple as what to wear today to how many reporters the media should send to cover an event. Each of these decisions is an economic decision. After all, resources are scarce. If the media send ten reporters to cover an announcement, they are not available to cover other stories or complete other tasks. Information provides the necessary knowledge to make the best possible decisions on how to utilize scarce resources. Welcome to the world of economics! | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/01%3A_Welcome_to_Economics/1.05%3A_How_To_Organize_Economies-_An_Overview_of_Economic_Systems.txt |
circular flow diagram
a diagram that views the economy as consisting of households and firms interacting in a goods and services market and a labor market
command economy
an economy where economic decisions are passed down from government authority and where the government owns the resources
division of labor
the way in which different workers divide required tasks to produce a good or service
economics
the study of how humans make choices under conditions of scarcity
economies of scale
when the average cost of producing each individual unit declines as total output increases
exports
products (goods and services) made domestically and sold abroad
fiscal policy
economic policies that involve government spending and taxes
globalization
the trend in which buying and selling in markets have increasingly crossed national borders
goods and services market
a market in which firms are sellers of what they produce and households are buyers
gross domestic product (GDP)
measure of the size of total production in an economy
imports
products (goods and services) made abroad and then sold domestically
labor market
the market in which households sell their labor as workers to business firms or other employers
macroeconomics
the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance
market
interaction between potential buyers and sellers; a combination of demand and supply
market economy
an economy where economic decisions are decentralized, private individuals own resources, and businesses supply goods and services based on demand
microeconomics
the branch of economics that focuses on actions of particular agents within the economy, like households, workers, and business firms
model
see theory
monetary policy
policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing
private enterprise
system where private individuals or groups of private individuals own and operate the means of production (resources and businesses)
scarcity
when human wants for goods and services exceed the available supply
specialization
when workers or firms focus on particular tasks for which they are well-suited within the overall production process
theory
a representation of an object or situation that is simplified while including enough of the key features to help us understand the object or situation
traditional economy
typically an agricultural economy where things are done the same as they have always been done
underground economy
a market where the buyers and sellers make transactions in violation of one or more government regulations
1.07: Key Concepts and Summary
1.1 What Is Economics, and Why Is It Important?
Economics seeks to solve the problem of scarcity, which is when human wants for goods and services exceed the available supply. A modern economy displays a division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. Division and specialization of labor only work when individuals can purchase what they do not produce in markets. Learning about economics helps you understand the major problems facing the world today, prepares you to be a good citizen, and helps you become a well-rounded thinker.
1.2 Microeconomics and Macroeconomics
Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy.
1.3 How Economists Use Theories and Models to Understand Economic Issues
Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.
1.4 How To Organize Economies: An Overview of Economic Systems
We can organize societies as traditional, command, or market-oriented economies. Most societies are a mix. The last few decades have seen globalization evolve as a result of growth in commercial and financial networks that cross national borders, making businesses and workers from different economies increasingly interdependent. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/01%3A_Welcome_to_Economics/1.06%3A_Key_Terms.txt |
1.
What is scarcity? Can you think of two causes of scarcity?
2.
Residents of the town of Smithfield like to consume hams, but each ham requires 10 people to produce it and takes a month. If the town has a total of 100 people, what is the maximum amount of ham the residents can consume in a month?
3.
A consultant works for \$200 per hour. She likes to eat vegetables, but is not very good at growing them. Why does it make more economic sense for her to spend her time at the consulting job and shop for her vegetables?
4.
A computer systems engineer could paint her house, but it makes more sense for her to hire a painter to do it. Explain why.
5.
What would be another example of a “system” in the real world that could serve as a metaphor for micro and macroeconomics?
6.
Suppose we extend the circular flow model to add imports and exports. Copy the circular flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw a rough sketch of the flows of imports, exports, and the payments for each on your diagram.
7.
What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension?
8.
The chapter defines private enterprise as a characteristic of market-oriented economies. What would public enterprise be? Hint: It is a characteristic of command economies.
9.
Why might Belgium, France, Italy, and Sweden have a higher export to GDP ratio than the United States?
1.09: Review Questions
10.
Give the three reasons that explain why the division of labor increases an economy’s level of production.
11.
What are three reasons to study economics?
12.
What is the difference between microeconomics and macroeconomics?
13.
What are examples of individual economic agents?
14.
What are the three main goals of macroeconomics?
15.
How did John Maynard Keynes define economics?
16.
Are households primarily buyers or sellers in the goods and services market? In the labor market?
17.
Are firms primarily buyers or sellers in the goods and services market? In the labor market?
18.
What are the three ways that societies can organize themselves economically?
19.
What is globalization? How do you think it might have affected the economy over the past decade?
1.10: Critical Thinking Questions
20.
Suppose you have a team of two workers: one is a baker and one is a chef. Explain why the kitchen can produce more meals in a given period of time if each worker specializes in what they do best than if each worker tries to do everything from appetizer to dessert.
21.
Why would division of labor without trade not work?
22.
Can you think of any examples of free goods, that is, goods or services that are not scarce?
23.
A balanced federal budget and a balance of trade are secondary goals of macroeconomics, while growth in the standard of living (for example) is a primary goal. Why do you think that is so?
24.
Macroeconomics is an aggregate of what happens at the microeconomic level. Would it be possible for what happens at the macro level to differ from how economic agents would react to some stimulus at the micro level? Hint: Think about the behavior of crowds.
25.
Why is it unfair or meaningless to criticize a theory as “unrealistic?”
26.
Suppose, as an economist, you are asked to analyze an issue unlike anything you have ever done before. Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation?
27.
Why do you think that most modern countries’ economies are a mix of command and market types?
28.
Can you think of ways that globalization has helped you economically? Can you think of ways that it has not? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/01%3A_Welcome_to_Economics/1.08%3A_Self-Check_Questions.txt |
Figure 2.1 Choices and Tradeoffs In general, the higher the degree, the higher the salary, so why aren’t more people pursuing higher degrees? The short answer: choices and tradeoffs. (Credit: modification of "College of DuPage Commencement 2018 107" by COD Newsroom/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• How Individuals Make Choices Based on Their Budget Constraint
• The Production Possibilities Frontier and Social Choices
• Confronting Objections to the Economic Approach
Bring It Home
Choices ... to What Degree?
Does your level of education impact earning? Let’s look at some data from the Bureau of Labor Statistics (BLS). In 2020, among full-time wage and salary workers, median weekly earnings for those with a master’s degree were \$1,545. Multiply this average by 52 weeks, and you get average annual earnings of \$80,340. Compare that to the median weekly earnings for full-time workers aged 25 and over with just a bachelor’s degree: \$1,305 weekly and \$67,860 a year. What about those with no higher than a high school diploma in 2020? They earn an average of just \$781 weekly and \$40,612 over 12 months. In other words, data from the BLS indicates that receiving a bachelor’s degree boosts earnings by 67% over what workers would have earned if they only obtained a high school diploma, and a master’s degree yields average earnings that are nearly double those of workers with a high school diploma.
Given these statistics, we might expect many people to choose to go to college and at least earn a bachelor’s degree. Assuming that people want to improve their material well-being, it seems like they would make those choices that provide them with the greatest opportunity to consume goods and services. As it turns out, the analysis is not nearly as simple as this. In fact, in 2019, the BLS reported that while just over 90% of the population aged 25 and over in the United States had a high school diploma, only 36% of those aged 25 and over had a bachelor's or higher degree, and only 13.5% had earned a master's or higher degree.
This brings us to the subject of this chapter: why people make the choices they make and how economists explain those choices.
You will learn quickly when you examine the relationship between economics and scarcity that choices involve tradeoffs. Every choice has a cost.
In 1968, the Rolling Stones recorded “You Can’t Always Get What You Want.” Economists chuckled, because they had been singing a similar tune for decades. English economist Lionel Robbins (1898–1984), in his Essay on the Nature and Significance of Economic Science in 1932, described not always getting what you want in this way:
The time at our disposal is limited. There are only twenty-four hours in the day. We have to choose between the different uses to which they may be put. ... Everywhere we turn, if we choose one thing we must relinquish others which, in different circumstances, we would wish not to have relinquished. Scarcity of means to satisfy given ends is an almost ubiquitous condition of human nature.
Because people live in a world of scarcity, they cannot have all the time, money, possessions, and experiences they wish. Neither can society.
This chapter will continue our discussion of scarcity and the economic way of thinking by first introducing three critical concepts: opportunity cost, marginal decision making, and diminishing returns. Later, it will consider whether the economic way of thinking accurately describes either how we make choices and how we should make them. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/02%3A_Choice_in_a_World_of_Scarcity/2.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate and graph budget constraints
• Explain opportunity sets and opportunity costs
• Evaluate the law of diminishing marginal utility
• Explain how marginal analysis and utility influence choices
Consider the typical consumer’s budget problem. Consumers have a limited amount of income to spend on the things they need and want. Suppose Alphonso has \$10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost \$2 each, and bus tickets are 50 cents each. We can see Alphonso's budget problem in Figure 2.2.
Figure 2.2 The Budget Constraint: Alphonso’s Consumption Choice Opportunity Frontier Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of \$10. The relative price of burgers and bus tickets determines the slope of the budget constraint. All along the budget set, giving up one burger means gaining four bus tickets.
The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. (\$10 per week/\$2 per burger = 5 burgers per week.) However, if he does this, he will not be able to afford any bus tickets. Point A in the figure shows the choice (zero bus tickets and five burgers). Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week. (\$10 per week/\$0.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. Point F shows this alternative choice (20 bus tickets and zero burgers).
If we connect all the points between A and F, we get Alphonso's budget constraint. This indicates all the combination of burgers and bus tickets Alphonso can afford, given the price of the two goods and his budget amount.
If Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that is between points A and F. Every point on (or inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.
The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he can afford 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer \$2, but that’s not the way economists think. Instead they ask, how many bus tickets would Alphonso have to give up to get one more burger, while staying within his budget? Since bus tickets cost 50 cents, Alphonso would have to give up four to afford one more burger. That is the true cost to Alphonso.
The Concept of Opportunity Cost
Economists use the term opportunity cost to indicate what people must give up to obtain what they desire. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. Since people must choose, they inevitably face tradeoffs in which they have to give up things they desire to obtain other things they desire more.
Link It Up
View this website for an example of opportunity cost—paying someone else to wait in line for you.
A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class, the opportunity cost is the learning you miss from not attending class. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us and part of human existence.
The following Work It Out feature shows a step-by-step analysis of a budget constraint calculation. Read through it to understand another important concept—slope—that we further explain in the appendix The Use of Mathematics in Principles of Economics.
Work It Out
Understanding Budget Constraints
Budget constraints are easy to understand if you apply a little math. The appendix The Use of Mathematics in Principles of Economics explains all the math you are likely to need in this book. Therefore, if math is not your strength, you might want to take a look at the appendix.
Step 1: The equation for any budget constraint is:
$Budget=P1 × Q1 + P2× Q2Budget=P1 × Q1 + P2× Q2$
where P and Q are the price and quantity of items purchased (which we assume here to be two items) and Budget is the amount of income one has to spend.
Step 2. Apply the budget constraint equation to the scenario. In Alphonso’s case, this works out to be:
$Budget= P1 × Q1 + P2× Q2 10 budget=2 per burger × quantity of burgers + 0.50 per bus ticket × quantity of bus tickets10=2 × Qburgers + 0.50 × Qbus ticketsBudget= P1 × Q1 + P2× Q2 10 budget=2 per burger × quantity of burgers + 0.50 per bus ticket × quantity of bus tickets10=2 × Qburgers + 0.50 × Qbus tickets$
Step 3. Using a little algebra, we can turn this into the familiar equation of a line:
$y = b + mxy = b + mx$
For Alphonso, this is:
$10 = 2 × Qburgers + 0.50 × Qbus tickets10 = 2 × Qburgers + 0.50 × Qbus tickets$
Step 4. Simplify the equation. Begin by multiplying both sides of the equation by 2:
$2 × 10 = 2 × 2 × Qburgers + 2 × 0.5 × Qbus tickets 20 = 4 × Qburgers + 1 × Qbus tickets2 × 10 = 2 × 2 × Qburgers + 2 × 0.5 × Qbus tickets 20 = 4 × Qburgers + 1 × Qbus tickets$
Step 5. Subtract one bus ticket from both sides:
$20 – Qbus tickets = 4 × Qburgers20 – Qbus tickets = 4 × Qburgers$
Divide each side by 4 to yield the answer:
$5 – 0.25 × Qbus tickets = QburgersorQburgers = 5 – 0.25 × Qbus tickets5 – 0.25 × Qbus tickets = QburgersorQburgers = 5 – 0.25 × Qbus tickets$
Step 6. Notice that this equation fits the budget constraint in Figure 2.2. The vertical intercept is 5 and the slope is –0.25, just as the equation says. If you plug 20 bus tickets into the equation, you get 0 burgers. If you plug other numbers of bus tickets into the equation, you get the results (see Table 2.1), which are the points on Alphonso’s budget constraint.
Point Quantity of Burgers (at \$2) Quantity of Bus Tickets (at 50 cents)
A 5 0
B 4 4
C 3 8
D 2 12
E 1 16
F 0 20
Table 2.1
Step 7. Notice that the slope of a budget constraint always shows the opportunity cost of the good which is on the horizontal axis. For Alphonso, the slope is −0.25, indicating that for every bus ticket he buys, he must give up 1/4 burger. To phrase it differently, for every four tickets he buys, Alphonso must give up 1 burger.
There are two important observations here. First, the algebraic sign of the slope is negative, which means that the only way to get more of one good is to give up some of the other. Second, we define the slope as the price of bus tickets (whatever is on the horizontal axis in the graph) divided by the price of burgers (whatever is on the vertical axis), in this case \$0.50/\$2 = 0.25. If you want to determine the opportunity cost quickly, just divide the two prices.
Identifying Opportunity Cost
In many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for \$300, then \$300 measures the amount of “other consumption” that he has forsaken. For practical purposes, there may be no special need to identify the specific alternative product or products that he could have bought with that \$300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved.
For example, consider a boss who decides that all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants. However, an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work.
Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. However, in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.
Clear It Up
What is the opportunity cost associated with increased airport security measures?
After the terrorist plane hijackings on September 11, 2001, many steps were proposed to improve air travel safety. For example, the federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly \$3 billion per year. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of \$450 million. Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face recognition software, could cost another \$2 billion.
However, the single biggest cost of greater airline security does not involve spending money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation (DOT), there were 895.5 million systemwide (domestic and international) scheduled service passengers in 2015. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively high-paid business people, conservative estimates set the average price of time for air travelers at \$20 per hour. By these back-of-the-envelope calculations, the opportunity cost of delays in airports could be as much as 800 million × 0.5 hours × \$20/hour, or \$8 billion per year. Clearly, the opportunity costs of waiting time can be just as important as costs that involve direct spending.
In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you spend \$8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only \$3 a day, so the opportunity cost of buying lunch at the restaurant is \$5 each day (that is, the \$8 buying lunch costs minus the \$3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 days a year × \$5 per day equals \$1,250, the cost, perhaps, of a decent vacation. If you describe the opportunity cost as “a nice vacation” instead of “\$5 a day,” you might make different choices.
Marginal Decision-Making and Diminishing Marginal Utility
The budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another; that is, they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end. Instead, most choices involve marginal analysis, which means examining the benefits and costs of choosing a little more or a little less of a good. People naturally compare costs and benefits, but often we look at total costs and total benefits, when the optimal choice necessitates comparing how costs and benefits change from one option to another. You might think of marginal analysis as “change analysis.” Marginal analysis is used throughout economics.
We now turn to the notion of utility. People desire goods and services for the satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on Consumer Choices, is subjective but that does not make it less real. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides that he chooses might provide him with a great deal of utility—perhaps they help him get to a job interview or a doctor’s appointment. However, later bus rides might provide much less utility—they may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to buy may be on a day when he missed breakfast and is ravenously hungry. However, if Alphonso has multiple burgers every day, the last few burgers may taste pretty boring. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth.
The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now on.” Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high. Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive. The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less.
A rational consumer would only purchase additional units of some product as long as the marginal utility exceeds the opportunity cost. Suppose Alphonso moves down his budget constraint from Point A to Point B to Point C and further. As he consumes more bus tickets, the marginal utility of bus tickets will diminish, while the opportunity cost, that is, the marginal utility of foregone burgers, will increase. Eventually, the opportunity cost will exceed the marginal utility of an additional bus ticket. If Alphonso is rational, he won’t purchase more bus tickets once the marginal utility just equals the opportunity cost. While we can’t (yet) say exactly how many bus tickets Alphonso will buy, that number is unlikely to be the most he can afford, 20.
Sunk Costs
In the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will you consume, how many hours will you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered, should not affect the current decision.
Consider the case of Selena, who pays \$8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is sympathetic, Selena will not get a refund. However, staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do something—anything—else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options.
For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. However, the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future.
From a Model with Two Goods to One of Many Goods
The budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. In more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that we presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/02%3A_Choice_in_a_World_of_Scarcity/2.02%3A_How_Individuals_Make_Choices_Based_on_Their_Budget_Constraint.txt |
Learning Objectives
By the end of this section, you will be able to:
• Interpret production possibilities frontier graphs
• Contrast a budget constraint and a production possibilities frontier
• Explain the relationship between a production possibilities frontier and the law of diminishing returns
• Contrast productive efficiency and allocative efficiency
• Define comparative advantage
Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section of the chapter will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities.
Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in Figure 2.3 illustrates this situation.
Figure 2.3 A Healthcare vs. Education Production Possibilities Frontier This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education.
Figure 2.3 shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier. In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Alphonso. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF.
Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to forgo. Just as with Alphonso’s budget constraint, the slope of the production possibilities frontier shows the opportunity cost. By now you might be saying, “Hey, this PPF is sounding like the budget constraint.” If so, read the following Clear It Up feature.
Clear It Up
What’s the difference between a budget constraint and a PPF?
There are two major differences between a budget constraint and a production possibilities frontier. The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods, which from the point of view of an individual consumer, are fixed, so the slope doesn't change. In contrast, the PPF has a curved shape because of the law of the diminishing returns. Thus, the slope is different at various points on the PPF. The second major difference is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education. If this were a real world example, that data would be available.
Whether or not we have specific numbers, conceptually we can measure the opportunity cost of additional education as society moves from point B to point C on the PPF. We measure the additional education by the horizontal distance between B and C. The foregone healthcare is given by the vertical distance between B and C. The slope of the PPF between B and C is (approximately) the vertical distance (the “rise”) over the horizontal distance (the “run”). This is the opportunity cost of the additional education.
The PPF and the Law of Increasing Opportunity Cost
The budget constraints that we presented earlier in this chapter, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the relative prices of the two goods in the consumption budget constraint determined the slope of the budget constraint. However, we drew the production possibilities frontier for healthcare and education as a curved line. Why does the PPF have a different shape?
To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to healthcare and none are left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.
Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to healthcare, and moves to point F, which is devoting all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.
The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If on the one hand, very few resources are currently committed to education, then an increase in resources used for education can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains.
This pattern is common enough that economists have given it a name: the law of increasing opportunity cost, which holds that as production of a good or service increases, the marginal opportunity cost of producing it increases as well. This happens because some resources are better suited for producing certain goods and services instead of others. When government spends a certain amount more on reducing crime, for example, the original increase in opportunity cost of reducing crime could be relatively small. However, additional increases typically cause relatively larger increases in the opportunity cost of reducing crime, and paying for enough police and security to reduce crime to nothing at all would be a tremendously high opportunity cost.
The curvature of the production possibilities frontier shows that as we add more resources to education, moving from left to right along the horizontal axis, the original increase in opportunity cost is fairly small, but gradually increases. Thus, the slope of the PPF is relatively flat near the vertical-axis intercept. Conversely, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original declines in opportunity cost are fairly large, but again gradually diminish. Thus, the slope of the PPF is relatively steep near the horizontal-axis intercept. In this way, the law of increasing opportunity cost produces the outward-bending shape of the production possibilities frontier.
Productive Efficiency and Allocative Efficiency
The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.
The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency. Figure 2.4 illustrates these ideas using a production possibilities frontier between healthcare and education.
Figure 2.4 Productive and Allocative Efficiency Productive efficiency means it is impossible to produce more of one good without decreasing the quantity that is produced of another good. Thus, all choices along a given PPF like B, C, and D display productive efficiency, but R does not. Allocative efficiency means that the particular mix of goods being produced—that is, the specific choice along the production possibilities frontier—represents the allocation that society most desires.
Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. All choices on the PPF in Figure 2.4, including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.
For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1).
We can show the particular mix of goods and services produced—that is, the specific combination of selected healthcare and education along the production possibilities frontier—as a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray.
Allocative efficiency means that the particular combination of goods and services on the production possibility curve that a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually a discussion in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.
Why Society Must Choose
In Welcome to Economics! we learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants. The production possibilities curve illustrates the choices involved in this dilemma.
Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods. In addition, over time, improvements in technology can increase the level of production with given resources, and hence push out the PPF.
However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.
The PPF and Comparative Advantage
While every society must choose how much of each good or service it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills.
Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce quite a bit of sugar cane per acre but not much wheat. Conversely, the U.S. can produce large amounts of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true: the U.S. has a lower opportunity cost of producing wheat than Brazil. We illustrate this by the PPFs of the two countries in Figure 2.5.
Figure 2.5 Production Possibility Frontier for the U.S. and Brazil The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in terms of sugar cane is lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane.
When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. In our example, Brazil has an absolute advantage in sugar cane and the U.S. has an absolute advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If however it had devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount than the U.S., at point B.
The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat is generally higher in Brazil. In the chapter on International Trade you will learn that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage, and trade part of that production for goods in which they do not have comparative advantage. With trade, manufacturers produce goods where the opportunity cost is lowest, so total production increases, benefiting both trading parties. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/02%3A_Choice_in_a_World_of_Scarcity/2.03%3A_The_Production_Possibilities_Frontier_and_Social_Choices.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze arguments against economic approaches to decision-making
• Interpret a tradeoff diagram
• Contrast normative statements and positive statements
It is one thing to understand the economic approach to decision-making and another thing to feel comfortable applying it. The sources of discomfort typically fall into two categories: that people do not act in the way that fits the economic way of thinking, and that even if people did act that way, they should try not to. Let’s consider these arguments in turn.
First Objection: People, Firms, and Society Do Not Act Like This
The economic approach to decision-making seems to require more information than most individuals possess and more careful decision-making than most individuals actually display. After all, do you or any of your friends draw a budget constraint and mutter to yourself about maximizing utility before you head to the shopping mall? Do members of the U.S. Congress contemplate production possibilities frontiers before they vote on the annual budget? The messy ways in which people and societies operate somehow doesn’t look much like neat budget constraints or smoothly curving production possibilities frontiers.
However, the economics approach can be a useful way to analyze and understand the tradeoffs of economic decisions. To appreciate this point, imagine for a moment that you are playing basketball, dribbling to the right, and throwing a bounce-pass to the left to a teammate who is running toward the basket. A physicist or engineer could work out the correct speed and trajectory for the pass, given the different movements involved and the weight and bounciness of the ball. However, when you are playing basketball, you do not perform any of these calculations. You just pass the ball, and if you are a good player, you will do so with high accuracy.
Someone might argue: “The scientist’s formula of the bounce-pass requires a far greater knowledge of physics and far more specific information about speeds of movement and weights than the basketball player actually has, so it must be an unrealistic description of how basketball passes actually occur.” This reaction would be wrongheaded. The fact that a good player can throw the ball accurately because of practice and skill, without making a physics calculation, does not mean that the physics calculation is wrong.
Similarly, from an economic point of view, someone who shops for groceries every week has a great deal of practice with how to purchase the combination of goods that will provide that person with utility, even if the shopper does not phrase decisions in terms of a budget constraint. Government institutions may work imperfectly and slowly, but in general, a democratic form of government feels pressure from voters and social institutions to make the choices that are most widely preferred by people in that society. Thus, when thinking about the economic actions of groups of people, firms, and society, it is reasonable, as a first approximation, to analyze them with the tools of economic analysis. For more on this, read about behavioral economics in the chapter on Consumer Choices.
Second Objection: People, Firms, and Society Should Not Act This Way
The economics approach portrays people as self-interested. For some critics of this approach, even if self-interest is an accurate description of how people behave, these behaviors are not moral. Instead, the critics argue that people should be taught to care more deeply about others. Economists offer several answers to these concerns.
First, economics is not a form of moral instruction. Rather, it seeks to describe economic behavior as it actually exists. Philosophers draw a distinction between positive statements, which describe the world as it is, and normative statements, which describe how the world should be. Positive statements are factual. They may be true or false, but we can test them, at least in principle. Normative statements are subjective questions of opinion. We cannot test them since we cannot prove opinions to be true or false. They just are opinions based on one's values. For example, an economist could analyze a proposed subway system in a certain city. If the expected benefits exceed the costs, he concludes that the project is worthy—an example of positive analysis. Another economist argues for extended unemployment compensation during the COVID-19 pandemic because a rich country like the United States should take care of its less fortunate citizens—an example of normative analysis.
Even if the line between positive and normative statements is not always crystal clear, economic analysis does try to remain rooted in the study of the actual people who inhabit the actual economy. Fortunately however, the assumption that individuals are purely self-interested is a simplification about human nature. In fact, we need to look no further than to Adam Smith, the very father of modern economics to find evidence of this. The opening sentence of his book, The Theory of Moral Sentiments, puts it very clearly: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” Clearly, individuals are both self-interested and altruistic.
Second, we can label self-interested behavior and profit-seeking with other names, such as personal choice and freedom. The ability to make personal choices about buying, working, and saving is an important personal freedom. Some people may choose high-pressure, high-paying jobs so that they can earn and spend considerable amounts of money on themselves. Others may allocate large portions of their earnings to charity or spend it on their friends and family. Others may devote themselves to a career that can require much time, energy, and expertise but does not offer high financial rewards, like being an elementary school teacher or a social worker. Still others may choose a job that does consume much of their time or provide a high level of income, but still leaves time for family, friends, and contemplation. Some people may prefer to work for a large company; others might want to start their own business. People’s freedom to make their own economic choices has a moral value worth respecting.
Clear It Up
Is a diagram by any other name the same?
When you study economics, you may feel buried under an avalanche of diagrams. Your goal should be to recognize the common underlying logic and pattern of the diagrams, not to memorize each one.
This chapter uses only one basic diagram, although we present it with different sets of labels. The consumption budget constraint and the production possibilities frontier for society, as a whole, are the same basic diagram. Figure 2.6 shows an individual budget constraint and a production possibilities frontier for two goods, Good 1 and Good 2. The tradeoff diagram always illustrates three basic themes: scarcity, tradeoffs, and economic efficiency.
The first theme is scarcity. It is not feasible to have unlimited amounts of both goods. Even if the budget constraint or a PPF shifts, scarcity remains—just at a different level. The second theme is tradeoffs. As depicted in the budget constraint or the production possibilities frontier, it is necessary to forgo some of one good to gain more of the other good. The details of this tradeoff vary. In a budget constraint we determine, the tradeoff is determined by the relative prices of the goods: that is, the relative price of two goods in the consumption choice budget constraint. These tradeoffs appear as a straight line. However, a curved line represents the tradeoffs in many production possibilities frontiers because the law of diminishing returns holds that as we add resources to an area, the marginal gains tend to diminish. Regardless of the specific shape, tradeoffs remain.
The third theme is economic efficiency, or getting the most benefit from scarce resources. All choices on the production possibilities frontier show productive efficiency because in such cases, there is no way to increase the quantity of one good without decreasing the quantity of the other. Similarly, when an individual makes a choice along a budget constraint, there is no way to increase the quantity of one good without decreasing the quantity of the other. The choice on a production possibilities set that is socially preferred, or the choice on an individual’s budget constraint that is personally preferred, will display allocative efficiency.
The basic budget constraint/production possibilities frontier diagram will recur throughout this book. Some examples include using these tradeoff diagrams to analyze trade, environmental protection and economic output, equality of incomes and economic output, and the macroeconomic tradeoff between consumption and investment. Do not allow the different labels to confuse you. The budget constraint/production possibilities frontier diagram is always just a tool for thinking carefully about scarcity, tradeoffs, and efficiency in a particular situation.
Figure 2.6 The Tradeoff Diagram Both the individual opportunity set (or budget constraint) and the social production possibilities frontier show the constraints under which individual consumers and society as a whole operate. Both diagrams show the tradeoff in choosing more of one good at the cost of less of the other.
Third, self-interested behavior can lead to positive social results. For example, when people work hard to make a living, they create economic output. Consumers who are looking for the best deals will encourage businesses to offer goods and services that meet their needs. Adam Smith, writing in The Wealth of Nations, named this property the invisible hand. In describing how consumers and producers interact in a market economy, Smith wrote:
Every individual…generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain. And he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.
The metaphor of the invisible hand suggests the remarkable possibility that broader social good can emerge from selfish individual actions.
Fourth, even people who focus on their own self-interest in the economic part of their life often set aside their own narrow self-interest in other parts of life. For example, you might focus on your own self-interest when asking your employer for a raise or negotiating to buy a car. Then you might turn around and focus on other people when you volunteer to read stories at the local library, help a friend move to a new apartment, or donate money to a charity. Self-interest is a reasonable starting point for analyzing many economic decisions, without needing to imply that people never do anything that is not in their own immediate self-interest.
Bring It Home
Choices ... to What Degree?
What have we learned? We know that scarcity impacts all the choices we make. An economist might argue that people do not obtain a bachelor’s or master’s degree because they do not have the resources to make those choices or because their incomes are too low and/or the price of these degrees is too high. A bachelor’s or a master’s degree may not be available in their opportunity set.
The price of these degrees may be too high not only because the actual price, college tuition (and perhaps room and board), is too high. An economist might also say that for many people, the full opportunity cost of a bachelor’s or a master’s degree is too high. For these people, they are unwilling or unable to make the tradeoff of forfeiting years of working, and earning an income, to earn a degree.
Finally, the statistics we introduced at the start of the chapter reveal information about intertemporal choices. An economist might say that people choose not to obtain a college degree because they may have to borrow money to attend college, and the interest they have to pay on that loan in the future will affect their decisions today. Also, it could be that some people have a preference for current consumption over future consumption, so they choose to work now at a lower salary and consume now, rather than postponing that consumption until after they graduate college. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/02%3A_Choice_in_a_World_of_Scarcity/2.04%3A_Confronting_Objections_to_the_Economic_Approach.txt |
allocative efficiency
when the mix of goods produced represents the mix that society most desires
budget constraint
all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set
comparative advantage
when a country can produce a good at a lower cost in terms of other goods; or, when a country has a lower opportunity cost of production
invisible hand
Adam Smith's concept that individuals' self-interested behavior can lead to positive social outcomes
law of diminishing marginal utility
as we consume more of a good or service, the utility we get from additional units of the good or service tends to become smaller than what we received from earlier units
law of diminishing returns
as we add additional increments of resources to producing a good or service, the marginal benefit from those additional increments will decline
marginal analysis
examination of decisions on the margin, meaning a little more or a little less from the status quo
normative statement
statement which describes how the world should be
opportunity cost
measures cost by what we give up/forfeit in exchange; opportunity cost measures the value of the forgone alternative
opportunity set
all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income
positive statement
statement which describes the world as it is
production possibilities frontier (PPF)
a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available.
productive efficiency
when it is impossible to produce more of one good (or service) without decreasing the quantity produced of another good (or service)
sunk costs
costs that we make in the past that we cannot recover
utility
satisfaction, usefulness, or value one obtains from consuming goods and services
2.06: Key Concepts and Summary
2.1 How Individuals Make Choices Based on Their Budget Constraint
Economists see the real world as one of scarcity: that is, a world in which people’s desires exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals, firms, and society must forgo something that they desire to obtain things that they desire more. Individuals face the tradeoff of what quantities of goods and services to consume. The budget constraint, which is the frontier of the opportunity set, illustrates the range of available choices. The relative price of the choices determines the slope of the budget constraint. Choices beyond the budget constraint are not affordable.
Opportunity cost measures cost by what we forgo in exchange. Sometimes we can measure opportunity cost in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that we must forfeit.
Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal analysis, which means they are about decisions on the margin, involving a little more or a little less. The law of diminishing marginal utility points out that as a person receives more of something—whether it is a specific good or another resource—the additional marginal gains tend to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should be disregarded in making current decisions.
2.2 The Production Possibilities Frontier and Social Choices
A production possibilities frontier defines the set of choices society faces for the combinations of goods and services it can produce given the resources and the technology that are available. The shape of the PPF is typically curved outward, rather than straight. Choices outside the PPF are unattainable and choices inside the PPF are wasteful. Over time, a growing economy will tend to shift the PPF outwards.
The law of diminishing returns holds that as increments of additional resources are devoted to producing something, the marginal increase in output will become increasingly smaller. All choices along a production possibilities frontier display productive efficiency; that is, it is impossible to use society’s resources to produce more of one good without decreasing production of the other good. The specific choice along a production possibilities frontier that reflects the mix of goods society prefers is the choice with allocative efficiency. The curvature of the PPF is likely to differ by country, which results in different countries having comparative advantage in different goods. Total production can increase if countries specialize in the goods in which they have comparative advantage and trade some of their production for the remaining goods.
2.3 Confronting Objections to the Economic Approach
The economic way of thinking provides a useful approach to understanding human behavior. Economists make the careful distinction between positive statements, which describe the world as it is, and normative statements, which describe how the world should be. Even when economics analyzes the gains and losses from various events or policies, and thus draws normative conclusions about how the world should be, the analysis of economics is rooted in a positive analysis of how people, firms, and governments actually behave, not how they should behave. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/02%3A_Choice_in_a_World_of_Scarcity/2.05%3A_Key_Terms.txt |
1.
Suppose Alphonso’s town raised the price of bus tickets from \$0.50 per trip to \$1 per trip (while the price of burgers stayed at \$2 and his budget remained \$10 per week.) Draw Alphonso’s new budget constraint. What happens to the opportunity cost of bus tickets?
2.
Return to the example in Figure 2.4. Suppose there is an improvement in medical technology that enables more healthcare with the same amount of resources. How would this affect the production possibilities curve and, in particular, how would it affect the opportunity cost of education?
3.
Could a nation be producing in a way that is allocatively efficient, but productively inefficient?
4.
What are the similarities between a consumer’s budget constraint and society’s production possibilities frontier, not just graphically but analytically?
5.
Individuals may not act in the rational, calculating way described by the economic model of decision making, measuring utility and costs at the margin, but can you make a case that they behave approximately that way?
6.
Would an op-ed piece in a newspaper urging the adoption of a particular economic policy be a positive or normative statement?
7.
Would a research study on the effects of soft drink consumption on children’s cognitive development be a positive or normative statement?
2.08: Review Questions
8.
Explain why scarcity leads to tradeoffs.
9.
Explain why individuals make choices that are directly on the budget constraint, rather than inside the budget constraint or outside it.
10.
What is comparative advantage?
11.
What does a production possibilities frontier illustrate?
12.
Why is a production possibilities frontier typically drawn as a curve, rather than a straight line?
13.
Explain why societies cannot make a choice above their production possibilities frontier and should not make a choice below it.
14.
What are diminishing marginal returns?
15.
What is productive efficiency? Allocative efficiency?
16.
What is the difference between a positive and a normative statement?
17.
Is the economic model of decision-making intended as a literal description of how individuals, firms, and the governments actually make decisions?
18.
What are four responses to the claim that people should not behave in the way described in this chapter?
2.09: Critical Thinking Questions
19.
Suppose Alphonso’s town raises the price of bus tickets from \$0.50 to \$1 and the price of burgers rises from \$2 to \$4. Why is the opportunity cost of bus tickets unchanged? Suppose Alphonso’s weekly spending money increases from \$10 to \$20. How is his budget constraint affected from all three changes? Explain.
20.
During the Second World War, Germany’s factories were decimated. It also suffered many human casualties, both soldiers and civilians. How did the war affect Germany’s production possibilities curve?
21.
It is clear that productive inefficiency is a waste since resources are used in a way that produces less goods and services than a nation is capable of. Why is allocative inefficiency also wasteful?
22.
What assumptions about the economy must be true for the invisible hand to work? To what extent are those assumptions valid in the real world?
23.
Do economists have any particular expertise at making normative arguments? In other words, they have expertise at making positive statements (i.e., what will happen) about some economic policy, for example, but do they have special expertise to judge whether or not the policy should be undertaken?
2.10: Problems
Use this information to answer the following 4 questions: Jade has a weekly budget of \$24, which she likes to spend on magazines and pies.
24.
If the price of a magazine is \$4 each, what is the maximum number of magazines she could buy in a week?
25.
If the price of a pie is \$12, what is the maximum number of pies she could buy in a week?
26.
Draw Jade's budget constraint with pies on the horizontal axis and magazines on the vertical axis. What is the slope of the budget constraint?
27.
What is Jade's opportunity cost of purchasing a pie? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/02%3A_Choice_in_a_World_of_Scarcity/2.07%3A_Self-Check_Questions.txt |
Figure 3.1 Farmer’s Market Organic vegetables and fruits that are grown and sold within a specific geographical region should, in theory, cost less than conventional produce because the transportation costs are less. That is not, however, usually the case. (Credit: modification of "Old Farmers' Market" by NatalieMaynor/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Demand, Supply, and Equilibrium in Markets for Goods and Services
• Shifts in Demand and Supply for Goods and Services
• Changes in Equilibrium Price and Quantity: The Four-Step Process
• Price Ceilings and Price Floors
Bring It Home
Why Can We Not Get Enough of Organic Foods?
Organic food is increasingly popular, not just in the United States, but worldwide. At one time, consumers had to go to specialty stores or farmers' markets to find organic produce. Now it is available in most grocery stores. In short, organic has become part of the mainstream.
Ever wonder why organic food costs more than conventional food? Why, say, does an organic Fuji apple cost \$2.75 a pound, while its conventional counterpart costs \$1.72 a pound? The same price relationship is true for just about every organic product on the market. If many organic foods are locally grown, would they not take less time to get to market and therefore be cheaper? What are the forces that keep those prices from coming down? Turns out those forces have quite a bit to do with this chapter’s topic: demand and supply.
An auction bidder pays thousands of dollars for a dress Whitney Houston wore. A collector spends a small fortune for a few drawings by John Lennon. People usually react to purchases like these in two ways: their jaw drops because they think these are high prices to pay for such goods or they think these are rare, desirable items and the amount paid seems right.
Link It Up
Visit this website to read a list of bizarre items that have been purchased for their ties to celebrities. These examples represent an interesting facet of demand and supply.
When economists talk about prices, they are less interested in making judgments than in gaining a practical understanding of what determines prices and why prices change. Consider a price most of us contend with weekly: that of a gallon of gas. Why was the average price of gasoline in the United States \$3.16 per gallon in June of 2020? Why did the price for gasoline fall sharply to \$2.42 per gallon by January of 2021? To explain these price movements, economists focus on the determinants of what gasoline buyers are willing to pay and what gasoline sellers are willing to accept.
As it turns out, the price of gasoline in June of any given year is nearly always higher than the price in January of that same year. Over recent decades, gasoline prices in midsummer have averaged about 10 cents per gallon more than their midwinter low. The likely reason is that people drive more in the summer, and are also willing to pay more for gas, but that does not explain how steeply gas prices fell. Other factors were at work during those 18 months, such as increases in supply and decreases in the demand for crude oil.
This chapter introduces the economic model of demand and supply—one of the most powerful models in all of economics. The discussion here begins by examining how demand and supply determine the price and the quantity sold in markets for goods and services, and how changes in demand and supply lead to changes in prices and quantities. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain demand, quantity demanded, and the law of demand
• Explain supply, quantity supplied, and the law of supply
• Identify a demand curve and a supply curve
• Explain equilibrium, equilibrium price, and equilibrium quantity
First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.
Demand for Goods and Services
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a person who does not have a drivers license has no effective demand for a car.
What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.
We can show an example from the market for gasoline in a table or a graph. Economist call a table that shows the quantity demanded at each price, such as Table 3.1, a demand schedule. In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like Figure 3.2, with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical axis. Economics is not math.)
Table 3.1 shows the demand schedule and the graph in Figure 3.2 shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded.
Price (per gallon) Quantity Demanded (millions of gallons)
\$1.00 800
\$1.20 700
\$1.40 600
\$1.60 550
\$1.80 500
\$2.00 460
\$2.20 420
Table 3.1 Price and Quantity Demanded of Gasoline
Figure 3.2 A Demand Curve for Gasoline The demand schedule shows that as price rises, quantity demanded decreases, and vice versa. We graph these points, and the line connecting them is the demand curve (D). The downward slope of the demand curve again illustrates the law of demand—the inverse relationship between prices and quantity demanded.
Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.
Confused about these different types of demand? Read the next Clear It Up feature.
Clear It Up
Is demand the same as quantity demanded?
In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to a (specific) point on the curve.
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.
Still unsure about the different types of supply? See the following Clear It Up feature.
Clear It Up
Is supply the same as quantity supplied?
In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that we can illustrate with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to a (specific) point on the curve.
Figure 3.3 illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like Table 3.2, that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.
Figure 3.3 A Supply Curve for Gasoline The supply schedule is the table that shows quantity supplied of gasoline at each price. As price rises, quantity supplied also increases, and vice versa. The supply curve (S) is created by graphing the points from the supply schedule and then connecting them. The upward slope of the supply curve illustrates the law of supply—that a higher price leads to a higher quantity supplied, and vice versa.
Price (per gallon) Quantity Supplied (millions of gallons)
\$1.00 500
\$1.20 550
\$1.40 600
\$1.60 640
\$1.80 680
\$2.00 700
\$2.20 720
Table 3.2 Price and Supply of Gasoline
The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from \$1.00 per gallon to \$2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.
Equilibrium—Where Demand and Supply Intersect
Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.
Figure 3.4 illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 3.2. The supply curve (S) is identical to Figure 3.3. Table 3.3 contains the same information in tabular form.
Figure 3.4 Demand and Supply for Gasoline The demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of \$1.40 and a quantity of 600. The equilibrium price is the only price where quantity demanded is equal to quantity supplied. At a price above equilibrium like \$1.80, quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium such as \$1.20, quantity demanded exceeds quantity supplied, so there is excess demand.
Price (per gallon) Quantity demanded (millions of gallons) Quantity supplied (millions of gallons)
\$1.00 800 500
\$1.20 700 550
\$1.40 600 600
\$1.60 550 640
\$1.80 500 680
\$2.00 460 700
\$2.20 420 720
Table 3.3 Price, Quantity Demanded, and Quantity Supplied
Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in Figure 3.4, is called the equilibrium. The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.
In Figure 3.4, the equilibrium price is \$1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.
The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.
Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of \$1.40 per gallon, the price is \$1.80 per gallon. The dashed horizontal line at the price of \$1.80 in Figure 3.4 illustrates this above-equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.
Moreover, at this higher price of \$1.80, the quantity of gasoline supplied rises from 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus.
With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.
Now suppose that the price is below its equilibrium level at \$1.20 per gallon, as the dashed horizontal line at this price in Figure 3.4 shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.
When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which has been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.02%3A_Demand_Supply_and_Equilibrium_in_Markets_for_Goods_and_Services.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify factors that affect demand
• Graph demand curves and demand shifts
• Identify factors that affect supply
• Graph supply curves and supply shifts
The previous module explored how price affects the quantity demanded and the quantity supplied. The result was the demand curve and the supply curve. Price, however, is not the only factor that influences buyers’ and sellers’ decisions. For example, how is demand for vegetarian food affected if, say, health concerns cause more consumers to avoid eating meat? How is the supply of diamonds affected if diamond producers discover several new diamond mines? What are the major factors, in addition to the price, that influence demand or supply?
Link It Up
Visit this website to read a brief note on how marketing strategies can influence supply and demand of products.
What Factors Affect Demand?
We defined demand as the amount of some product a consumer is willing and able to purchase at each price. That suggests at least two factors that affect demand. Willingness to purchase suggests a desire, based on what economists call tastes and preferences. If you neither need nor want something, you will not buy it, and if you really like something, you will buy more of it than someone who does not share your strong preference for it. Ability to purchase suggests that income is important. Professors are usually able to afford better housing and transportation than students, because they have more income. Prices of related goods can affect demand also. If you need a new car, the price of a Honda may affect your demand for a Ford. Finally, the size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less for diapers and baby formula.
These factors matter for both individual and market demand as a whole. Exactly how do these various factors affect demand, and how do we show the effects graphically? To answer those questions, we need the ceteris paribus assumption.
The Ceteris Paribus Assumption
A demand curve or a supply curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a demand curve or a supply curve is that no relevant economic factors, other than the product’s price, are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. A demand curve or a supply curve is a relationship between two, and only two, variables when all other variables are kept constant. If all else is not held equal, then the laws of supply and demand will not necessarily hold, as the following Clear It Up feature shows.
Clear It Up
When does ceteris paribus apply?
We typically apply ceteris paribus when we observe how changes in price affect demand or supply, but we can apply ceteris paribus more generally. In the real world, demand and supply depend on more factors than just price. For example, a consumer’s demand depends on income and a producer’s supply depends on the cost of producing the product. How can we analyze the effect on demand or supply if multiple factors are changing at the same time—say price rises and income falls? The answer is that we examine the changes one at a time, assuming the other factors are held constant.
For example, we can say that an increase in the price reduces the amount consumers will buy (assuming income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged). This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the higher price and second because of the lower income.
How Does Income Affect Demand?
Let’s use income as an example of how factors other than price affect demand. Figure 3.5 shows the initial demand for automobiles as D0. At point Q, for example, if the price is \$20,000 per car, the quantity of cars demanded is 18 million. D0 also shows how the quantity of cars demanded would change as a result of a higher or lower price. For example, if the price of a car rose to \$22,000, the quantity demanded would decrease to 17 million, at point R.
The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand? How can we show this graphically?
Return to Figure 3.5. The price of cars is still \$20,000, but with higher incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve D1, indicating an increase in demand. Table 3.4 shows clearly that this increased demand would occur at every price, not just the original one.
Figure 3.5 Shifts in Demand: A Car Example Increased demand means that at every given price, the quantity demanded is higher, so that the demand curve shifts to the right from D0 to D1. Decreased demand means that at every given price, the quantity demanded is lower, so that the demand curve shifts to the left from D0 to D2.
Price Decrease to D2 Original Quantity Demanded D0 Increase to D1
\$16,000 17.6 million 22.0 million 24.0 million
\$18,000 16.0 million 20.0 million 22.0 million
\$20,000 14.4 million 18.0 million 20.0 million
\$22,000 13.6 million 17.0 million 19.0 million
\$24,000 13.2 million 16.5 million 18.5 million
\$26,000 12.8 million 16.0 million 18.0 million
Table 3.4 Price and Demand Shifts: A Car Example
Now, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2 represents such a decrease in demand: At any given price level, the quantity demanded is now lower. In this example, a price of \$20,000 means 18 million cars sold along the original demand curve, but only 14.4 million sold after demand fell.
When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole.
In the previous section, we argued that higher income causes greater demand at every price. This is true for most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is called a normal good. A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left.
Other Factors That Shift Demand Curves
Income is not the only factor that causes a shift in demand. Other factors that change demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. Graphically, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Let’s look at these factors.
Changing Tastes or Preferences
From 1980 to 2021, the per-person consumption of chicken by Americans rose from 47 pounds per year to 97 pounds per year, and consumption of beef fell from 76 pounds per year to 59 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good, rightward for chicken and leftward for beef.
Changes in the Composition of the Population
The proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000, and will be a projected (by the U.S. Census Bureau) 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.
Changes in the Prices of Related Goods
Changes in the prices of related goods such as substitutes or complements also can affect the demand for a product. A substitute is a good or service that we can use in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which we can show graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.
Other goods are complements for each other, meaning we often use the goods together, because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity demanded of golf clubs falls (because of the law of demand), demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.
Changes in Expectations about Future Prices or Other Factors that Affect Demand
While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. We show these changes in demand as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price. The following Work It Out feature shows how this happens.
Work It Out
Shift in Demand
A shift in demand means that at any price (and at every price), the quantity demanded will be different than it was before. Following is an example of a shift in demand due to an income increase.
Step 1. Draw the graph of a demand curve for a normal good like pizza. Pick a price (like P0). Identify the corresponding Q0. See an example in Figure 3.6.
Figure 3.6 Demand Curve We can use the demand curve to identify how much consumers would buy at any given price.
Step 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1. Figure 3.7 provides an example.
Figure 3.7 Demand Curve with Income Increase With an increase in income, consumers will purchase larger quantities, pushing demand to the right.
Step 3. Now, shift the curve through the new point. You will see that an increase in income causes an upward (or rightward) shift in the demand curve, so that at any price the quantities demanded will be higher, as Figure 3.8 illustrates.
Figure 3.8 Demand Curve Shifted Right With an increase in income, consumers will purchase larger quantities, pushing demand to the right, and causing the demand curve to shift right.
Summing Up Factors That Change Demand
Figure 3.9 summarizes six factors that can shift demand curves. The direction of the arrows indicates whether the demand curve shifts represent an increase in demand or a decrease in demand. Notice that a change in the price of the good or service itself is not listed among the factors that can shift a demand curve. A change in the price of a good or service causes a movement along a specific demand curve, and it typically leads to some change in the quantity demanded, but it does not shift the demand curve.
Figure 3.9 Factors That Shift Demand Curves (a) A list of factors that can cause an increase in demand from D0 to D1. (b) The same factors, if their direction is reversed, can cause a decrease in demand from D0 to D1.
When a demand curve shifts, it will then intersect with a given supply curve at a different equilibrium price and quantity. We are, however, getting ahead of our story. Before discussing how changes in demand can affect equilibrium price and quantity, we first need to discuss shifts in supply curves.
How Production Costs Affect Supply
A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as we described a shift in demand as a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.
In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. A firm produces goods and services using combinations of labor, materials, and machinery, or what we call inputs or factors of production. If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it is more motivated to produce output, since the more it produces the more profit it will earn. When costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. We can show this by the supply curve shifting to the right.
Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver messages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.
Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.
Consider the supply for cars, shown by curve S0 in Figure 3.10. Point J indicates that if the price is \$20,000, the quantity supplied will be 18 million cars. If the price rises to \$22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. We can show the same information in table form, as in Table 3.5.
Figure 3.10 Shifts in Supply: A Car Example Decreased supply means that at every given price, the quantity supplied is lower, so that the supply curve shifts to the left, from S0 to S1. Increased supply means that at every given price, the quantity supplied is higher, so that the supply curve shifts to the right, from S0 to S2.
Price Decrease to S1 Original Quantity Supplied S0 Increase to S2
\$16,000 10.5 million 12.0 million 13.2 million
\$18,000 13.5 million 15.0 million 16.5 million
\$20,000 16.5 million 18.0 million 19.8 million
\$22,000 18.5 million 20.0 million 22.0 million
\$24,000 19.5 million 21.0 million 23.1 million
\$26,000 20.5 million 22.0 million 24.2 million
Table 3.5 Price and Shifts in Supply: A Car Example
Now, imagine that the price of steel, an important ingredient in manufacturing cars, rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. We can show this graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of \$20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.
Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of \$20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.
Other Factors That Affect Supply
In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.
Changes in weather and climate will affect the cost of production for many agricultural products. For example, in 2014 the Manchurian Plain in Northeastern China, which produces most of the country's wheat, corn, and soybeans, experienced its most severe drought in 50 years. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied. Conversely, especially good weather would shift the supply curve to the right.
When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world used these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.
Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about \$8 billion per year from producers. Businesses treat taxes as costs. Higher costs decrease supply for the reasons we discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace. Complying with regulations increases costs.
A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right. The following Work It Out feature shows how this shift happens.
Work It Out
Shift in Supply
We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to a production cost increase. (We’ll introduce some other concepts regarding firm decision-making in Chapters 7 and 8.)
Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. Figure 3.11 provides an example.
Figure 3.11 Supply Curve You can use a supply curve to show the minimum price a firm will accept to produce a given quantity of output.
Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the cost of producing pizzas at the margin; in this case, the cost of producing the pizza, including cost of ingredients (e.g., dough, sauce, cheese, and pepperoni), the cost of the pizza oven, the shop rent, and the workers' wages. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. (Desired profit is not necessarily the same as economic profit, which will be explained in Chapter 7.) If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as Figure 3.12 illustrates.
Figure 3.12 Setting Prices The cost of production and the desired profit equal the price a firm will set for a product.
Step 3. Now, suppose that the cost of production increases. Perhaps cheese has become more expensive by \$0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost (\$0.75). Draw this point on the supply curve directly above the initial point on the curve, but \$0.75 higher, as Figure 3.13 shows.
Figure 3.13 Increasing Costs Leads to Increasing Price Because the cost of production and the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.
Step 4. Shift the supply curve through this point. You will see that an increase in cost causes an upward (or a leftward) shift of the supply curve so that at any price, the quantities supplied will be smaller, as Figure 3.14 illustrates.
Figure 3.14 Supply Curve Shifts When the cost of production increases, the supply curve shifts upwardly to a new price level.
Summing Up Factors That Change Supply
Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.
Figure 3.15 summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.
Figure 3.15 Factors That Shift Supply Curves (a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.
Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. We include factors other than price that affect demand and supply by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.03%3A_Shifts_in_Demand_and_Supply_for_Goods_and_Services.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify equilibrium price and quantity through the four-step process
• Graph equilibrium price and quantity
• Contrast shifts of demand or supply and movements along a demand or supply curve
• Graph demand and supply curves, including equilibrium price and quantity, based on real-world examples
Let’s begin this discussion with a single economic event. It might be an event that affects demand, like a change in income, population, tastes, prices of substitutes or complements, or expectations about future prices. It might be an event that affects supply, like a change in natural conditions, input prices, or technology, or government policies that affect production. How does this economic event affect equilibrium price and quantity? We will analyze this question using a four-step process.
Step 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve is negative; the law of supply, which tells us that the slope of the supply curve is positive; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity.
Step 2. Decide whether the economic change you are analyzing affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors?
Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. In other words, does the event increase or decrease the amount consumers want to buy or producers want to sell?
Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.
Let’s consider one example that involves a shift in supply and one that involves a shift in demand. Then we will consider an example where both supply and demand shift.
Good Weather for Salmon Fishing
Suppose that during the summer of 2015, weather conditions were excellent for commercial salmon fishing off the California coast. Heavy rains meant higher than normal levels of water in the rivers, which helps the salmon to breed. Slightly cooler ocean temperatures stimulated the growth of plankton, the microscopic organisms at the bottom of the ocean food chain, providing everything in the ocean with a hearty food supply. The ocean stayed calm during fishing season, so commercial fishing operations did not lose many days to bad weather. How did these climate conditions affect the quantity and price of salmon? Figure 3.16 illustrates the four-step approach, which we explain below, to work through this problem. Table 3.6 also provides the information to work the problem.
Figure 3.16 Good Weather for Salmon Fishing: The Four-Step Process Unusually good weather leads to changes in the price and quantity of salmon.
Price per Pound Quantity Supplied in 2014 Quantity Supplied in 2015 Quantity Demanded
\$2.00 80 400 840
\$2.25 120 480 680
\$2.50 160 550 550
\$2.75 200 600 450
\$3.00 230 640 350
\$3.25 250 670 250
\$3.50 270 700 200
Table 3.6 Salmon Fishing
Step 1. Draw a demand and supply model to illustrate the market for salmon in the year before the good weather conditions began. The demand curve D0 and the supply curve S0 show that the original equilibrium price is \$3.25 per pound and the original equilibrium quantity is 250,000 fish. (This price per pound is what commercial buyers pay at the fishing docks. What consumers pay at the grocery is higher.)
Step 2. Did the economic event affect supply or demand? Good weather is an example of a natural condition that affects supply.
Step 3. Was the effect on supply an increase or a decrease? Good weather is a change in natural conditions that increases the quantity supplied at any given price. The supply curve shifts to the right, moving from the original supply curve S0 to the new supply curve S1, which Figure 3.16 and Table 3.6 show.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium. At the new equilibrium E1, the equilibrium price falls from \$3.25 to \$2.50, but the equilibrium quantity increases from 250,000 to 550,000 salmon. Notice that the equilibrium quantity demanded increased, even though the demand curve did not move.
In short, good weather conditions increased supply of the California commercial salmon. The result was a higher equilibrium quantity of salmon bought and sold in the market at a lower price.
Newspapers and the Internet
According to the Pew Research Center for People and the Press, increasingly more people, especially younger people, are obtaining their news from online and digital sources. The majority of U.S. adults now own smartphones or tablets, and most of those Americans say they use them in part to access the news. From 2004 to 2012, the share of Americans who reported obtaining their news from digital sources increased from 24% to 39%. How has this affected consumption of print news media, and radio and television news? Figure 3.17 and the text below illustrates using the four-step analysis to answer this question.
Figure 3.17 The Print News Market: A Four-Step Analysis A change in tastes from print news sources to digital sources results in a leftward shift in demand for the former. The result is a decrease in both equilibrium price and quantity.
Step 1. Develop a demand and supply model to think about what the market looked like before the event. The demand curve D0 and the supply curve S0 show the original relationships. In this case, we perform the analysis without specific numbers on the price and quantity axis.
Step 2. Did the described change affect supply or demand? A change in tastes, from traditional news sources (print, radio, and television) to digital sources, caused a change in demand for the former.
Step 3. Was the effect on demand positive or negative? A shift to digital news sources will tend to mean a lower quantity demanded of traditional news sources at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from D0 to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a lower price than the original equilibrium (E0).
The decline in print news reading predates 2004. Print newspaper circulation peaked in 1973 and has declined since then due to competition from television and radio news. In 1991, 55% of Americans indicated they received their news from print sources, while only 29% did so in 2012. Radio news has followed a similar path in recent decades, with the share of Americans obtaining their news from radio declining from 54% in 1991 to 33% in 2012. Television news has held its own in recent years, with a market share staying in the mid to upper fifties. What does this suggest for the future, given that two-thirds of Americans under 30 years old say they do not obtain their news from television at all?
The Interconnections and Speed of Adjustment in Real Markets
In the real world, many factors that affect demand and supply can change all at once. For example, the demand for cars might increase because of rising incomes and population, and it might decrease because of rising gasoline prices (a complementary good). Likewise, the supply of cars might increase because of innovative new technologies that reduce the cost of car production, and it might decrease as a result of new government regulations requiring the installation of costly pollution-control technology.
Moreover, rising incomes and population or changes in gasoline prices will affect many markets, not just cars. How can an economist sort out all these interconnected events? The answer lies in the ceteris paribus assumption. Look at how each economic event affects each market, one event at a time, holding all else constant. Then combine the analyses to see the net effect.
A Combined Example
The U.S. Postal Service is facing difficult challenges. Compensation for postal workers tends to increase most years due to cost-of-living increases. At the same time, increasingly more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others. What does this suggest about the continued viability of the Postal Service? Figure 3.18 and the text below illustrate this using the four-step analysis to answer this question.
Figure 3.18 Higher Compensation for Postal Workers: A Four-Step Analysis (a) Higher labor compensation causes a leftward shift in the supply curve, a decrease in the equilibrium quantity, and an increase in the equilibrium price. (b) A change in tastes away from Postal Services causes a leftward shift in the demand curve, a decrease in the equilibrium quantity, and a decrease in the equilibrium price.
Since this problem involves two disturbances, we need two four-step analyses, the first to analyze the effects of higher compensation for postal workers, the second to analyze the effects of many people switching from “snail mail” to email and other digital messages.
Figure 3.18 (a) shows the shift in supply discussed in the following steps.
Step 1. Draw a demand and supply model to illustrate what the market for the U.S. Postal Service looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships.
Step 2. Did the described change affect supply or demand? Labor compensation is a cost of production. A change in production costs caused a change in supply for the Postal Service.
Step 3. Was the effect on supply positive or negative? Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from S0 to S1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a higher price than the original equilibrium (E0).
Figure 3.18 (b) shows the shift in demand in the following steps.
Step 1. Draw a demand and supply model to illustrate what the market for U.S. Postal Services looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships. Note that this diagram is independent from the diagram in panel (a).
Step 2. Did the change described affect supply or demand? A change in tastes away from snail mail toward digital messages will cause a change in demand for the Postal Service.
Step 3. Was the effect on demand positive or negative? A change in tastes away from snailmail toward digital messages causes lower quantity demanded of postal services at every given price, causing the demand curve for postal services to shift to the left, from D0 to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E2) occurs at a lower quantity and a lower price than the original equilibrium (E0).
The final step in a scenario where both supply and demand shift is to combine the two individual analyses to determine what happens to the equilibrium quantity and price. Graphically, we superimpose the previous two diagrams one on top of the other, as in Figure 3.19.
Figure 3.19 Combined Effect of Decreased Demand and Decreased Supply Supply and demand shifts cause changes in equilibrium price and quantity.
Following are the results:
Effect on Quantity: The effect of higher labor compensation on Postal Services because it raises the cost of production is to decrease the equilibrium quantity. The effect of a change in tastes away from snail mail is to decrease the equilibrium quantity. Since both shifts are to the left, the overall impact is a decrease in the equilibrium quantity of Postal Services (Q3). This is easy to see graphically, since Q3 is to the left of Q0.
Effect on Price: The overall effect on price is more complicated. The effect of higher labor compensation on Postal Services, because it raises the cost of production, is to increase the equilibrium price. The effect of a change in tastes away from snail mail is to decrease the equilibrium price. Since the two effects are in opposite directions, unless we know the magnitudes of the two effects, the overall effect is unclear. This is not unusual. When both curves shift, typically we can determine the overall effect on price or on quantity, but not on both. In this case, we determined the overall effect on the equilibrium quantity, but not on the equilibrium price. In other cases, it might be the opposite.
The next Clear It Up feature focuses on the difference between shifts of supply or demand and movements along a curve.
Clear It Up
What is the difference between shifts of demand or supply versus movements along a demand or supply curve?
One common mistake in applying the demand and supply framework is to confuse the shift of a demand or a supply curve with movement along a demand or supply curve. As an example, consider a problem that asks whether a drought will increase or decrease the equilibrium quantity and equilibrium price of wheat. Lee, a student in an introductory economics class, might reason:
“Well, it is clear that a drought reduces supply, so I will shift back the supply curve, as in the shift from the original supply curve S0 to S1 on the diagram (Shift 1). The equilibrium moves from E0 to E1, the equilibrium quantity is lower and the equilibrium price is higher. Then, a higher price makes farmers more likely to supply the good, so the supply curve shifts right, as shows the shift from S1 to S2, shows on the diagram (Shift 2), so that the equilibrium now moves from E1 to E2. The higher price, however, also reduces demand and so causes demand to shift back, like the shift from the original demand curve, D0 to D1 on the diagram (labeled Shift 3), and the equilibrium moves from E2 to E3.”
Figure 3.20 Shifts of Demand or Supply versus Movements along a Demand or Supply Curve A shift in one curve never causes a shift in the other curve. Rather, a shift in one curve causes a movement along the second curve.
At about this point, Lee suspects that this answer is headed down the wrong path. Think about what might be wrong with Lee’s logic, and then read the answer that follows.
Answer: Lee’s first step is correct: that is, a drought shifts back the supply curve of wheat and leads to a prediction of a lower equilibrium quantity and a higher equilibrium price. This corresponds to a movement along the original demand curve (D0), from E0 to E1. The rest of Lee’s argument is wrong, because it mixes up shifts in supply with quantity supplied, and shifts in demand with quantity demanded. A higher or lower price never shifts the supply curve, as suggested by the shift in supply from S1 to S2. Instead, a price change leads to a movement along a given supply curve. Similarly, a higher or lower price never shifts a demand curve, as suggested in the shift from D0 to D1. Instead, a price change leads to a movement along a given demand curve. Remember, a change in the price of a good never causes the demand or supply curve for that good to shift.
Think carefully about the timeline of events: What happens first, what happens next? What is cause, what is effect? If you keep the order right, you are more likely to get the analysis correct.
In the four-step analysis of how economic events affect equilibrium price and quantity, the movement from the old to the new equilibrium seems immediate. As a practical matter, however, prices and quantities often do not zoom straight to equilibrium. More realistically, when an economic event causes demand or supply to shift, prices and quantities set off in the general direction of equilibrium. Even as they are moving toward one new equilibrium, a subsequent change in demand or supply often pushes prices toward another equilibrium. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.04%3A_Changes_in_Equilibrium_Price_and_Quantity-_The_Four-Step_Process.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain price controls, price ceilings, and price floors
• Analyze demand and supply as a social adjustment mechanism
To this point in the chapter, we have been assuming that markets are free, that is, they operate with no government intervention. In this section, we will explore the outcomes, both anticipated and otherwise, when government does intervene in a market either to prevent the price of some good or service from rising “too high” or to prevent the price of some good or service from falling “too low”.
Economists believe there are a small number of fundamental principles that explain how economic agents respond in different situations. Two of these principles, which we have already introduced, are the laws of demand and supply.
Governments can pass laws affecting market outcomes, but no law can negate these economic principles. Rather, the principles will become apparent in sometimes unexpected ways, which may undermine the intent of the government policy. This is one of the major conclusions of this section.
Controversy sometimes surrounds the prices and quantities established by demand and supply, especially for products that are considered necessities. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing “too high” or falling “too low.”
The demand and supply model shows how people and firms will react to the incentives that these laws provide to control prices, in ways that will often lead to undesirable consequences. Alternative policy tools can often achieve the desired goals of price control laws, while avoiding at least some of their costs and tradeoffs.
Price Ceilings
Laws that governments enact to regulate prices are called price controls. Price controls come in two flavors. A price ceiling keeps a price from rising above a certain level (the “ceiling”), while a price floor keeps a price from falling below a given level (the “floor”). This section uses the demand and supply framework to analyze price ceilings. The next section discusses price floors.
A price ceiling is a legal maximum price that one pays for some good or service. A government imposes price ceilings in order to keep the price of some necessary good or service affordable. For example, in 2005 during Hurricane Katrina, the price of bottled water increased above \$5 per gallon. As a result, many people called for price controls on bottled water to prevent the price from rising so high. In this particular case, the government did not impose a price ceiling, but there are other examples of where price ceilings did occur.
In many markets for goods and services, demanders outnumber suppliers. Consumers, who are also potential voters, sometimes unite behind a political proposal to hold down a certain price. In some cities, such as Albany, renters have pressed political leaders to pass rent control laws, a price ceiling that usually works by stating that landlords can raise rents by only a certain maximum percentage each year. Some of the best examples of rent control occur in urban areas such as New York, Washington D.C., or San Francisco.
Rent control becomes a politically hot topic when rents begin to rise rapidly. Everyone needs an affordable place to live. Perhaps a change in tastes makes a certain suburb or town a more popular place to live. Perhaps locally-based businesses expand, bringing higher incomes and more people into the area. Such changes can cause a change in the demand for rental housing, as Figure 3.21 illustrates. The original equilibrium (E0) lies at the intersection of supply curve S0 and demand curve D0, corresponding to an equilibrium price of \$500 and an equilibrium quantity of 15,000 units of rental housing. The effect of greater income or a change in tastes is to shift the demand curve for rental housing to the right, as the data in Table 3.7 shows and the shift from D0 to D1 on the graph. In this market, at the new equilibrium E1, the price of a rental unit would rise to \$600 and the equilibrium quantity would increase to 17,000 units.
Figure 3.21 A Price Ceiling Example—Rent Control The original intersection of demand and supply occurs at E0. If demand shifts from D0 to D1, the new equilibrium would be at E1—unless a price ceiling prevents the price from rising. If the price is not permitted to rise, the quantity supplied remains at 15,000. However, after the change in demand, the quantity demanded rises to 19,000, resulting in a shortage.
Price Original Quantity Supplied Original Quantity Demanded New Quantity Demanded
\$400 12,000 18,000 23,000
\$500 15,000 15,000 19,000
\$600 17,000 13,000 17,000
\$700 19,000 11,000 15,000
\$800 20,000 10,000 14,000
Table 3.7 Rent Control
Suppose that a city government passes a rent control law to keep the price at the original equilibrium of \$500 for a typical apartment. In Figure 3.21, the horizontal line at the price of \$500 shows the legally fixed maximum price set by the rent control law. However, the underlying forces that shifted the demand curve to the right are still there. At that price (\$500), the quantity supplied remains at the same 15,000 rental units, but the quantity demanded is 19,000 rental units. In other words, the quantity demanded exceeds the quantity supplied, so there is a shortage of rental housing. One of the ironies of price ceilings is that while the price ceiling was intended to help renters, there are actually fewer apartments rented out under the price ceiling (15,000 rental units) than would be the case at the market rent of \$600 (17,000 rental units).
Price ceilings do not simply benefit renters at the expense of landlords. Rather, some renters (or potential renters) lose their housing as landlords convert apartments to co-ops and condos. Even when the housing remains in the rental market, landlords tend to spend less on maintenance and on essentials like heating, cooling, hot water, and lighting. The first rule of economics is you do not get something for nothing—everything has an opportunity cost. Thus, if renters obtain “cheaper” housing than the market requires, they tend to also end up with lower quality housing.
Price ceilings are enacted in an attempt to keep prices low for those who need the product. However, when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs. Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate.
Price Floors
A price floor is the lowest price that one can legally pay for some good or service. Perhaps the best-known example of a price floor is the minimum wage, which is based on the view that someone working full time should be able to afford a basic standard of living. The federal minimum wage in 2022 was \$7.25 per hour, although some states and localities have a higher minimum wage. The federal minimum wage yields an annual income for a single person of \$15,080, which is slightly higher than the Federal poverty line of \$11,880. Congress periodically raises the federal minimum wage as the cost of living rises. As of March 2022, the most recent adjustment occurred in 2009, when the federal minimum wage was raised from \$6.55 to \$7.25.
Price floors are sometimes called “price supports,” because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices and thus farm incomes fluctuate, sometimes widely. Even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings.
The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be. According to the Common Agricultural Policy reform effective in 2019, the European Union (EU) will spend about 58 billion euros per year, or 65.5 billion dollars per year (with the December 2021 exchange rate), or roughly 36% of the EU budget, on price supports for Europe’s farmers.
Figure 3.22 illustrates the effects of a government program that assures a price above the equilibrium by focusing on the market for wheat in Europe. In the absence of government intervention, the price would adjust so that the quantity supplied would equal the quantity demanded at the equilibrium point E0, with price P0 and quantity Q0. However, policies to keep prices high for farmers keep the price above what would have been the market equilibrium level—the price Pf shown by the dashed horizontal line in the diagram. The result is a quantity supplied in excess of the quantity demanded (Qd). When quantity supplied exceeds quantity demanded, a surplus exists.
Economists estimate that the high-income areas of the world, including the United States, Europe, and Japan, spend roughly \$1 billion per day in supporting their farmers. If the government is willing to purchase the excess supply (or to provide payments for others to purchase it), then farmers will benefit from the price floor, but taxpayers and consumers of food will pay the costs. Agricultural economists and policy makers have offered numerous proposals for reducing farm subsidies. In many countries, however, political support for subsidies for farmers remains strong. This is either because the population views this as supporting the traditional rural way of life or because of industry's lobbying power of the agro-business.
Figure 3.22 European Wheat Prices: A Price Floor Example The intersection of demand (D) and supply (S) would be at the equilibrium point E0. However, a price floor set at Pf holds the price above E0 and prevents it from falling. The result of the price floor is that the quantity supplied Qs exceeds the quantity demanded Qd. There is excess supply, also called a surplus. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.05%3A_Price_Ceilings_and_Price_Floors.txt |
Learning Objectives
By the end of this section, you will be able to:
• Contrast consumer surplus, producer surplus, and social surplus
• Explain why price floors and price ceilings can be inefficient
• Analyze demand and supply as a social adjustment mechanism
The familiar demand and supply diagram holds within it the concept of economic efficiency. One typical way that economists define efficiency is when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.
Efficiency in the demand and supply model has the same basic meaning: The economy is getting as much benefit as possible from its scarce resources and all the possible gains from trade have been achieved. In other words, the optimal amount of each good and service is produced and consumed.
Consumer Surplus, Producer Surplus, Social Surplus
Consider a market for tablet computers, as Figure 3.23 shows. The equilibrium price is \$80 and the equilibrium quantity is 28 million. To see the benefits to consumers, look at the segment of the demand curve above the equilibrium point and to the left. This portion of the demand curve shows that at least some demanders would have been willing to pay more than \$80 for a tablet.
For example, point J shows that if the price were \$90, 20 million tablets would be sold. Those consumers who would have been willing to pay \$90 for a tablet based on the utility they expect to receive from it, but who were able to pay the equilibrium price of \$80, clearly received a benefit beyond what they had to pay. Remember, the demand curve traces consumers’ willingness to pay for different quantities. The amount that individuals would have been willing to pay, minus the amount that they actually paid, is called consumer surplus. Consumer surplus is the area labeled F—that is, the area above the market price and below the demand curve.
Figure 3.23 Consumer and Producer Surplus The somewhat triangular area labeled by F shows the area of consumer surplus, which shows that the equilibrium price in the market was less than what many of the consumers were willing to pay. Point J on the demand curve shows that, even at the price of \$90, consumers would have been willing to purchase a quantity of 20 million. The somewhat triangular area labeled by G shows the area of producer surplus, which shows that the equilibrium price received in the market was more than what many of the producers were willing to accept for their products. For example, point K on the supply curve shows that at a price of \$45, firms would have been willing to supply a quantity of 14 million.
The supply curve shows the quantity that firms are willing to supply at each price. For example, point K in Figure 3.23 illustrates that, at \$45, firms would still have been willing to supply a quantity of 14 million. Those producers who would have been willing to supply the tablets at \$45, but who were instead able to charge the equilibrium price of \$80, clearly received an extra benefit beyond what they required to supply the product. The extra benefit producers receive from selling a good or service, measured by the price the producer actually received minus the price the producer would have been willing to accept is called producer surplus. In Figure 3.23, producer surplus is the area labeled G—that is, the area between the market price and the segment of the supply curve below the equilibrium.
The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus or total surplus. In Figure 3.23 we show social surplus as the area F + G. Social surplus is larger at equilibrium quantity and price than it would be at any other quantity. This demonstrates the economic efficiency of the market equilibrium. In addition, at the efficient level of output, it is impossible to produce greater consumer surplus without reducing producer surplus, and it is impossible to produce greater producer surplus without reducing consumer surplus.
Inefficiency of Price Floors and Price Ceilings
The imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, and thus will create an inefficient outcome. However, there is an additional twist here. Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to producers, or some producer surplus to consumers.
Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy is left to the market, the equilibrium price will be \$600 per month and 20,000 people will use the drug, as shown in Figure 3.24 (a). The original level of consumer surplus is T + U and producer surplus is V + W + X. However, the government decides to impose a price ceiling of \$400 to make the drug more affordable. At this price ceiling, firms in the market now produce only 15,000.
As a result, two changes occur. First, an inefficient outcome occurs and the total surplus of society is reduced. The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In Figure 3.24 (a), the deadweight loss is the area U + W. When deadweight loss exists, it is possible for both consumer and producer surplus to be higher, in this case because the price control is blocking some suppliers and demanders from transactions they would both be willing to make.
A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is T + V, while the new producer surplus is X. In other words, the price ceiling transfers the area of surplus (V) from producers to consumers. Note that the gain to consumers is less than the loss to producers, which is just another way of seeing the deadweight loss.
Figure 3.24 Efficiency and Price Floors and Ceilings (a) The original equilibrium price is \$600 with a quantity of 20,000. Consumer surplus is T + U, and producer surplus is V + W + X. A price ceiling is imposed at \$400, so firms in the market now produce only a quantity of 15,000. As a result, the new consumer surplus is T + V, while the new producer surplus is X. (b) The original equilibrium is \$8 at a quantity of 1,800. Consumer surplus is G + H + J, and producer surplus is I + K. A price floor is imposed at \$12, which means that quantity demanded falls to 1,400. As a result, the new consumer surplus is G, and the new producer surplus is H + I.
Figure 3.24 (b) shows a price floor example using a string of struggling movie theaters, all in the same city. The current equilibrium is \$8 per movie ticket, with 1,800 people attending movies. The original consumer surplus is G + H + J, and producer surplus is I + K. The city government is worried that movie theaters will go out of business, reducing the entertainment options available to citizens, so it decides to impose a price floor of \$12 per ticket. As a result, the quantity demanded of movie tickets falls to 1,400. The new consumer surplus is G, and the new producer surplus is H + I. In effect, the price floor causes the area H to be transferred from consumer to producer surplus, but also causes a deadweight loss of J + K.
This analysis shows that a price ceiling, like a law establishing rent controls, will transfer some producer surplus to consumers—which helps to explain why consumers often favor them. Conversely, a price floor like a guarantee that farmers will receive a certain price for their crops will transfer some consumer surplus to producers, which explains why producers often favor them. However, both price floors and price ceilings block some transactions that buyers and sellers would have been willing to make, and creates deadweight loss. Removing such barriers, so that prices and quantities can adjust to their equilibrium level, will increase the economy’s social surplus.
Demand and Supply as a Social Adjustment Mechanism
The demand and supply model emphasizes that prices are not set only by demand or only by supply, but by the interaction between the two. In 1890, the famous economist Alfred Marshall wrote that asking whether supply or demand determined a price was like arguing “whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper.” The answer is that both blades of the demand and supply scissors are always involved.
The adjustments of equilibrium price and quantity in a market-oriented economy often occur without much government direction or oversight. If the coffee crop in Brazil suffers a terrible frost, then the supply curve of coffee shifts to the left and the price of coffee rises. Some people continue to drink coffee and pay the higher price. Others switch to tea or soft drinks. No government commission is needed to figure out how to adjust coffee prices, which companies will be allowed to process the remaining supply, which supermarkets in which cities will get how much coffee to sell, or which consumers will ultimately be allowed to drink the brew. Such adjustments in response to price changes happen all the time in a market economy, often so smoothly and rapidly that we barely notice them.
Think for a moment of all the seasonal foods that are available and inexpensive at certain times of the year, like fresh corn in midsummer, but more expensive at other times of the year. People alter their diets and restaurants alter their menus in response to these fluctuations in prices without fuss or fanfare. For both the U.S. economy and the world economy as a whole, markets—that is, demand and supply—are the primary social mechanism for answering the basic questions about what is produced, how it is produced, and for whom it is produced.
Bring It Home
Why Can We Not Get Enough of Organic Food?
Organic food is grown without synthetic pesticides, chemical fertilizers or genetically modified seeds. In recent decades, the demand for organic products has increased dramatically. The Organic Trade Association reported sales increased from \$1 billion in 1990 to nearly \$62 billion in 2020, more than 90% of which were sales of food products.
Why, then, are organic foods more expensive than their conventional counterparts? The answer is a clear application of the theories of supply and demand. As people have learned more about the harmful effects of chemical fertilizers, growth hormones, pesticides and the like from large-scale factory farming, our tastes and preferences for safer, organic foods have increased. This change in tastes has been reinforced by increases in income, which allow people to purchase pricier products, and has made organic foods more mainstream. This shift, in addition to population growth, has led to an increased demand for organic foods. Graphically, the demand curve has shifted right, and we have moved up the supply curve as producers have responded to the higher prices by supplying a greater quantity.
In addition to the movement along the supply curve, we have also had an increase in the number of farmers converting to organic farming over time. This is represented by a shift to the right of the supply curve. Since both demand and supply have shifted to the right, the resulting equilibrium quantity of organic foods is definitely higher, but the price will only fall when the increase in supply is larger than the increase in demand. We may need more time before we see lower prices in organic foods. Since the production costs of these foods may remain higher than conventional farming, because organic fertilizers and pest management techniques are more expensive, they may never fully catch up with the lower prices of non-organic foods.
As a final, specific example: The Environmental Working Group’s “Dirty Dozen” list of fruits and vegetables, which test high for pesticide residue even after washing, was released in April 2013. The inclusion of strawberries on the list led to an increase in demand for organic strawberries, resulting in both a higher equilibrium price and quantity of sales. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.06%3A_Demand_Supply_and_Efficiency.txt |
ceteris paribus
other things being equal
complements
goods that are often used together so that consumption of one good tends to enhance consumption of the other
consumer surplus
the extra benefit consumers receive from buying a good or service, measured by what the individuals would have been willing to pay minus the amount that they actually paid
deadweight loss
the loss in social surplus that occurs when a market produces an inefficient quantity
demand
the relationship between price and the quantity demanded of a certain good or service
demand curve
a graphic representation of the relationship between price and quantity demanded of a certain good or service, with quantity on the horizontal axis and the price on the vertical axis
demand schedule
a table that shows a range of prices for a certain good or service and the quantity demanded at each price
economic surplus
see social surplus
equilibrium
the situation where quantity demanded is equal to the quantity supplied; the combination of price and quantity where there is no economic pressure from surpluses or shortages that would cause price or quantity to change
equilibrium price
the price where quantity demanded is equal to quantity supplied
equilibrium quantity
the quantity at which quantity demanded and quantity supplied are equal for a certain price level
excess demand
at the existing price, the quantity demanded exceeds the quantity supplied; also called a shortage
excess supply
at the existing price, quantity supplied exceeds the quantity demanded; also called a surplus
factors of production
the resources such as labor, materials, and machinery that are used to produce goods and services; also called inputs
inferior good
a good in which the quantity demanded falls as income rises, and in which quantity demanded rises and income falls
inputs
the resources such as labor, materials, and machinery that are used to produce goods and services; also called factors of production
law of demand
the common relationship that a higher price leads to a lower quantity demanded of a certain good or service and a lower price leads to a higher quantity demanded, while all other variables are held constant
law of supply
the common relationship that a higher price leads to a greater quantity supplied and a lower price leads to a lower quantity supplied, while all other variables are held constant
normal good
a good in which the quantity demanded rises as income rises, and in which quantity demanded falls as income falls
price
what a buyer pays for a unit of the specific good or service
price ceiling
a legal maximum price
price control
government laws to regulate prices instead of letting market forces determine prices
price floor
a legal minimum price
producer surplus
the extra benefit producers receive from selling a good or service, measured by the price the producer actually received minus the price the producer would have been willing to accept
quantity demanded
the total number of units of a good or service consumers are willing to purchase at a given price
quantity supplied
the total number of units of a good or service producers are willing to sell at a given price
shift in demand
when a change in some economic factor (other than price) causes a different quantity to be demanded at every price
shift in supply
when a change in some economic factor (other than price) causes a different quantity to be supplied at every price
shortage
at the existing price, the quantity demanded exceeds the quantity supplied; also called excess demand
social surplus
the sum of consumer surplus and producer surplus
substitute
a good that can replace another to some extent, so that greater consumption of one good can mean less of the other
supply
the relationship between price and the quantity supplied of a certain good or service
supply curve
a line that shows the relationship between price and quantity supplied on a graph, with quantity supplied on the horizontal axis and price on the vertical axis
supply schedule
a table that shows a range of prices for a good or service and the quantity supplied at each price
surplus
at the existing price, quantity supplied exceeds the quantity demanded; also called excess supply
total surplus
see social surplus | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.07%3A_Key_Terms.txt |
3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
A demand schedule is a table that shows the quantity demanded at different prices in the market. A demand curve shows the relationship between quantity demanded and price in a given market on a graph. The law of demand states that a higher price typically leads to a lower quantity demanded.
A supply schedule is a table that shows the quantity supplied at different prices in the market. A supply curve shows the relationship between quantity supplied and price on a graph. The law of supply says that a higher price typically leads to a higher quantity supplied.
The equilibrium price and equilibrium quantity occur where the supply and demand curves cross. The equilibrium occurs where the quantity demanded is equal to the quantity supplied. If the price is below the equilibrium level, then the quantity demanded will exceed the quantity supplied. Excess demand or a shortage will exist. If the price is above the equilibrium level, then the quantity supplied will exceed the quantity demanded. Excess supply or a surplus will exist. In either case, economic pressures will push the price toward the equilibrium level.
3.2 Shifts in Demand and Supply for Goods and Services
Economists often use the ceteris paribus or “other things being equal” assumption: while examining the economic impact of one event, all other factors remain unchanged for analysis purposes. Factors that can shift the demand curve for goods and services, causing a different quantity to be demanded at any given price, include changes in tastes, population, income, prices of substitute or complement goods, and expectations about future conditions and prices. Factors that can shift the supply curve for goods and services, causing a different quantity to be supplied at any given price, include input prices, natural conditions, changes in technology, and government taxes, regulations, or subsidies.
3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
When using the supply and demand framework to think about how an event will affect the equilibrium price and quantity, proceed through four steps: (1) sketch a supply and demand diagram to think about what the market looked like before the event; (2) decide whether the event will affect supply or demand; (3) decide whether the effect on supply or demand is negative or positive, and draw the appropriate shifted supply or demand curve; (4) compare the new equilibrium price and quantity to the original ones.
3.4 Price Ceilings and Price Floors
Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result. Price floors prevent a price from falling below a certain level. When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and excess supply or surpluses will result. Price floors and price ceilings often lead to unintended consequences.
3.5 Demand, Supply, and Efficiency
Consumer surplus is the gap between the price that consumers are willing to pay, based on their preferences, and the market equilibrium price. Producer surplus is the gap between the price for which producers are willing to sell a product, based on their costs, and the market equilibrium price. Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price. Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.08%3A_Key_Concepts_and_Summary.txt |
1.
Review Figure 3.4. Suppose the price of gasoline is \$1.60 per gallon. Is the quantity demanded higher or lower than at the equilibrium price of \$1.40 per gallon? What about the quantity supplied? Is there a shortage or a surplus in the market? If so, how much?
2.
Why do economists use the ceteris paribus assumption?
3.
In an analysis of the market for paint, an economist discovers the facts listed below. State whether each of these changes will affect supply or demand, and in what direction.
1. There have recently been some important cost-saving inventions in the technology for making paint.
2. Paint is lasting longer, so that property owners need not repaint as often.
3. Because of severe hailstorms, many people need to repaint now.
4. The hailstorms damaged several factories that make paint, forcing them to close down for several months.
4.
Many changes are affecting the market for oil. Predict how each of the following events will affect the equilibrium price and quantity in the market for oil. In each case, state how the event will affect the supply and demand diagram. Create a sketch of the diagram if necessary.
1. Cars are becoming more fuel efficient, and therefore get more miles to the gallon.
2. The winter is exceptionally cold.
3. A major discovery of new oil is made off the coast of Norway.
4. The economies of some major oil-using nations, like Japan, slow down.
5. A war in the Middle East disrupts oil-pumping schedules.
6. Landlords install additional insulation in buildings.
7. The price of solar energy falls dramatically.
8. Chemical companies invent a new, popular kind of plastic made from oil.
5.
Let’s think about the market for air travel. From August 2014 to January 2015, the price of jet fuel increased roughly 47%. Using the four-step analysis, how do you think this fuel price increase affected the equilibrium price and quantity of air travel?
6.
A tariff is a tax on imported goods. Suppose the U.S. government cuts the tariff on imported flat screen televisions. Using the four-step analysis, how do you think the tariff reduction will affect the equilibrium price and quantity of flat screen TVs?
7.
What is the effect of a price ceiling on the quantity demanded of the product? What is the effect of a price ceiling on the quantity supplied? Why exactly does a price ceiling cause a shortage?
8.
Does a price ceiling change the equilibrium price?
9.
What would be the impact of imposing a price floor below the equilibrium price?
10.
Does a price ceiling increase or decrease the number of transactions in a market? Why? What about a price floor?
11.
If a price floor benefits producers, why does a price floor reduce social surplus?
3.10: Review Questions
12.
What determines the level of prices in a market?
13.
What does a downward-sloping demand curve mean about how buyers in a market will react to a higher price?
14.
Will demand curves have the same exact shape in all markets? If not, how will they differ?
15.
Will supply curves have the same shape in all markets? If not, how will they differ?
16.
What is the relationship between quantity demanded and quantity supplied at equilibrium? What is the relationship when there is a shortage? What is the relationship when there is a surplus?
17.
How can you locate the equilibrium point on a demand and supply graph?
18.
If the price is above the equilibrium level, would you predict a surplus or a shortage? If the price is below the equilibrium level, would you predict a surplus or a shortage? Why?
19.
When the price is above the equilibrium, explain how market forces move the market price to equilibrium. Do the same when the price is below the equilibrium.
20.
What is the difference between the demand and the quantity demanded of a product, say milk? Explain in words and show the difference on a graph with a demand curve for milk.
21.
What is the difference between the supply and the quantity supplied of a product, say milk? Explain in words and show the difference on a graph with the supply curve for milk.
22.
When analyzing a market, how do economists deal with the problem that many factors that affect the market are changing at the same time?
23.
Name some factors that can cause a shift in the demand curve in markets for goods and services.
24.
Name some factors that can cause a shift in the supply curve in markets for goods and services.
25.
How does one analyze a market where both demand and supply shift?
26.
What causes a movement along the demand curve? What causes a movement along the supply curve?
27.
Does a price ceiling attempt to make a price higher or lower?
28.
How does a price ceiling set below the equilibrium level affect quantity demanded and quantity supplied?
29.
Does a price floor attempt to make a price higher or lower?
30.
How does a price floor set above the equilibrium level affect quantity demanded and quantity supplied?
31.
What is consumer surplus? How is it illustrated on a demand and supply diagram?
32.
What is producer surplus? How is it illustrated on a demand and supply diagram?
33.
What is total surplus? How is it illustrated on a demand and supply diagram?
34.
What is the relationship between total surplus and economic efficiency?
35.
What is deadweight loss? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.09%3A_Self-Check_Questions.txt |
36.
Review Figure 3.4. Suppose the government decided that, since gasoline is a necessity, its price should be legally capped at \$1.30 per gallon. What do you anticipate would be the outcome in the gasoline market?
37.
Explain why the following statement is false: “In the goods market, no buyer would be willing to pay more than the equilibrium price.”
38.
Explain why the following statement is false: “In the goods market, no seller would be willing to sell for less than the equilibrium price.”
39.
Consider the demand for hamburgers. If the price of a substitute good (for example, hot dogs) increases and the price of a complement good (for example, hamburger buns) increases, can you tell for sure what will happen to the demand for hamburgers? Why or why not? Illustrate your answer with a graph.
40.
How do you suppose the demographics of an aging population of “Baby Boomers” in the United States will affect the demand for milk? Justify your answer.
41.
We know that a change in the price of a product causes a movement along the demand curve. Suppose consumers believe that prices will be rising in the future. How will that affect demand for the product in the present? Can you show this graphically?
42.
Suppose there is a soda tax to curb obesity. What should a reduction in the soda tax do to the supply of sodas and to the equilibrium price and quantity? Can you show this graphically? Hint: Assume that the soda tax is collected from the sellers.
43.
Use the four-step process to analyze the impact of the advent of the iPod (or other portable digital music players) on the equilibrium price and quantity of the Sony Walkman (or other portable audio cassette players).
44.
Use the four-step process to analyze the impact of a reduction in tariffs on imports of iPods on the equilibrium price and quantity of Sony Walkman-type products.
45.
Suppose both of these events took place at the same time. Combine your analyses of the impacts of the iPod and the tariff reduction to determine the likely impact on the equilibrium price and quantity of Sony Walkman-type products. Show your answer graphically.
46.
Most government policy decisions have winners and losers. What are the effects of raising the minimum wage? It is more complex than simply producers lose and workers gain. Who are the winners and who are the losers, and what exactly do they win and lose? To what extent does the policy change achieve its goals?
47.
Agricultural price supports result in governments holding large inventories of agricultural products. Why do you think the government cannot simply give the products away to people experiencing poverty?
48.
Can you propose a policy that would induce the market to supply more rental housing units?
49.
What term would an economist use to describe what happens when a shopper gets a “good deal” on a product?
50.
Explain why voluntary transactions improve social welfare.
51.
Why would a free market never operate at a quantity greater than the equilibrium quantity? Hint: What would be required for a transaction to occur at that quantity? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.11%3A_Critical_Thinking_Questions.txt |
52.
Review Figure 3.4 again. Suppose the price of gasoline is \$1.00. Will the quantity demanded be lower or higher than at the equilibrium price of \$1.40 per gallon? Will the quantity supplied be lower or higher? Is there a shortage or a surplus in the market? If so, of how much?
53.
Table 3.8 shows information on the demand and supply for bicycles, where the quantities of bicycles are measured in thousands.
Price Qd Qs
\$120 50 36
\$150 40 40
\$180 32 48
\$210 28 56
\$240 24 70
Table 3.8
1. What is the quantity demanded and the quantity supplied at a price of \$210?
2. At what price is the quantity supplied equal to 48,000?
3. Graph the demand and supply curve for bicycles. How can you determine the equilibrium price and quantity from the graph? How can you determine the equilibrium price and quantity from the table? What are the equilibrium price and equilibrium quantity?
4. If the price was \$120, what would the quantities demanded and supplied be? Would a shortage or surplus exist? If so, how large would the shortage or surplus be?
54.
The computer market in recent years has seen many more computers sell at much lower prices. What shift in demand or supply is most likely to explain this outcome? Sketch a demand and supply diagram and explain your reasoning for each.
1. A rise in demand
2. A fall in demand
3. A rise in supply
4. A fall in supply
55.
Table 3.9 illustrates the market's demand and supply for cheddar cheese. Graph the data and find the equilibrium. Next, create a table showing the change in quantity demanded or quantity supplied, and a graph of the new equilibrium, in each of the following situations:
1. The price of milk, a key input for cheese production, rises, so that the supply decreases by 80 pounds at every price.
2. A new study says that eating cheese is good for your health, so that demand increases by 20% at every price.
Price per Pound Qd Qs
\$3.00 750 540
\$3.20 700 600
\$3.40 650 650
\$3.60 620 700
\$3.80 600 720
\$4.00 590 730
Table 3.9
56.
Table 3.10 shows the supply and demand for movie tickets in a city. Graph demand and supply and identify the equilibrium. Then calculate in a table and graph the effect of the following two changes.
1. Three new nightclubs open. They offer decent bands and have no cover charge, but make their money by selling food and drink. As a result, demand for movie tickets falls by six units at every price.
2. The city eliminates a tax that it placed on all local entertainment businesses. The result is that the quantity supplied of movies at any given price increases by 10%.
Price per Ticket Qd Qs
\$5.00 26 16
\$6.00 24 18
\$7.00 22 20
\$8.00 21 21
\$9.00 20 22
Table 3.10
57.
A low-income country decides to set a price ceiling on bread so it can make sure that bread is affordable to the poor. Table 3.11 provides the conditions of demand and supply. What are the equilibrium price and equilibrium quantity before the price ceiling? What will the excess demand or the shortage (that is, quantity demanded minus quantity supplied) be if the price ceiling is set at \$2.40? At \$2.00? At \$3.60?
Price Qd Qs
\$1.60 9,000 5,000
\$2.00 8,500 5,500
\$2.40 8,000 6,400
\$2.80 7,500 7,500
\$3.20 7,000 9,000
\$3.60 6,500 11,000
\$4.00 6,000 15,000
Table 3.11 | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/03%3A_Demand_and_Supply/3.12%3A_Problems.txt |
Figure 4.1 People often think of demand and supply in relation to goods, but labor markets, such as the nursing profession, can also apply to this analysis. (Credit: modification of "Hospital do Subúrbio" by Jaques Wagner Governador/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Demand and Supply at Work in Labor Markets
• Demand and Supply in Financial Markets
• The Market System as an Efficient Mechanism for Information
Bring It Home
Baby Boomers Come of Age
According to the 2020 Census, 22% of the U.S. population was 60 years old or older, which means that more than 74 million people have reached an age when they will need increased medical care.
The baby boomer population, the group born between 1946 and 1964, is comprised of more than 71 million people who have already reached retirement age or will soon reach retirement. As this population grows older, they will be faced with common healthcare issues such as heart conditions, arthritis, and Alzheimer’s that may require hospitalization, long-term, or at-home nursing care. Aging baby boomers and advances in life-saving and life-extending technologies will increase the demand for healthcare and nursing. Additionally, the Affordable Care Act, which expands access to healthcare for millions of Americans, has further increased the demand.
These data tell us, as economists, that the market for healthcare professionals, and nurses in particular, will face several challenges. Our study of supply and demand will help us to analyze what might happen in the labor market for nursing and other healthcare professionals, as we will discuss in the second half of this case at the end of the chapter.
The theories of supply and demand do not apply just to markets for goods. They apply to any market, even markets for things we may not think of as goods and services like labor and financial services. Labor markets are markets for employees or jobs. Financial services markets are markets for saving or borrowing.
When we think about demand and supply curves in goods and services markets, it is easy to picture the demanders and suppliers: businesses produce the products and households buy them. Who are the demanders and suppliers in labor and financial service markets? In labor markets job seekers (individuals) are the suppliers of labor, while firms and other employers who hire labor are the demanders for labor. In financial markets, any individual or firm who saves contributes to the supply of money, and any entity that borrows (person, firm, or government) contributes to the demand for money.
As a college student, you most likely participate in both labor and financial markets. Employment is a fact of life for most college students: According to the National Center for Educational Statistics, in 2018 43% of full-time college students and 81% of part-time college students were employed. Most college students are also heavily involved in financial markets, primarily as borrowers. As of the 2018–19 school year, 43% of full-time undergraduate students were receiving loan aid to help finance their education, and those loans averaged \$7,300 per year. Many students also borrow for other expenses, like purchasing a car. As this chapter will illustrate, we can analyze labor markets and financial markets with the same tools we use to analyze demand and supply in the goods markets. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/04%3A_Labor_and_Financial_Markets/4.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Predict shifts in the demand and supply curves of the labor market
• Explain the impact of new technology on the demand and supply curves of the labor market
• Explain price floors in the labor market such as minimum wage or a living wage
Markets for labor have demand and supply curves, just like markets for goods. The law of demand applies in labor markets this way: A higher salary or wage—that is, a higher price in the labor market—leads to a decrease in the quantity of labor demanded by employers, while a lower salary or wage leads to an increase in the quantity of labor demanded. The law of supply functions in labor markets, too: A higher price for labor leads to a higher quantity of labor supplied; a lower price leads to a lower quantity supplied.
Equilibrium in the Labor Market
In 2020, nearly 41,000 registered nurses worked in the Minneapolis-St. Paul-Bloomington, Minnesota-Wisconsin metropolitan area, according to the BLS. They worked for a variety of employers: hospitals, doctors’ offices, schools, health clinics, and nursing homes. Figure 4.2 illustrates how demand and supply determine equilibrium in this labor market. The demand and supply schedules in Table 4.1 list the quantity supplied and quantity demanded of nurses at different salaries.
Figure 4.2 Labor Market Example: Demand and Supply for Nurses in Minneapolis-St. Paul-Bloomington The demand curve (D) of those employers who want to hire nurses intersects with the supply curve (S) of those who are qualified and willing to work as nurses at the equilibrium point (E). The equilibrium salary is \$85,000 and the equilibrium quantity is 41,000 nurses. At an above-equilibrium salary of \$90,000, quantity supplied increases to 45,000, but the quantity of nurses demanded at the higher pay declines to 40,000. At this above-equilibrium salary, an excess supply or surplus of nurses would exist. At a below-equilibrium salary of \$75,000, quantity supplied declines to 34,000, while the quantity demanded at the lower wage increases to 47,000 nurses. At this below-equilibrium salary, excess demand or a shortage exists.
Annual Salary Quantity Demanded Quantity Supplied
\$70,000 52,000 27,000
\$75,000 47,000 34,000
\$80,000 44,000 38,000
\$85,000 41,000 41,000
\$90,000 40,000 45,000
\$95,000 39,000 48,000
Table 4.1 Demand and Supply of Nurses in Minneapolis-St. Paul-Bloomington
The horizontal axis shows the quantity of nurses hired. In this example we measure labor by number of workers, but another common way to measure the quantity of labor is by the number of hours worked. The vertical axis shows the price for nurses’ labor—that is, how much they are paid. In the real world, this “price” would be total labor compensation: salary plus benefits. It is not obvious, but benefits are a significant part (as high as 30 percent) of labor compensation. In this example we measure the price of labor by salary on an annual basis, although in other cases we could measure the price of labor by monthly or weekly pay, or even the wage paid per hour. As the salary for nurses rises, the quantity demanded will fall. Some hospitals and nursing homes may reduce the number of nurses they hire, or they may lay off some of their existing nurses, rather than pay them higher salaries. Employers who face higher nurses’ salaries may also try to replace some nursing functions by investing in physical equipment, like computer monitoring and diagnostic systems to monitor patients, or by using lower-paid health care aides to reduce the number of nurses they need.
As the salary for nurses rises, the quantity supplied will rise. If nurses’ salaries in Minneapolis-St. Paul-Bloomington are higher than in other cities, more nurses will move to Minneapolis-St. Paul-Bloomington to find jobs, more people will be willing to train as nurses, and those currently trained as nurses will be more likely to pursue nursing as a full-time job. In other words, there will be more nurses looking for jobs in the area.
At equilibrium, the quantity supplied and the quantity demanded are equal. Thus, every employer who wants to hire a nurse at this equilibrium wage can find a willing worker, and every nurse who wants to work at this equilibrium salary can find a job. In Figure 4.2, the supply curve (S) and demand curve (D) intersect at the equilibrium point (E). The equilibrium quantity of nurses in the Minneapolis-St. Paul-Bloomington area is 41,000, and the equilibrium salary is \$86,000 per year. This example simplifies the nursing market by focusing on the “average” nurse. In reality, of course, the market for nurses actually comprises many smaller markets, like markets for nurses with varying degrees of experience and credentials. Many markets contain closely related products that differ in quality. For instance, even a simple product like gasoline comes in regular, premium, and super-premium, each with a different price. Even in such cases, discussing the average price of gasoline, like the average salary for nurses, can still be useful because it reflects what is happening in most of the submarkets.
When the price of labor is not at the equilibrium, economic incentives tend to move salaries toward the equilibrium. For example, if salaries for nurses in Minneapolis-St. Paul-Bloomington were above the equilibrium at \$90,000 per year, then 43,000 people want to work as nurses, but employers want to hire only 39,000 nurses. At that above-equilibrium salary, excess supply or a surplus results. In a situation of excess supply in the labor market, with many applicants for every job opening, employers will have an incentive to offer lower wages than they otherwise would have. Nurses’ salary will move down toward equilibrium.
In contrast, if the salary is below the equilibrium at, say, \$60,000 per year, then a situation of excess demand or a shortage arises. In this case, employers encouraged by the relatively lower wage want to hire 40,000 nurses, but only 27,000 individuals want to work as nurses at that salary in Minneapolis-St. Paul-Bloomington. In response to the shortage, some employers will offer higher pay to attract the nurses. Other employers will have to match the higher pay to keep their own employees. The higher salaries will encourage more nurses to train or work in Minneapolis-St. Paul-Bloomington. Again, price and quantity in the labor market will move toward equilibrium.
Shifts in Labor Demand
The demand curve for labor shows the quantity of labor employers wish to hire at any given salary or wage rate, under the ceteris paribus assumption. A change in the wage or salary will result in a change in the quantity demanded of labor. If the wage rate increases, employers will want to hire fewer employees. The quantity of labor demanded will decrease, and there will be a movement upward along the demand curve. If the wages and salaries decrease, employers are more likely to hire a greater number of workers. The quantity of labor demanded will increase, resulting in a downward movement along the demand curve.
Shifts in the demand curve for labor occur for many reasons. One key reason is that the demand for labor is based on the demand for the good or service that is produced. For example, the more new automobiles consumers demand, the greater the number of workers automakers will need to hire. Therefore the demand for labor is called a “derived demand.” Here are some examples of derived demand for labor:
• The demand for chefs is dependent on the demand for restaurant meals.
• The demand for pharmacists is dependent on the demand for prescription drugs.
• The demand for attorneys is dependent on the demand for legal services.
As the demand for the goods and services increases, the demand for labor will increase, or shift to the right, to meet employers’ production requirements. As the demand for the goods and services decreases, the demand for labor will decrease, or shift to the left. Table 4.2 shows that in addition to the derived demand for labor, demand can also increase or decrease (shift) in response to several factors.
Factors Results
Demand for Output When the demand for the good produced (output) increases, both the output price and profitability increase. As a result, producers demand more labor to ramp up production.
Education and Training A well-trained and educated workforce causes an increase in the demand for that labor by employers. Increased levels of productivity within the workforce will cause the demand for labor to shift to the right. If the workforce is not well-trained or educated, employers will not hire from within that labor pool, since they will need to spend a significant amount of time and money training that workforce. Demand for such will shift to the left.
Technology Technology changes can act as either substitutes for or complements to labor. When technology acts as a substitute, it replaces the need for the number of workers an employer needs to hire. For example, word processing decreased the number of typists needed in the workplace. This shifted the demand curve for typists left. An increase in the availability of certain technologies may increase the demand for labor. Technology that acts as a complement to labor will increase the demand for certain types of labor, resulting in a rightward shift of the demand curve. For example, the increased use of word processing and other software has increased the demand for information technology professionals who can resolve software and hardware issues related to a firm’s network. More and better technology will increase demand for skilled workers who know how to use technology to enhance workplace productivity. Those workers who do not adapt to changes in technology will experience a decrease in demand.
Number of Companies An increase in the number of companies producing a given product will increase the demand for labor resulting in a shift to the right. A decrease in the number of companies producing a given product will decrease the demand for labor resulting in a shift to the left.
Government Regulations Complying with government regulations can increase or decrease the demand for labor at any given wage. In the healthcare industry, government rules may require that nurses be hired to carry out certain medical procedures. This will increase the demand for nurses. Less-trained healthcare workers would be prohibited from carrying out these procedures, and the demand for these workers will shift to the left.
Price and Availability of Other Inputs Labor is not the only input into the production process. For example, a salesperson at a call center needs a telephone and a computer terminal to enter data and record sales. If prices of other inputs fall, production will become more profitable and suppliers will demand more labor to increase production. This will cause a rightward shift in the demand curve for labor. The opposite is also true. Higher prices for other inputs lower demand for labor.
Table 4.2 Factors That Can Shift Demand
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Shifts in Labor Supply
The supply of labor is upward-sloping and adheres to the law of supply: The higher the price, the greater the quantity supplied and the lower the price, the less quantity supplied. The supply curve models the tradeoff between supplying labor into the market or using time in leisure activities at every given price level. The higher the wage, the more labor is willing to work and forego leisure activities. Table 4.3 lists some of the factors that will cause the supply to increase or decrease.
Factors Results
Number of Workers An increased number of workers will cause the supply curve to shift to the right. An increased number of workers can be due to several factors, such as immigration, increasing population, an aging population, and changing demographics. Policies that encourage immigration will increase the supply of labor, and vice versa. Population grows when birth rates exceed death rates. This eventually increases supply of labor when the former reach working age. Another example of changing demographics is more women working outside of the home, which increases the supply of labor.
Required Education The more required education, the lower the supply. There is a lower supply of PhD mathematicians than of high school mathematics teachers; there is a lower supply of cardiologists than of primary care physicians; and there is a lower supply of physicians than of nurses.
Government Policies Government policies can also affect the supply of labor for jobs. Alternatively, the government may support rules that set high qualifications for certain jobs: academic training, certificates or licenses, or experience. When these qualifications are made tougher, the number of qualified workers will decrease at any given wage. On the other hand, the government may also subsidize training or even reduce the required level of qualifications. For example, government might offer subsidies for nursing schools or nursing students. Such provisions would shift the supply curve of nurses to the right. In addition, government policies that change the relative desirability of working versus not working also affect the labor supply. These include unemployment benefits, maternity leave, child care benefits, and welfare policy. For example, child care benefits may increase the labor supply of working mothers. Long term unemployment benefits may discourage job searching for unemployed workers. All these policies must therefore be carefully designed to minimize any negative labor supply effects.
Table 4.3 Factors that Can Shift Supply
A change in salary will lead to a movement along labor demand or labor supply curves, but it will not shift those curves. However, other events like those we have outlined here will cause either the demand or the supply of labor to shift, and thus will move the labor market to a new equilibrium salary and quantity.
Technology and Wage Inequality: The Four-Step Process
Economic events can change the equilibrium salary (or wage) and quantity of labor. Consider how the wave of new information technologies, like computer and telecommunications networks, has affected low-skill and high-skill workers in the U.S. economy. From the perspective of employers who demand labor, these new technologies are often a substitute for low-skill laborers like file clerks who used to keep file cabinets full of paper records of transactions. However, the same new technologies are a complement to high-skill workers like managers, who benefit from the technological advances by having the ability to monitor more information, communicate more easily, and juggle a wider array of responsibilities. How will the new technologies affect the wages of high-skill and low-skill workers? For this question, the four-step process of analyzing how shifts in supply or demand affect a market (introduced in Demand and Supply) works in this way:
Step 1. What did the markets for low-skill labor and high-skill labor look like before the arrival of the new technologies? In Figure 4.3 (a) and Figure 4.3 (b), S0 is the original supply curve for labor and D0 is the original demand curve for labor in each market. In each graph, the original point of equilibrium, E0, occurs at the price W0 and the quantity Q0.
Figure 4.3 Technology and Wages: Applying Demand and Supply (a) The demand for low-skill labor shifts to the left when technology can do the job previously done by these workers. (b) New technologies can also increase the demand for high-skill labor in fields such as information technology and network administration.
Step 2. Does the new technology affect the supply of labor from households or the demand for labor from firms? The technology change described here affects demand for labor by firms that hire workers.
Step 3. Will the new technology increase or decrease demand? Based on the description earlier, as the substitute for low-skill labor becomes available, demand for low-skill labor will shift to the left, from D0 to D1. As the technology complement for high-skill labor becomes cheaper, demand for high-skill labor will shift to the right, from D0 to D1.
Step 4. The new equilibrium for low-skill labor, shown as point E1 with price W1 and quantity Q1, has a lower wage and quantity hired than the original equilibrium, E0. The new equilibrium for high-skill labor, shown as point E1 with price W1 and quantity Q1, has a higher wage and quantity hired than the original equilibrium (E0).
Thus, the demand and supply model predicts that the new computer and communications technologies will raise the pay of high-skill workers but reduce the pay of low-skill workers. From the 1970s to the mid-2000s, the wage gap widened between high-skill and low-skill labor. According to the National Center for Education Statistics, in 1980, for example, a college graduate earned about 30% more than a high school graduate with comparable job experience, but by 2019, a college graduate earned about 59% more than an otherwise comparable high school graduate. Many economists believe that the trend toward greater wage inequality across the U.S. economy is due to improvements in technology.
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Price Floors in the Labor Market: Living Wages and Minimum Wages
In contrast to goods and services markets, price ceilings are rare in labor markets, because rules that prevent people from earning income are not politically popular. There is one exception: boards of trustees or stockholders, as an example, propose limits on the high incomes of top business executives.
The labor market, however, presents some prominent examples of price floors, which are an attempt to increase the wages of low-paid workers. The U.S. government sets a minimum wage, a price floor that makes it illegal for an employer to pay employees less than a certain hourly rate. In mid-2009, the U.S. minimum wage was raised to \$7.25 per hour. Local political movements in a number of U.S. cities have pushed for a higher minimum wage, which they call a living wage. Promoters of living wage laws maintain that the minimum wage is too low to ensure a reasonable standard of living. They base this conclusion on the calculation that, if you work 40 hours a week at a minimum wage of \$7.25 per hour for 50 weeks a year, your annual income is \$14,500, which is less than the official U.S. government definition of what it means for a family to be in poverty. (A family with two adults earning minimum wage and two young children will find it more cost efficient for one parent to provide childcare while the other works for income. Thus the family income would be \$14,500, which is significantly lower than the federal poverty line for a family of four, which was \$26,500 in 2021.)
Supporters of the living wage argue that full-time workers should be assured a high enough wage so that they can afford the essentials of life: food, clothing, shelter, and healthcare. Since Baltimore passed the first living wage law in 1994, several dozen cities enacted similar laws in the late 1990s and the 2000s. The living wage ordinances do not apply to all employers, but they have specified that all employees of the city or employees of firms that the city hires be paid at least a certain wage that is usually a few dollars per hour above the U.S. minimum wage.
Figure 4.4 illustrates the situation of a city considering a living wage law. For simplicity, we assume that there is no federal minimum wage. The wage appears on the vertical axis, because the wage is the price in the labor market. Before the passage of the living wage law, the equilibrium wage is \$10 per hour and the city hires 1,200 workers at this wage. However, a group of concerned citizens persuades the city council to enact a living wage law requiring employers to pay no less than \$12 per hour. In response to the higher wage, 1,600 workers look for jobs with the city. At this higher wage, the city, as an employer, is willing to hire only 700 workers. At the price floor, the quantity supplied exceeds the quantity demanded, and a surplus of labor exists in this market. For workers who continue to have a job at a higher salary, life has improved. For those who were willing to work at the old wage rate but lost their jobs with the wage increase, life has not improved. Table 4.4 shows the differences in supply and demand at different wages.
Figure 4.4 A Living Wage: Example of a Price Floor The original equilibrium in this labor market is a wage of \$10/hour and a quantity of 1,200 workers, shown at point E. Imposing a wage floor at \$12/hour leads to an excess supply of labor. At that wage, the quantity of labor supplied is 1,600 and the quantity of labor demanded is only 700.
Wage Quantity Labor Demanded Quantity Labor Supplied
\$8/hr 1,900 500
\$9/hr 1,500 900
\$10/hr 1,200 1,200
\$11/hr 900 1,400
\$12/hr 700 1,600
\$13/hr 500 1,800
\$14/hr 400 1,900
Table 4.4 Living Wage: Example of a Price Floor
The Minimum Wage as an Example of a Price Floor
The U.S. minimum wage is a price floor that is set either very close to the equilibrium wage or even slightly below it. About 1.5% of hourly workers in the U.S. are paid the minimum wage. In other words, the vast majority of the U.S. labor force has its wages determined in the labor market, not as a result of the government price floor. However, for workers with low skills and little experience, like those without a high school diploma or teenagers, the minimum wage is quite important. In many cities, the federal minimum wage is apparently below the market price for unskilled labor, because employers offer more than the minimum wage to checkout clerks and other low-skill workers without any government prodding.
Economists have attempted to estimate how much the minimum wage reduces the quantity demanded of low-skill labor. A typical result of such studies is that a 10% increase in the minimum wage would decrease the hiring of unskilled workers by 1 to 2%, which seems a relatively small reduction. In fact, some studies have even found no effect of a higher minimum wage on employment at certain times and places—although these studies are controversial. Well-known economists Walter Williams and Thomas Sowell, who both focus on the intersections of race and economics, argue that minimum wages increase discrimination and limit economic mobility. Williams, for example, indicates that higher minimum wages would increase employment barriers for lower-skilled workers, reducing the opportunity for them to learn on the job and gain experience that would give them more choice in employment.
Let’s suppose that the minimum wage lies just slightly below the equilibrium wage level. Wages could fluctuate according to market forces above this price floor, but they would not be allowed to move beneath the floor. In this situation, the price floor minimum wage is nonbinding —that is, the price floor is not determining the market outcome. Even if the minimum wage moves just a little higher, it will still have no effect on the quantity of employment in the economy, as long as it remains below the equilibrium wage. Even if the government increases the minimum wage by enough so that it rises slightly above the equilibrium wage and becomes binding, there will be only a small excess supply gap between the quantity demanded and quantity supplied.
These insights help to explain why U.S. minimum wage laws have historically had only a small impact on employment. Since the minimum wage has typically been set close to the equilibrium wage for low-skill labor and sometimes even below it, it has not had a large effect in creating an excess supply of labor. However, if the minimum wage increased dramatically—say, if it doubled to match the living wages that some U.S. cities have considered—then its impact on reducing the quantity demanded of employment would be far greater. The following Clear It Up feature describes in greater detail some of the arguments for and against changes to the minimum wage.
Clear It Up
What’s the harm in raising the minimum wage?
Because of the law of demand, a higher required wage will reduce the amount of low-skill employment either in terms of employees or in terms of work hours. Although there is controversy over the numbers, let’s say for the sake of the argument that a 10% rise in the minimum wage will reduce the employment of low-skill workers by 2%. Does this outcome mean that raising the minimum wage by 10% is bad public policy? Not necessarily.
If 98% of those receiving the minimum wage have a pay increase of 10%, but 2% of those receiving the minimum wage lose their jobs, are the gains for society as a whole greater than the losses? The answer is not clear, because job losses, even for a small group, may cause more pain than modest income gains for others. For one thing, we need to consider which minimum wage workers are losing their jobs. If the 2% of minimum wage workers who lose their jobs are struggling to support families, that is one thing. If those who lose their job are high school students picking up spending money over summer vacation, that is something else.
Another complexity is that many minimum wage workers do not work full-time for an entire year. Imagine a minimum wage worker who holds different part-time jobs for a few months at a time, with bouts of unemployment in between. The worker in this situation receives the 10% raise in the minimum wage when working, but also ends up working 2% fewer hours during the year because the higher minimum wage reduces how much employers want people to work. Overall, this worker’s income would rise because the 10% pay raise would more than offset the 2% fewer hours worked.
Of course, these arguments do not prove that raising the minimum wage is necessarily a good idea either. There may well be other, better public policy options for helping low-wage workers. (The Poverty and Economic Inequality chapter discusses some possibilities.) The lesson from this maze of minimum wage arguments is that complex social problems rarely have simple answers. Even those who agree on how a proposed economic policy affects quantity demanded and quantity supplied may still disagree on whether the policy is a good idea. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/04%3A_Labor_and_Financial_Markets/4.02%3A_Demand_and_Supply_at_Work_in_Labor_Markets.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify the demanders and suppliers in a financial market
• Explain how interest rates can affect supply and demand
• Analyze the economic effects of U.S. debt in terms of domestic financial markets
• Explain the role of price ceilings and usury laws in the U.S.
United States' households, institutions, and domestic businesses saved almost \$1.3 trillion in 2015. Where did that savings go and how was it used? Some of the savings ended up in banks, which in turn loaned the money to individuals or businesses that wanted to borrow money. Some was invested in private companies or loaned to government agencies that wanted to borrow money to raise funds for purposes like building roads or mass transit. Some firms reinvested their savings in their own businesses.
In this section, we will determine how the demand and supply model links those who wish to supply financial capital (i.e., savings) with those who demand financial capital (i.e., borrowing). Those who save money (or make financial investments, which is the same thing), whether individuals or businesses, are on the supply side of the financial market. Those who borrow money are on the demand side of the financial market. For a more detailed treatment of the different kinds of financial investments like bank accounts, stocks and bonds, see the Financial Markets chapter.
Who Demands and Who Supplies in Financial Markets?
In any market, the price is what suppliers receive and what demanders pay. In financial markets, those who supply financial capital through saving expect to receive a rate of return, while those who demand financial capital by receiving funds expect to pay a rate of return. This rate of return can come in a variety of forms, depending on the type of investment.
The simplest example of a rate of return is the interest rate. For example, when you supply money into a savings account at a bank, you receive interest on your deposit. The interest the bank pays you as a percent of your deposits is the interest rate. Similarly, if you demand a loan to buy a car or a computer, you will need to pay interest on the money you borrow.
Let’s consider the market for borrowing money with credit cards. In 2021, almost 200 million Americans were cardholders. Credit cards allow you to borrow money from the card's issuer, and pay back the borrowed amount plus interest, although most allow you a period of time in which you can repay the loan without paying interest. A typical credit card interest rate ranges from 12% to 18% per year. In May 2021, Americans had about \$807 billion outstanding in credit card debts. As of 2021, just over 45% of American families carried some credit card debt. Let’s say that, on average, the annual interest rate for credit card borrowing is 15% per year. Thus, Americans pay tens of billions of dollars every year in interest on their credit cards—plus basic fees for the credit card or fees for late payments.
Figure 4.5 illustrates demand and supply in the financial market for credit cards. The horizontal axis of the financial market shows the quantity of money loaned or borrowed in this market. The vertical or price axis shows the rate of return, which in the case of credit card borrowing we can measure with an interest rate. Table 4.5 shows the quantity of financial capital that consumers demand at various interest rates and the quantity that credit card firms (often banks) are willing to supply.
Figure 4.5 Demand and Supply for Borrowing Money with Credit Cards In this market for credit card borrowing, the demand curve (D) for borrowing financial capital intersects the supply curve (S) for lending financial capital at equilibrium E. At the equilibrium, the interest rate (the “price” in this market) is 15% and the quantity of financial capital loaned and borrowed is \$600 billion. The equilibrium price is where the quantity demanded and the quantity supplied are equal. At an above-equilibrium interest rate like 21%, the quantity of financial capital supplied would increase to \$750 billion, but the quantity demanded would decrease to \$480 billion. At a below-equilibrium interest rate like 13%, the quantity of financial capital demanded would increase to \$700 billion, but the quantity of financial capital supplied would decrease to \$510 billion.
Interest Rate (%) Quantity of Financial Capital Demanded (Borrowing) (\$ billions) Quantity of Financial Capital Supplied (Lending) (\$ billions)
11 \$800 \$420
13 \$700 \$510
15 \$600 \$600
17 \$550 \$660
19 \$500 \$720
21 \$480 \$750
Table 4.5 Demand and Supply for Borrowing Money with Credit Cards
The laws of demand and supply continue to apply in the financial markets. According to the law of demand, a higher rate of return (that is, a higher price) will decrease the quantity demanded. As the interest rate rises, consumers will reduce the quantity that they borrow. According to the law of supply, a higher price increases the quantity supplied. Consequently, as the interest rate paid on credit card borrowing rises, more firms will be eager to issue credit cards and to encourage customers to use them. Conversely, if the interest rate on credit cards falls, the quantity of financial capital supplied in the credit card market will decrease and the quantity demanded will increase.
Equilibrium in Financial Markets
In the financial market for credit cards in Figure 4.5, the supply curve (S) and the demand curve (D) cross at the equilibrium point (E). The equilibrium occurs at an interest rate of 15%, where the quantity of funds demanded and the quantity supplied are equal at an equilibrium quantity of \$600 billion.
If the interest rate (remember, this measures the “price” in the financial market) is above the equilibrium level, then an excess supply, or a surplus, of financial capital will arise in this market. For example, at an interest rate of 21%, the quantity of funds supplied increases to \$750 billion, while the quantity demanded decreases to \$480 billion. At this above-equilibrium interest rate, firms are eager to supply loans to credit card borrowers, but relatively few people or businesses wish to borrow. As a result, some credit card firms will lower the interest rates (or other fees) they charge to attract more business. This strategy will push the interest rate down toward the equilibrium level.
If the interest rate is below the equilibrium, then excess demand or a shortage of funds occurs in this market. At an interest rate of 13%, the quantity of funds credit card borrowers demand increases to \$700 billion, but the quantity credit card firms are willing to supply is only \$510 billion. In this situation, credit card firms will perceive that they are overloaded with eager borrowers and conclude that they have an opportunity to raise interest rates or fees. The interest rate will face economic pressures to creep up toward the equilibrium level.
The FRED database publishes some two dozen measures of interest rates, including interest rates on credit cards, automobile loans, personal loans, mortgage loans, and more. You can find these at the FRED website.
Shifts in Demand and Supply in Financial Markets
Those who supply financial capital face two broad decisions: how much to save, and how to divide up their savings among different forms of financial investments. We will discuss each of these in turn.
Participants in financial markets must decide when they prefer to consume goods: now or in the future. Economists call this intertemporal decision making because it involves decisions across time. Unlike a decision about what to buy from the grocery store, people make investment or savings decisions across a period of time, sometimes a long period.
Most workers save for retirement because their income in the present is greater than their needs, while the opposite will be true once they retire. Thus, they save today and supply financial markets. If their income increases, they save more. If their perceived situation in the future changes, they change the amount of their saving. For example, there is some evidence that Social Security, the program that workers pay into in order to qualify for government checks after retirement, has tended to reduce the quantity of financial capital that workers save. If this is true, Social Security has shifted the supply of financial capital at any interest rate to the left.
By contrast, many college students need money today when their income is low (or nonexistent) to pay their college expenses. As a result, they borrow today and demand from financial markets. Once they graduate and become employed, they will pay back the loans. Individuals borrow money to purchase homes or cars. A business seeks financial investment so that it has the funds to build a factory or invest in a research and development project that will not pay off for five years, ten years, or even more. Thus, when consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right.
For example, in the technology boom of the late 1990s, many businesses became extremely confident that investments in new technology would have a high rate of return, and their demand for financial capital shifted to the right. Conversely, during the 2008 and 2009 Great Recession, their demand for financial capital at any given interest rate shifted to the left.
To this point, we have been looking at saving in total. Now let us consider what affects saving in different types of financial investments. In deciding between different forms of financial investments, suppliers of financial capital will have to consider the rates of return and the risks involved. Rate of return is a positive attribute of investments, but risk is a negative. If Investment A becomes more risky, or the return diminishes, then savers will shift their funds to Investment B—and the supply curve of financial capital for Investment A will shift back to the left while the supply curve of capital for Investment B shifts to the right.
The United States as a Global Borrower
In the global economy, trillions of dollars of financial investment cross national borders every year. In the early 2000s, financial investors from foreign countries were investing several hundred billion dollars per year more in the U.S. economy than U.S. financial investors were investing abroad. The following Work It Out deals with one of the macroeconomic concerns for the U.S. economy in recent years.
Work It Out
The Effect of Growing U.S. Debt
Imagine that foreign investors viewed the U.S. economy as a less desirable place to put their money because of fears about the growth of the U.S. public debt. Using the four-step process for analyzing how changes in supply and demand affect equilibrium outcomes, how would increased U.S. public debt affect the equilibrium price and quantity for capital in U.S. financial markets?
Step 1. Draw a diagram showing demand and supply for financial capital that represents the original scenario in which foreign investors are pouring money into the U.S. economy. Figure 4.6 shows a demand curve, D, and a supply curve, S, where the supply of capital includes the funds arriving from foreign investors. The original equilibrium E0 occurs at interest rate R0 and quantity of financial investment Q0.
Figure 4.6 The United States as a Global Borrower Before U.S. Debt Uncertainty The graph shows the demand for financial capital from and supply of financial capital into the U.S. financial markets by the foreign sector before the increase in uncertainty regarding U.S. public debt. The original equilibrium (E0) occurs at an equilibrium rate of return (R0) and the equilibrium quantity is at Q0.
Step 2. Will the diminished confidence in the U.S. economy as a place to invest affect demand or supply of financial capital? Yes, it will affect supply. Many foreign investors look to the U.S. financial markets to store their money in safe financial vehicles with low risk and stable returns. Diminished confidence means U.S. financial assets will be seen as more risky.
Step 3. Will supply increase or decrease? When the enthusiasm of foreign investors’ for investing their money in the U.S. economy diminishes, the supply of financial capital shifts to the left. Figure 4.7 shows the supply curve shift from S0 to S1.
Figure 4.7 The United States as a Global Borrower Before and After U.S. Debt Uncertainty The graph shows the demand for financial capital and supply of financial capital into the U.S. financial markets by the foreign sector before and after the increase in uncertainty regarding U.S. public debt. The original equilibrium (E0) occurs at an equilibrium rate of return (R0) and the equilibrium quantity is at Q0.
Step 4. Thus, foreign investors’ diminished enthusiasm leads to a new equilibrium, E1, which occurs at the higher interest rate, R1, and the lower quantity of financial investment, Q1. In short, U.S. borrowers will have to pay more interest on their borrowing.
The economy has experienced an enormous inflow of foreign capital. According to the U.S. Bureau of Economic Analysis, by the third quarter of 2021, U.S. investors had accumulated \$34.45 trillion of foreign assets, but foreign investors owned a total of \$50.53 trillion of U.S. assets. If foreign investors were to pull their money out of the U.S. economy and invest elsewhere in the world, the result could be a significantly lower quantity of financial investment in the United States, available only at a higher interest rate. This reduced inflow of foreign financial investment could impose hardship on U.S. consumers and firms interested in borrowing.
In a modern, developed economy, financial capital often moves invisibly through electronic transfers between one bank account and another. Yet we can analyze these flows of funds with the same tools of demand and supply as markets for goods or labor.
Price Ceilings in Financial Markets: Usury Laws
As we noted earlier, about 200 million Americans own credit cards, and their interest payments and fees total tens of billions of dollars each year. It is little wonder that political pressures sometimes arise for setting limits on the interest rates or fees that credit card companies charge. The firms that issue credit cards, including banks, oil companies, phone companies, and retail stores, respond that the higher interest rates are necessary to cover the losses created by those who borrow on their credit cards and who do not repay on time or at all. These companies also point out that cardholders can avoid paying interest if they pay their bills on time.
Consider the credit card market as Figure 4.8 illustrates. In this financial market, the vertical axis shows the interest rate (which is the price in the financial market). Demanders in the credit card market are households and businesses. Suppliers are the companies that issue credit cards. This figure does not use specific numbers, which would be hypothetical in any case, but instead focuses on the underlying economic relationships. Imagine a law imposes a price ceiling that holds the interest rate charged on credit cards at the rate Rc, which lies below the interest rate R0 that would otherwise have prevailed in the market. The horizontal dashed line at interest rate Rc in Figure 4.8 shows the price ceiling. The demand and supply model predicts that at the lower price ceiling interest rate, the quantity demanded of credit card debt will increase from its original level of Q0 to Qd; however, the quantity supplied of credit card debt will decrease from the original Q0 to Qs. At the price ceiling (Rc), quantity demanded will exceed quantity supplied. Consequently, a number of people who want to have credit cards and are willing to pay the prevailing interest rate will find that companies are unwilling to issue cards to them. The result will be a credit shortage.
Figure 4.8 Credit Card Interest Rates: Another Price Ceiling Example The original intersection of demand D and supply S occurs at equilibrium E0. However, a price ceiling is set at the interest rate Rc, below the equilibrium interest rate R0, and so the interest rate cannot adjust upward to the equilibrium. At the price ceiling, the quantity demanded, Qd, exceeds the quantity supplied, Qs. There is excess demand, also called a shortage.
Many states do have usury laws, which impose an upper limit on the interest rate that lenders can charge. However, in many cases these upper limits are well above the market interest rate. For example, if the interest rate is not allowed to rise above 30% per year, it can still fluctuate below that level according to market forces. A price ceiling that is set at a relatively high level is nonbinding, and it will have no practical effect unless the equilibrium price soars high enough to exceed the price ceiling. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/04%3A_Labor_and_Financial_Markets/4.03%3A_Demand_and_Supply_in_Financial_Markets.txt |
Learning Objectives
By the end of this section, you will be able to:
• Apply demand and supply models to analyze prices and quantities
• Explain the effects of price controls on the equilibrium of prices and quantities
Prices exist in markets for goods and services, for labor, and for financial capital. In all of these markets, prices serve as a remarkable social mechanism for collecting, combining, and transmitting information that is relevant to the market—namely, the relationship between demand and supply—and then serving as messengers to convey that information to buyers and sellers. In a market-oriented economy, no government agency or guiding intelligence oversees the set of responses and interconnections that result from a change in price. Instead, each consumer reacts according to that person’s preferences and budget set, and each profit-seeking producer reacts to the impact on its expected profits. The following Clear It Up feature examines the demand and supply models.
Clear It Up
Why are demand and supply curves important?
The demand and supply model is the second fundamental diagram for this course. (The opportunity set model that we introduced in the Choice in a World of Scarcity chapter was the first.) Just as it would be foolish to try to learn the arithmetic of long division by memorizing every possible combination of numbers that can be divided by each other, it would be foolish to try to memorize every specific example of demand and supply in this chapter, this textbook, or this course. Demand and supply is not primarily a list of examples. It is a model to analyze prices and quantities. Even though demand and supply diagrams have many labels, they are fundamentally the same in their logic. Your goal should be to understand the underlying model so you can use it to analyze any market.
Figure 4.9 displays a generic demand and supply curve. The horizontal axis shows the different measures of quantity: a quantity of a good or service, or a quantity of labor for a given job, or a quantity of financial capital. The vertical axis shows a measure of price: the price of a good or service, the wage in the labor market, or the rate of return (like the interest rate) in the financial market.
The demand and supply model can explain the existing levels of prices, wages, and rates of return. To carry out such an analysis, think about the quantity that will be demanded at each price and the quantity that will be supplied at each price—that is, think about the shape of the demand and supply curves—and how these forces will combine to produce equilibrium.
We can also use demand and supply to explain how economic events will cause changes in prices, wages, and rates of return. There are only four possibilities: the change in any single event may cause the demand curve to shift right or to shift left, or it may cause the supply curve to shift right or to shift left. The key to analyzing the effect of an economic event on equilibrium prices and quantities is to determine which of these four possibilities occurred. The way to do this correctly is to think back to the list of factors that shift the demand and supply curves. Note that if more than one variable is changing at the same time, the overall impact will depend on the degree of the shifts. When there are multiple variables, economists isolate each change and analyze it independently.
Figure 4.9 Demand and Supply Curves The figure displays a generic demand and supply curve. The horizontal axis shows the different measures of quantity: a quantity of a good or service, a quantity of labor for a given job, or a quantity of financial capital. The vertical axis shows a measure of price: the price of a good or service, the wage in the labor market, or the rate of return (like the interest rate) in the financial market. We can use the demand and supply curves explain how economic events will cause changes in prices, wages, and rates of return.
An increase in the price of some product signals consumers that there is a shortage; therefore, they may want to economize on buying this product. For example, if you are thinking about taking a plane trip to Hawaii, but the ticket turns out to be expensive during the week you intend to go, you might consider other weeks when the ticket might be cheaper. The price could be high because you were planning to travel during a holiday when demand for traveling is high. Maybe the cost of an input like jet fuel increased or the airline has raised the price temporarily to see how many people are willing to pay it. Perhaps all of these factors are present at the same time. You do not need to analyze the market and break down the price change into its underlying factors. You just have to look at the ticket price and decide whether and when to fly.
In the same way, price changes provide useful information to producers. Imagine the situation of a farmer who grows oats and learns that the price of oats has risen. The higher price could be due to an increase in demand caused by a new scientific study proclaiming that eating oats is especially healthful. Perhaps the price of a substitute grain, like corn, has risen, and people have responded by buying more oats. The oat farmer does not need to know the details. The farmer only needs to know that the price of oats has risen and that it will be profitable to expand production as a result.
The actions of individual consumers and producers as they react to prices overlap and interlock in markets for goods, labor, and financial capital. A change in any single market is transmitted through these multiple interconnections to other markets. The vision of the role of flexible prices helping markets to reach equilibrium and linking different markets together helps to explain why price controls can be so counterproductive. Price controls are government laws that serve to regulate prices rather than allow the various markets to determine prices. There is an old proverb: “Don’t kill the messenger.” In ancient times, messengers carried information between distant cities and kingdoms. When they brought bad news, there was an emotional impulse to kill the messenger. However, killing the messenger did not kill the bad news. Moreover, killing the messenger had an undesirable side effect: Other messengers would refuse to bring news to that city or kingdom, depriving its citizens of vital information.
Those who seek price controls are trying to kill the messenger—or at least to stifle an unwelcome message that prices are bringing about the equilibrium level of price and quantity. However, price controls do nothing to affect the underlying forces of demand and supply, and this can have serious repercussions. During China’s “Great Leap Forward” in the late 1950s, the government kept food prices artificially low, with the result that 30 to 40 million people died of starvation because the low prices depressed farm production. This was communist party leader Mao Zedong's social and economic campaign to rapidly transform the country from an agrarian economy to a socialist society through rapid industrialization and collectivization. Changes in demand and supply will continue to reveal themselves through consumers’ and producers’ behavior. Immobilizing the price messenger through price controls will deprive everyone in the economy of critical information. Without this information, it becomes difficult for everyone—buyers and sellers alike—to react in a flexible and appropriate manner as changes occur throughout the economy.
Bring It Home
Baby Boomers Come of Age
The theory of supply and demand can explain what happens in the labor markets and suggests that the demand for nurses will increase as healthcare needs of baby boomers increase, as Figure 4.10 shows. The impact of that increase will result in an average salary higher than the \$75,330 earned in 2020 referenced in the first part of this case. The new equilibrium (E1) will be at the new equilibrium price (Pe1).Equilibrium quantity will also increase from Qe0 to Qe1.
Figure 4.10 Impact of Increasing Demand for Nurses 2020–2030 In 2020, the median salary for nurses was \$75,330. As demand for services increases, the demand curve shifts to the right (from D0 to D1) and the equilibrium quantity of nurses increases from Qe0 to Qe1. The equilibrium salary increases from Pe0 to Pe1.
Suppose that as the demand for nurses increases, the supply shrinks due to an increasing number of nurses entering retirement and increases in the tuition of nursing degrees. The leftward shift of the supply curve in Figure 4.11 captures the impact of a decreasing supply of nurses. The shifts in the two curves result in higher salaries for nurses, but the overall impact on the quantity of nurses is uncertain, as it depends on the relative shifts of supply and demand.
Figure 4.11 Impact of Decreasing Supply of Nurses between 2020 and 2030 The increase in demand for nurses shown in Figure 4.10 leads to both higher prices and higher quantities demanded. As nurses retire from the work force, the supply of nurses decreases, causing a leftward shift in the supply curve and higher salaries for nurses at Pe2. The net effect on the equilibrium quantity of nurses is uncertain, which in this representation is less than Qe1, but more than the initial Qe0.
While we do not know if the number of nurses will increase or decrease relative to their initial employment, we know they will have higher salaries. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/04%3A_Labor_and_Financial_Markets/4.04%3A_The_Market_System_as_an_Efficient_Mechanism_for_Information.txt |
interest rate
the “price” of borrowing in the financial market; a rate of return on an investment
minimum wage
a price floor that makes it illegal for an employer to pay employees less than a certain hourly rate
usury laws
laws that impose an upper limit on the interest rate that lenders can charge
4.06: Key Concepts and Summary
4.1 Demand and Supply at Work in Labor Markets
In the labor market, households are on the supply side of the market and firms are on the demand side. In the market for financial capital, households and firms can be on either side of the market: they are suppliers of financial capital when they save or make financial investments, and demanders of financial capital when they borrow or receive financial investments.
In the demand and supply analysis of labor markets, we can measure the price by the annual salary or hourly wage received. We can measure the quantity of labor various ways, like number of workers or the number of hours worked.
Factors that can shift the demand curve for labor include: a change in the quantity demanded of the product that the labor produces; a change in the production process that uses more or less labor; and a change in government policy that affects the quantity of labor that firms wish to hire at a given wage. Demand can also increase or decrease (shift) in response to: workers’ level of education and training, technology, the number of companies, and availability and price of other inputs.
The main factors that can shift the supply curve for labor are: how desirable a job appears to workers relative to the alternatives, government policy that either restricts or encourages the quantity of workers trained for the job, the number of workers in the economy, and required education.
4.2 Demand and Supply in Financial Markets
In the demand and supply analysis of financial markets, the “price” is the rate of return or the interest rate received. We measure the quantity by the money that flows from those who supply financial capital to those who demand it.
Two factors can shift the supply of financial capital to a certain investment: if people want to alter their existing levels of consumption, and if the riskiness or return on one investment changes relative to other investments. Factors that can shift demand for capital include business confidence and consumer confidence in the future—since financial investments received in the present are typically repaid in the future.
4.3 The Market System as an Efficient Mechanism for Information
The market price system provides a highly efficient mechanism for disseminating information about relative scarcities of goods, services, labor, and financial capital. Market participants do not need to know why prices have changed, only that the changes require them to revisit previous decisions they made about supply and demand. Price controls hide information about the true scarcity of products and thereby cause misallocation of resources.
4.07: Self-Check Questions
1.
In the labor market, what causes a movement along the demand curve? What causes a shift in the demand curve?
2.
In the labor market, what causes a movement along the supply curve? What causes a shift in the supply curve?
3.
Why is a living wage considered a price floor? Does imposing a living wage have the same outcome as a minimum wage?
4.
In the financial market, what causes a movement along the demand curve? What causes a shift in the demand curve?
5.
In the financial market, what causes a movement along the supply curve? What causes a shift in the supply curve?
6.
If a usury law limits interest rates to no more than 35%, what would the likely impact be on the amount of loans made and interest rates paid?
7.
Which of the following changes in the financial market will lead to a decline in interest rates:
1. a rise in demand
2. a fall in demand
3. a rise in supply
4. a fall in supply
8.
Which of the following changes in the financial market will lead to an increase in the quantity of loans made and received:
1. a rise in demand
2. a fall in demand
3. a rise in supply
4. a fall in supply
9.
Identify the most accurate statement. A price floor will have the largest effect if it is set:
1. substantially above the equilibrium price
2. slightly above the equilibrium price
3. slightly below the equilibrium price
4. substantially below the equilibrium price
Sketch all four of these possibilities on a demand and supply diagram to illustrate your answer.
10.
A price ceiling will have the largest effect:
1. substantially below the equilibrium price
2. slightly below the equilibrium price
3. substantially above the equilibrium price
4. slightly above the equilibrium price
Sketch all four of these possibilities on a demand and supply diagram to illustrate your answer.
11.
Select the correct answer. A price floor will usually shift:
1. demand
2. supply
3. both
4. neither
Illustrate your answer with a diagram.
12.
Select the correct answer. A price ceiling will usually shift:
1. demand
2. supply
3. both
4. neither
4.08: Review Questions
13.
What is the “price” commonly called in the labor market?
14.
Are households demanders or suppliers in the goods market? Are firms demanders or suppliers in the goods market? What about the labor market and the financial market?
15.
Name some factors that can cause a shift in the demand curve in labor markets.
16.
Name some factors that can cause a shift in the supply curve in labor markets.
17.
How do economists define equilibrium in financial markets?
18.
What would be a sign of a shortage in financial markets?
19.
Would usury laws help or hinder resolution of a shortage in financial markets?
20.
Whether the product market or the labor market, what happens to the equilibrium price and quantity for each of the four possibilities: increase in demand, decrease in demand, increase in supply, and decrease in supply. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/04%3A_Labor_and_Financial_Markets/4.05%3A_Key_Terms.txt |
21.
Other than the demand for labor, what would be another example of a “derived demand?”
22.
Suppose that a 5% increase in the minimum wage causes a 5% reduction in employment. How would this affect employers and how would it affect workers? In your opinion, would this be a good policy?
23.
Under what circumstances would a minimum wage be a nonbinding price floor? Under what circumstances would a living wage be a binding price floor?
24.
Suppose the U.S. economy began to grow more rapidly than other countries in the world. What would be the likely impact on U.S. financial markets as part of the global economy?
25.
If the government imposed a federal interest rate ceiling of 20% on all loans, who would gain and who would lose?
26.
Why are the factors that shift the demand for a product different from the factors that shift the demand for labor? Why are the factors that shift the supply of a product different from those that shift the supply of labor?
27.
During a discussion several years ago on building a pipeline to Alaska to carry natural gas, the U.S. Senate passed a bill stipulating that there should be a guaranteed minimum price for the natural gas that would flow through the pipeline. The thinking behind the bill was that if private firms had a guaranteed price for their natural gas, they would be more willing to drill for gas and to pay to build the pipeline.
1. Using the demand and supply framework, predict the effects of this price floor on the price, quantity demanded, and quantity supplied.
2. With the enactment of this price floor for natural gas, what are some of the likely unintended consequences in the market?
3. Suggest some policies other than the price floor that the government can pursue if it wishes to encourage drilling for natural gas and for a new pipeline in Alaska.
4.10: Problems
28.
Identify each of the following as involving either demand or supply. Draw a circular flow diagram and label the flows A through F. (Some choices can be on both sides of the goods market.)
1. Households in the labor market
2. Firms in the goods market
3. Firms in the financial market
4. Households in the goods market
5. Firms in the labor market
6. Households in the financial market
29.
Predict how each of the following events will raise or lower the equilibrium wage and quantity of oil workers in Texas. In each case, sketch a demand and supply diagram to illustrate your answer.
1. The price of oil rises.
2. New oil-drilling equipment is invented that is cheap and requires few workers to run.
3. Several major companies that do not drill oil open factories in Texas, offering many well-paid jobs outside the oil industry.
4. Government imposes costly new regulations to make oil-drilling a safer job.
30.
Predict how each of the following economic changes will affect the equilibrium price and quantity in the financial market for home loans. Sketch a demand and supply diagram to support your answers.
1. The number of people at the most common ages for home-buying increases.
2. People gain confidence that the economy is growing and that their jobs are secure.
3. Banks that have made home loans find that a larger number of people than they expected are not repaying those loans.
4. Because of a threat of a war, people become uncertain about their economic future.
5. The overall level of saving in the economy diminishes.
6. The federal government changes its bank regulations in a way that makes it cheaper and easier for banks to make home loans.
31.
Table 4.6 shows the amount of savings and borrowing in a market for loans to purchase homes, measured in millions of dollars, at various interest rates. What is the equilibrium interest rate and quantity in the capital financial market? How can you tell? Now, imagine that because of a shift in the perceptions of foreign investors, the supply curve shifts so that there will be \$10 million less supplied at every interest rate. Calculate the new equilibrium interest rate and quantity, and explain why the direction of the interest rate shift makes intuitive sense.
Interest Rate Qs Qd
5% 130 170
6% 135 150
7% 140 140
8% 145 135
9% 150 125
10% 155 110
Table 4.6
32.
Imagine that to preserve the traditional way of life in small fishing villages, a government decides to impose a price floor that will guarantee all fishermen a certain price for their catch.
1. Using the demand and supply framework, predict the effects on the price, quantity demanded, and quantity supplied.
2. With the enactment of this price floor for fish, what are some of the likely unintended consequences in the market?
3. Suggest some policies other than the price floor to make it possible for small fishing villages to continue.
33.
What happens to the price and the quantity bought and sold in the cocoa market if countries producing cocoa experience a drought and a new study is released demonstrating the health benefits of cocoa? Illustrate your answer with a demand and supply graph. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/04%3A_Labor_and_Financial_Markets/4.09%3A_Critical_Thinking_Questions.txt |
Figure 5.1 On-Demand Media Pricing Many on-demand Internet streaming media providers, such as Netflix, have introduced tiered pricing for levels of access to services, begging the question, how will these prices affect buyer’s purchasing choices? (Credit: modification of “160906_FF_CreditCardAgreements” by kdiwavvou/Flickr, Public Domain)
Chapter Objectives
In this chapter, you will learn about:
• Price Elasticity of Demand and Price Elasticity of Supply
• Polar Cases of Elasticity and Constant Elasticity
• Elasticity and Pricing
• Elasticity in Areas Other Than Price
Bring It Home
That Will Be How Much?
Imagine going to your favorite coffee shop and having the waiter inform you the pricing has changed. Instead of \$3 for a cup of coffee, you will now be charged \$2 for coffee, \$1 for creamer, and \$1 for your choice of sweetener. If you pay your usual \$3 for a cup of coffee, you must choose between creamer and sweetener. If you want both, you now face an extra charge of \$1. Sound absurd? Well, that is similar to the situation Netflix customers found themselves in—they faced a 60% price hike to retain the same service in 2011.
In early 2011, Netflix consumers paid about \$10 a month for a package consisting of streaming video and DVD rentals. In July 2011, the company announced a packaging change. Customers wishing to retain both streaming video and DVD rental would be charged \$15.98 per month, a price increase of about 60%. In 2014, Netflix also raised its streaming video subscription price from \$7.99 to \$8.99 per month for new U.S. customers. The company also changed its policy of 4K streaming content from \$9.00 to \$12.00 per month that year.
How would customers of the 18-year-old firm react? Would they abandon Netflix? Would the ease of access to other venues make a difference in how consumers responded to the Netflix price change? At the time, Netflix had few competitors; in the intervening years, the field has grown to ten major competitors and nearly 200 smaller ones. Is that likely to have a greater impact than the price changes? We will explore the answers to those questions in this chapter, which focuses on the change in quantity with respect to a change in price, a concept economists call elasticity.
Anyone who has studied economics knows the law of demand: a higher price will lead to a lower quantity demanded. What you may not know is how much lower the quantity demanded will be. Similarly, the law of supply states that a higher price will lead to a higher quantity supplied. The question is: How much higher? This chapter will explain how to answer these questions and why they are critically important in the real world.
To find answers to these questions, we need to understand the concept of elasticity. Elasticity is an economics concept that measures responsiveness of one variable to changes in another variable. Suppose you drop two items from a second-floor balcony. The first item is a tennis ball. The second item is a brick. Which will bounce higher? Obviously, the tennis ball. We would say that the tennis ball has greater elasticity.
Consider an economic example. Cigarette taxes are an example of a “sin tax,” a tax on something that is bad for you, like alcohol. Governments tax cigarettes at the state and national levels. As of 2021, state taxes ranged from a low of 17 cents per pack in Missouri to \$4.35 per pack in Connecticut and New York. The average state cigarette tax is \$1.76 per pack. The 2021 federal tax rate on cigarettes was \$1.01 per pack. In 2015, the Obama Administration proposed raising the federal tax nearly a dollar to \$1.95 per pack. The key question is: How much would cigarette purchases decline?
Taxes on cigarettes serve two purposes: to raise tax revenue for government and to discourage cigarette consumption. However, if a higher cigarette tax discourages consumption considerably, meaning a greatly reduced quantity of cigarette sales, then the cigarette tax on each pack will not raise much revenue for the government. Alternatively, a higher cigarette tax that does not discourage consumption by much will actually raise more tax revenue for the government. Thus, when a government agency tries to calculate the effects of altering its cigarette tax, it must analyze how much the tax affects the quantity of cigarettes consumed. This issue reaches beyond governments and taxes. Every firm faces a similar issue. When a firm considers raising the sales price, it must consider how much a price increase will reduce the quantity demanded of what it sells. Conversely, when a firm puts its products on sale, it must expect (or hope) that the lower price will lead to a significantly higher quantity demanded. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/05%3A_Elasticity/5.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate the price elasticity of demand
• Calculate the price elasticity of supply
Both the demand and supply curve show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.
We can usefully divide elasticities into three broad categories: elastic, inelastic, and unitary. Because price and quantity demanded move in opposite directions, price elasticity of demand is always a negative number. Therefore, price elasticity of demand is usually reported as its absolute value, without a negative sign. The summary in Table 5.1 is assuming absolute values for price elasticity of demand. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply, as Table 5.1 summarizes.
If . . . Then . . . And It Is Called . . .
$% change in quantity>% change in price% change in quantity>% change in price$ $% change in quantity% change in price>1% change in quantity% change in price>1$ Elastic
$% change in quantity=% change in price% change in quantity=% change in price$ $% change in quantity% change in price=1% change in quantity% change in price=1$ Unitary
$% change in quantity<% change in price% change in quantity<% change in price$ $% change in quantity% change in price<1% change in quantity% change in price<1$ Inelastic
Table 5.1 Elastic, Inelastic, and Unitary: Three Cases of Elasticity
Link It Up
Before we delve into the details of elasticity, enjoy this article on elasticity and ticket prices at the Super Bowl.
To calculate elasticity along a demand or supply curve economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity, and is represented in the following equations:
$% change in quantity=Q2–Q1Q2+ Q1/2 × 100% change in price=P2– P1P2+ P1/2 × 100 % change in quantity=Q2–Q1Q2+ Q1/2 × 100% change in price=P2– P1P2+ P1/2 × 100$
The advantage of the Midpoint Method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base (average quantity and average price) for both cases.
Calculating Price Elasticity of Demand
Let’s calculate the elasticity between points A and B and between points G and H as Figure 5.2 shows.
Figure 5.2 Calculating the Price Elasticity of Demand We calculate the price elasticity of demand as the percentage change in quantity divided by the percentage change in price.
First, apply the formula to calculate the elasticity as price decreases from \$70 at point B to \$60 at point A:
Work It Out
Finding the Price Elasticity of Demand
Calculate the price elasticity of demand using the data in Figure 5.2 for an increase in price from G to H. Has the elasticity increased or decreased?
Step 1. We know that:
$Price Elasticity of Demand=% change in quantity% change in pricePrice Elasticity of Demand=% change in quantity% change in price$
Step 2. From the Midpoint Formula we know that:
$% change in quantity=Q2–Q1(Q2+Q1)/2 × 100% change in price=P2–P1(P2+P1)/2 × 100% change in quantity=Q2–Q1(Q2+Q1)/2 × 100% change in price=P2–P1(P2+P1)/2 × 100$
Step 3. So we can use the values provided in the figure in each equation:
$% change in quantity=1,600–1,800(1,600+1,800)/2 × 100=–2001,700 × 100=–11.76% change in price=130–120(130+120)/2 × 100=10125 × 100=8.0% change in quantity=1,600–1,800(1,600+1,800)/2 × 100=–2001,700 × 100=–11.76% change in price=130–120(130+120)/2 × 100=10125 × 100=8.0$
Step 4. Then, we can use those values to determine the price elasticity of demand:
$Price Elasticity of Demand=% change in quantity% change in price=–11.768=1.47Price Elasticity of Demand=% change in quantity% change in price=–11.768=1.47$
Therefore, the elasticity of demand from G to is H 1.47. The magnitude of the elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. Recall that the elasticity between these two points was 0.45. Demand was inelastic between points A and B and elastic between points G and H. This shows us that price elasticity of demand changes at different points along a straight-line demand curve.
Calculating the Price Elasticity of Supply
Assume that an apartment rents for \$650 per month and at that price the landlord rents 10,000 units as Figure 5.3 shows. When the price increases to \$700 per month, the landlord supplies 13,000 units into the market. By what percentage does apartment supply increase? What is the price sensitivity?
Figure 5.3 Price Elasticity of Supply We calculate the price elasticity of supply as the percentage change in quantity divided by the percentage change in price.
Using the Midpoint Method,
Clear It Up
Is the elasticity the slope?
It is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. The slope is the rate of change in units along the curve, or the rise/run (change in y over the change in x). For example, in Figure 5.2, at each point shown on the demand curve, price drops by \$10 and the number of units demanded increases by 200 compared to the point to its left. The slope is –10/200 along the entire demand curve and does not change. The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning.
When we are at the upper end of a demand curve, where price is high and the quantity demanded is low, a small change in the quantity demanded, even in, say, one unit, is pretty big in percentage terms. A change in price of, say, a dollar, is going to be much less important in percentage terms than it would have been at the bottom of the demand curve. Likewise, at the bottom of the demand curve, that one unit change when the quantity demanded is high will be small as a percentage.
Thus, at one end of the demand curve, where we have a large percentage change in quantity demanded over a small percentage change in price, the elasticity value would be high, or demand would be relatively elastic. Even with the same change in the price and the same change in the quantity demanded, at the other end of the demand curve the quantity is much higher, and the price is much lower, so the percentage change in quantity demanded is smaller and the percentage change in price is much higher. That means at the bottom of the curve we'd have a small numerator over a large denominator, so the elasticity measure would be much lower, or inelastic.
As we move along the demand curve, the values for quantity and price go up or down, depending on which way we are moving, so the percentages for, say, a \$1 difference in price or a one unit difference in quantity, will change as well, which means the ratios of those percentages and hence the elasticity will change. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/05%3A_Elasticity/5.02%3A_Price_Elasticity_of_Demand_and_Price_Elasticity_of_Supply.txt |
Learning Objectives
By the end of this section, you will be able to:
• Differentiate between infinite and zero elasticity
• Analyze graphs in order to classify elasticity as constant unitary, infinite, or zero
There are two extreme cases of elasticity: when elasticity equals zero and when it is infinite. A third case of interest is that of constant unitary elasticity. We will describe each case. Infinite elasticity or perfect elasticity refers to the extreme case where either the quantity demanded (Qd) or supplied (Qs) changes by an infinite amount in response to any change in price at all. In both cases, the supply and the demand curve are horizontal as Figure 5.4 shows. While perfectly elastic supply curves are for the most part unrealistic, goods with readily available inputs and whose production can easily expand will feature highly elastic supply curves. Examples include pizza, bread, books, and pencils. Similarly, perfectly elastic demand is an extreme example. However, luxury goods, items that take a large share of individuals’ income, and goods with many substitutes are likely to have highly elastic demand curves. Examples of such goods are Caribbean cruises and sports vehicles.
Figure 5.4 Infinite Elasticity The horizontal lines show that an infinite quantity will be demanded or supplied at a specific price. This illustrates the cases of a perfectly (or infinitely) elastic demand curve and supply curve. The quantity supplied or demanded is extremely responsive to price changes, moving from zero for prices close to P to infinite when prices reach P.
Zero elasticity or perfect inelasticity, as Figure 5.5 depicts, refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. While a perfectly inelastic supply is an extreme example, goods with limited supply of inputs are likely to feature highly inelastic supply curves. Examples include diamond rings or housing in prime locations such as apartments facing Central Park in New York City. Similarly, while perfectly inelastic demand is an extreme case, necessities with no close substitutes are likely to have highly inelastic demand curves. This is the case of life-saving drugs and gasoline.
Figure 5.5 Zero Elasticity The vertical supply curve and vertical demand curve show that there will be zero percentage change in quantity (a) demanded or (b) supplied, regardless of the price.
Constant unitary elasticity, in either a supply or demand curve, occurs when a price change of one percent results in a quantity change of one percent. Figure 5.6 shows a demand curve with constant unit elasticity. Using the midpoint method, you can calculate that between points A and B on the demand curve, the price changes by 66.7% and quantity demanded also changes by 66.7%. Hence, the elasticity equals 1. Between points B and C, price again changes by 66.7% as does quantity, while between points C and D the corresponding percentage changes are again 66.7% for both price and quantity. In each case, then, the percentage change in price equals the percentage change in quantity, and consequently elasticity equals 1. Notice that in absolute value, the declines in price, as you step down the demand curve, are not identical. Instead, the price falls by \$8.00 from A to B, by a smaller amount of \$4.00 from B to C, and by a still smaller amount of \$2.00 from C to D. As a result, a demand curve with constant unitary elasticity moves from a steeper slope on the left and a flatter slope on the right—and a curved shape overall.
Figure 5.6 A Constant Unitary Elasticity Demand Curve A demand curve with constant unitary elasticity will be a curved line. Notice how price and quantity demanded change by an identical percentage amount between each pair of points on the demand curve.
Unlike the demand curve with unitary elasticity, the supply curve with unitary elasticity is represented by a straight line, and that line goes through the origin. In each pair of points on the supply curve there is an equal difference in quantity of 30. However, in percentage value, using the midpoint method, the steps are decreasing as one moves from left to right, from 28.6% to 22.2% to 18.2%, because the quantity points in each percentage calculation are getting increasingly larger, which expands the denominator in the elasticity calculation of the percentage change in quantity.
Consider the price changes moving up the supply curve in Figure 5.7. From points D to E to F and to G on the supply curve, each step of \$1.50 is the same in absolute value. However, if we measure the price changes in percentage change terms, using the midpoint method, they are also decreasing, from 28.6% to 22.2% to 18.2%, because the original price points in each percentage calculation are getting increasingly larger in value, increasing the denominator in the calculation of the percentage change in price. Along the constant unitary elasticity supply curve, the percentage quantity increases on the horizontal axis exactly match the percentage price increases on the vertical axis—so this supply curve has a constant unitary elasticity at all points.
Figure 5.7 A Constant Unitary Elasticity Supply Curve A constant unitary elasticity supply curve is a straight line reaching up from the origin. Between each pair of points, the percentage increase in quantity supplied is the same as the percentage increase in price. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/05%3A_Elasticity/5.03%3A_Polar_Cases_of_Elasticity_and_Constant_Elasticity.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze how price elasticities impact revenue
• Evaluate how elasticity can cause shifts in demand and supply
• Predict how the long-run and short-run impacts of elasticity affect equilibrium
• Explain how the elasticity of demand and supply determine the incidence of a tax on buyers and sellers
Studying elasticities is useful for a number of reasons, pricing being most important. Let’s explore how elasticity relates to revenue and pricing, both in the long and short run. First, let’s look at the elasticities of some common goods and services.
Table 5.2 shows a selection of demand elasticities for different goods and services drawn from a variety of different studies by economists, listed in order of increasing elasticity.
Goods and Services Elasticity of Price
Housing 0.12
Transatlantic air travel (economy class) 0.12
Rail transit (rush hour) 0.15
Electricity 0.20
Taxi cabs 0.22
Gasoline 0.35
Transatlantic air travel (first class) 0.40
Wine 0.55
Beef 0.59
Transatlantic air travel (business class) 0.62
Kitchen and household appliances 0.63
Cable TV (basic rural) 0.69
Chicken 0.64
Soft drinks 0.70
Beer 0.80
New vehicle 0.87
Rail transit (off-peak) 1.00
Computer 1.44
Cable TV (basic urban) 1.51
Cable TV (premium) 1.77
Restaurant meals 2.27
Table 5.2 Some Selected Elasticities of Demand
Note that demand for necessities such as housing and electricity is inelastic, while items that are not necessities such as restaurant meals are more price-sensitive. If the price of a restaurant meal increases by 10%, the quantity demanded will decrease by 22.7%. A 10% increase in the price of housing will cause only a slight decrease of 1.2% in the quantity of housing demanded.
Link It Up
Read this article for an example of price elasticity that may have affected you.
Does Raising Price Bring in More Revenue?
Imagine that a band on tour is playing in an indoor arena with 15,000 seats. To keep this example simple, assume that the band keeps all the money from ticket sales. Assume further that the band pays the costs for its appearance, but that these costs, like travel, and setting up the stage, are the same regardless of how many people are in the audience. Finally, assume that all the tickets have the same price. (The same insights apply if ticket prices are more expensive for some seats than for others, but the calculations become more complicated.) The band knows that it faces a downward-sloping demand curve; that is, if the band raises the ticket price, it will sell fewer seats. How should the band set the ticket price to generate the most total revenue, which in this example, because costs are fixed, will also mean the highest profits for the band? Should the band sell more tickets at a lower price or fewer tickets at a higher price?
The key concept in thinking about collecting the most revenue is the price elasticity of demand. Total revenue is price times the quantity of tickets sold. Imagine that the band starts off thinking about a certain price, which will result in the sale of a certain quantity of tickets. The three possibilities are in Table 5.3. If demand is elastic at that price level, then the band should cut the price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold—thus raising total revenue. However, if demand is inelastic at that original quantity level, then the band should raise the ticket price, because a certain percentage increase in price will result in a smaller percentage decrease in the quantity sold—and total revenue will rise. If demand has a unitary elasticity at that quantity, then an equal percentage change in quantity will offset a moderate percentage change in the price—so the band will earn the same revenue whether it (moderately) increases or decreases the ticket price.
If Demand Is . . . Then . . . Therefore . . .
Elastic $% change in Qd>% change in P% change in Qd>% change in P$ A given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P × Q) falls.
Unitary $% change in Qd=% change in P% change in Qd=% change in P$ A given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P × Q) is unchanged.
Inelastic $% change in Qd<% change in P% change in Qd<% change in P$ A given % rise in P will cause a smaller % fall in Q so that total revenue (P × Q) rises.
Table 5.3 Will the Band Earn More Revenue by Changing Ticket Prices?
What if the band keeps cutting price, because demand is elastic, until it reaches a level where it sells all 15,000 seats in the available arena? If demand remains elastic at that quantity, the band might try to move to a bigger arena, so that it could slash ticket prices further and see a larger percentage increase in the quantity of tickets sold. However, if the 15,000-seat arena is all that is available or if a larger arena would add substantially to costs, then this option may not work.
Conversely, a few bands are so famous, or have such fanatical followings, that demand for tickets may be inelastic right up to the point where the arena is full. These bands can, if they wish, keep raising the ticket price. Ironically, some of the most popular bands could make more revenue by setting prices so high that the arena is not full—but those who buy the tickets would have to pay very high prices. However, bands sometimes choose to sell tickets for less than the absolute maximum they might be able to charge, often in the hope that fans will feel happier and spend more on recordings, T-shirts, and other paraphernalia.
Can Businesses Pass Costs on to Consumers?
Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost, as one pathway to their goal of earning higher profits. However, in some cases, the price of a key input over which the firm has no control may rise. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. If the cost of a key input rises, can the firm pass those higher costs along to consumers in the form of higher prices? Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass the gains along to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions.
Imagine that as a consumer of legal pharmaceutical products, you read a newspaper story that a technological breakthrough in the production of aspirin has occurred, so that every aspirin factory can now produce aspirin more cheaply. What does this discovery mean to you? Figure 5.8 illustrates two possibilities. In Figure 5.8 (a), the demand curve is highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from S0 to S1, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In Figure 5.8 (b), the demand curve is highly elastic. In this case, the technological breakthrough leads to a much greater quantity sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers.
Figure 5.8 Passing along Cost Savings to Consumers Cost-saving gains cause supply to shift out to the right from S0 to S1; that is, at any given price, firms will be willing to supply a greater quantity. If demand is inelastic, as in (a), the result of this cost-saving technological improvement will be substantially lower prices. If demand is elastic, as in (b), the result will be only slightly lower prices. Consumers benefit in either case, from a greater quantity at a lower price, but the benefit is greater when demand is inelastic, as in (a).
Aspirin producers may find themselves in a nasty bind here. The situation in Figure 5.8, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from aspirin sales. However, if strong competition exists between aspirin producers, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs. After all, if one firm decides not to implement such a cost-saving technology, other firms that do can drive them out of business.
Since demand for food is generally inelastic, farmers may often face the situation in Figure 5.8 (a). That is, a surge in production leads to a severe drop in price that can actually decrease the total revenue that farmers receive. Conversely, poor weather or other conditions that cause a terrible year for farm production can sharply raise prices so that the total revenue that the farmer receives increases. The Clear It Up box discusses how these issues relate to coffee.
Clear It Up
How do coffee prices fluctuate?
Coffee is an international crop. The top five coffee-exporting nations are Brazil, Vietnam, Colombia, Indonesia, and Ethiopia. In these nations and others, 20 million families depend on selling coffee beans as their main source of income. These families are exposed to enormous risk, because the world price of coffee bounces up and down. For example, in 1993, the world price of coffee was about 50 cents per pound. In 1995 it was four times as high, at \$2 per pound. By 1997 it had fallen by half to \$1.00 per pound. In 1998 it leaped back up to \$2 per pound. By 2001 it had fallen back to 46 cents a pound. By early 2011 it rose to about \$2.31 per pound. By the end of 2012, the price had fallen back to about \$1.31 per pound. Since then, the price of coffee has continued to fluctuate.
The reason for these price fluctuations lies in a combination of inelastic demand and shifts in supply. The elasticity of coffee demand is only about 0.3; that is, a 10% rise in the price of coffee leads to a decline of about 3% in the quantity of coffee consumed. When a major frost hit the Brazilian coffee crop in 1994, coffee supply shifted to the left with an inelastic demand curve, leading to much higher prices. Conversely, when Vietnam entered the world coffee market as a major producer in the late 1990s, the supply curve shifted out to the right. With a highly inelastic demand curve, coffee prices fell dramatically. Figure 5.8 (a) illustrates this situation.
Elasticity also reveals whether firms can pass higher costs that they incur on to consumers. Addictive substances, for which demand is inelastic, are products for which producers can pass higher costs on to consumers. For example, the demand for cigarettes is relatively inelastic among regular smokers who are somewhat addicted. Economic research suggests that increasing cigarette prices by 10% leads to about a 3% reduction in the quantity of cigarettes that adults smoke, so the elasticity of demand for cigarettes is 0.3. If society increases taxes on companies that produce cigarettes, the result will be, as in Figure 5.9 (a), that the supply curve shifts from S0 to S1. However, as the equilibrium moves from E0 to E1, governments mainly pass along these taxes to consumers in the form of higher prices. These higher taxes on cigarettes will raise tax revenue for the government, but they will not much affect the quantity of smoking.
If the goal is to reduce the quantity of cigarettes demanded, we must achieve it by shifting this inelastic demand back to the left, perhaps with public programs to discourage cigarette use or to help people to quit. For example, anti-smoking advertising campaigns have shown some ability to reduce smoking. However, if cigarette demand were more elastic, as in Figure 5.9 (b), then an increase in taxes that shifts supply from S0 to S1 and equilibrium from E0 to E1 would reduce the quantity of cigarettes smoked substantially. Youth smoking seems to be more elastic than adult smoking—that is, the quantity of youth smoking will fall by a greater percentage than the quantity of adult smoking in response to a given percentage increase in price.
Figure 5.9 Passing along Higher Costs to Consumers Higher costs, like a higher tax on cigarette companies for the example we gave in the text, lead supply to shift to the left. This shift is identical in (a) and (b). However, in (a), where demand is inelastic, companies largely can pass the cost increase along to consumers in the form of higher prices, without much of a decline in equilibrium quantity. In (b), demand is elastic, so the shift in supply results primarily in a lower equilibrium quantity. Consumers do not benefit in either case, but in (a), they pay a higher price for the same quantity, while in (b), they must buy a lower quantity (and presumably needing to shift their consumption elsewhere).
Elasticity and Tax Incidence
The example of cigarette taxes demonstrated that because demand is inelastic, taxes are not effective at reducing the equilibrium quantity of smoking, and they are mainly passed along to consumers in the form of higher prices. The analysis, or manner, of how a tax burden is divided between consumers and producers is called tax incidence. Typically, the tax incidence, or burden, falls both on the consumers and producers of the taxed good. However, if one wants to predict which group will bear most of the burden, all one needs to do is examine the elasticity of demand and supply. In the tobacco example, the tax burden falls on the most inelastic side of the market.
If demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most of the tax burden.
The intuition for this is simple. When the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded reduces only modestly when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The government can then pass the tax burden along to consumers in the form of higher prices, without much of a decline in the equilibrium quantity.
Similarly, when a government introduces a tax in a market with an inelastic supply, such as, for example, beachfront hotels, and sellers have no alternative than to accept lower prices for their business, taxes do not greatly affect the equilibrium quantity. The tax burden now passes on to the sellers. If the supply was elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller. The tax would result in a much lower quantity sold instead of lower prices received. Figure 5.10 illustrates this relationship between the tax incidence and elasticity of demand and supply.
Figure 5.10 Elasticity and Tax Incidence An excise tax introduces a wedge between the price paid by consumers (Pc) and the price received by producers (Pp). The vertical distance between Pc and Pp is the amount of the tax per unit. Pe is the equilibrium price prior to introduction of the tax. (a) When the demand is more elastic than supply, the tax incidence on consumers Pc – Pe is lower than the tax incidence on producers Pe – Pp. (b) When the supply is more elastic than demand, the tax incidence on consumers Pc – Pe is larger than the tax incidence on producers Pe – Pp. The more elastic the demand and supply curves, the lower the tax revenue.
In Figure 5.10 (a), the supply is inelastic and the demand is elastic, such as in the example of beachfront hotels. While consumers may have other vacation choices, sellers can’t easily move their businesses. By introducing a tax, the government essentially creates a wedge between the price paid by consumers Pc and the price received by producers Pp. In other words, of the total price paid by consumers, part is retained by the sellers and part is paid to the government in the form of a tax. The distance between Pc and Pp is the tax rate. The new market price is Pc, but sellers receive only Pp per unit sold, as they pay Pc-Pp to the government. Since we can view a tax as raising the costs of production, this could also be represented by a leftward shift of the supply curve, where the new supply curve would intercept the demand at the new quantity Qt. For simplicity, Figure 5.10 omits the shift in the supply curve.
The tax revenue is given by the shaded area, which we obtain by multiplying the tax per unit by the total quantity sold Qt. The tax incidence on the consumers is given by the difference between the price paid Pc and the initial equilibrium price Pe. The tax incidence on the sellers is given by the difference between the initial equilibrium price Pe and the price they receive after the tax is introduced Pp. In Figure 5.10 (a), the tax burden falls disproportionately on the sellers, and a larger proportion of the tax revenue (the shaded area) is due to the resulting lower price received by the sellers than by the resulting higher prices paid by the buyers. Figure 5.10 (b) describes the example of the tobacco excise tax where the supply is more elastic than demand. The tax incidence now falls disproportionately on consumers, as shown by the large difference between the price they pay, Pc, and the initial equilibrium price, Pe. Sellers receive a lower price than before the tax, but this difference is much smaller than the change in consumers’ price. From this analysis one can also predict whether a tax is likely to create a large revenue or not. The more elastic the demand curve, the more likely that consumers will reduce quantity instead of paying higher prices. The more elastic the supply curve, the more likely that sellers will reduce the quantity sold, instead of taking lower prices. In a market where both the demand and supply are very elastic, the imposition of an excise tax generates low revenue.
Some believe that excise taxes hurt mainly the specific industries they target. For example, the medical device excise tax, which was implemented in 2013, has been controversial for it can delay industry profitability and therefore hamper start-ups and medical innovation. The tax was repealed in late 2019. However, whether the tax burden falls mostly on the medical device industry or on the patients depends simply on the elasticity of demand and supply.
Long-Run vs. Short-Run Impact
Elasticities are often lower in the short run than in the long run. On the demand side of the market, it can sometimes be difficult to change Qd in the short run, but easier in the long run. Consumption of energy is a clear example. In the short run, it is not easy for a person to make substantial changes in energy consumption. Maybe you can carpool to work sometimes or adjust your home thermostat by a few degrees if the cost of energy rises, but that is about all. However, in the long run you can purchase a car that gets more miles to the gallon, choose a job that is closer to where you live, buy more energy-efficient home appliances, or install more insulation in your home. As a result, the elasticity of demand for energy is somewhat inelastic in the short run, but much more elastic in the long run.
Figure 5.11 is an example, based roughly on historical experience, for the responsiveness of Qd to price changes. In 1973, the price of crude oil was \$12 per barrel and total consumption in the U.S. economy was 17 million barrels per day. That year, the nations who were members of the Organization of Petroleum Exporting Countries (OPEC) cut off oil exports to the United States for six months because the Arab members of OPEC disagreed with the U.S. support for Israel. OPEC did not bring exports back to their earlier levels until 1975—a policy that we can interpret as a shift of the supply curve to the left in the U.S. petroleum market. Figure 5.11 (a) and Figure 5.11 (b) show the same original equilibrium point and the same identical shift of a supply curve to the left from S0 to S1.
Figure 5.11 How a Shift in Supply Can Affect Price or Quantity The intersection (E0) between demand curve D and supply curve S0 is the same in both (a) and (b). The shift of supply to the left from S0 to S1 is identical in both (a) and (b). The new equilibrium (E1) has a higher price and a lower quantity than the original equilibrium (E0) in both (a) and (b). However, the shape of the demand curve D is different in (a) and (b), being more elastic in (b) than in (a). As a result, the shift in supply can result either in a new equilibrium with a much higher price and an only slightly smaller quantity, as in (a), with more inelastic demand, or in a new equilibrium with only a small increase in price and a relatively larger reduction in quantity, as in (b), with more elastic demand.
Figure 5.11 (a) shows inelastic demand for oil in the short run similar to that which existed for the United States in 1973. In Figure 5.11 (a), the new equilibrium (E1) occurs at a price of \$25 per barrel, roughly double the price before the OPEC shock, and an equilibrium quantity of 16 million barrels per day. Figure 5.11 (b) shows what the outcome would have been if the U.S. demand for oil had been more elastic, a result more likely over the long term. This alternative equilibrium (E1) would have resulted in a smaller price increase to \$14 per barrel and larger reduction in equilibrium quantity to 13 million barrels per day. In 1983, for example, U.S. petroleum consumption was 15.3 million barrels a day, which was lower than in 1973 or 1975. U.S. petroleum consumption was down even though the U.S. economy was about one-fourth larger in 1983 than it had been in 1973. The primary reason for the lower quantity was that higher energy prices spurred conservation efforts, and after a decade of home insulation, more fuel-efficient cars, more efficient appliances and machinery, and other fuel-conserving choices, the demand curve for energy had become more elastic.
On the supply side of markets, producers of goods and services typically find it easier to expand production in the long term of several years rather than in the short run of a few months. After all, in the short run it can be costly or difficult to build a new factory, hire many new workers, or open new stores. However, over a few years, all of these are possible.
In most markets for goods and services, prices bounce up and down more than quantities in the short run, but quantities often move more than prices in the long run. The underlying reason for this pattern is that supply and demand are often inelastic in the short run, so that shifts in either demand or supply can cause a relatively greater change in prices. However, since supply and demand are more elastic in the long run, the long-run movements in prices are more muted, while quantity adjusts more easily in the long run. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/05%3A_Elasticity/5.04%3A_Elasticity_and_Pricing.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate the income elasticity of demand and the cross-price elasticity of demand
• Calculate the elasticity in labor and financial capital markets through an understanding of the elasticity of labor supply and the elasticity of savings
• Apply concepts of price elasticity to real-world situations
The basic idea of elasticity—how a percentage change in one variable causes a percentage change in another variable—does not just apply to the responsiveness of quantity supplied and quantity demanded to changes in the price of a product. Recall that quantity demanded (Qd) depends on income, tastes and preferences, the prices of related goods, and so on, as well as price. Similarly, quantity supplied (Qs) depends on factors such as the cost of production, as well as price. We can measure elasticity for any determinant of quantity supplied and quantity demanded, not just the price.
Income Elasticity of Demand
The income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income.
$Income elasticity of demand=% change in quantity demanded% change in incomeIncome elasticity of demand=% change in quantity demanded% change in income$
For most products, most of the time, the income elasticity of demand is positive: that is, a rise in income will cause an increase in the quantity demanded. This pattern is common enough that we refer to these goods as normal goods. However, for a few goods, an increase in income means that one might purchase less of the good. For example, those with a higher income might buy fewer hamburgers, because they are buying more steak instead, or those with a higher income might buy less cheap wine and more imported beer. When the income elasticity of demand is negative, we call the good an inferior good.
We introduced the concepts of normal and inferior goods in Demand and Supply. A higher level of income causes a demand curve to shift to the right for a normal good, which means that the income elasticity of demand is positive. How far the demand shifts depends on the income elasticity of demand. A higher income elasticity means a larger shift. However, for an inferior good, that is, when the income elasticity of demand is negative, a higher level of income would cause the demand curve for that good to shift to the left. Again, how much it shifts depends on how large the (negative) income elasticity is.
Cross-Price Elasticity of Demand
A change in the price of one good can shift the quantity demanded for another good. If the two goods are complements, like bread and peanut butter, then a drop in the price of one good will lead to an increase in the quantity demanded of the other good. However, if the two goods are substitutes, like plane tickets and train tickets, then a drop in the price of one good will cause people to substitute toward that good, and to reduce consumption of the other good. Cheaper plane tickets lead to fewer train tickets, and vice versa.
The cross-price elasticity of demand puts some meat on the bones of these ideas. The term “cross-price” refers to the idea that the price of one good is affecting the quantity demanded of a different good. Specifically, the cross-price elasticity of demand is the percentage change in the quantity of good A that is demanded as a result of a percentage change in the price of good B.
$Cross-price elasticity of demand=% change in Qd of good A% change in price of good BCross-price elasticity of demand=% change in Qd of good A% change in price of good B$
Substitute goods have positive cross-price elasticities of demand: if good A is a substitute for good B, like coffee and tea, then a higher price for B will mean a greater quantity consumed of A. Complement goods have negative cross-price elasticities: if good A is a complement for good B, like coffee and sugar, then a higher price for B will mean a lower quantity consumed of A.
Elasticity in Labor and Financial Capital Markets
The concept of elasticity applies to any market, not just markets for goods and services. In the labor market, for example, the wage elasticity of labor supply—that is, the percentage change in hours worked divided by the percentage change in wages—will reflect the shape of the labor supply curve. Specifically:
$Elasticity of labor supply=% change in quantity of labor supplied% change in wageElasticity of labor supply=% change in quantity of labor supplied% change in wage$
The wage elasticity of labor supply for teenage workers is generally fairly elastic: that is, a certain percentage change in wages will lead to a larger percentage change in the quantity of hours worked. Conversely, the wage elasticity of labor supply for adult workers in their thirties and forties is fairly inelastic. When wages move up or down by a certain percentage amount, the quantity of hours that adults in their prime earning years are willing to supply changes but by a lesser percentage amount.
In markets for financial capital, the elasticity of savings—that is, the percentage change in the quantity of savings divided by the percentage change in interest rates—will describe the shape of the supply curve for financial capital. That is:
$Elasticity of savings=% change in quantity of financial savings% change in interest rateElasticity of savings=% change in quantity of financial savings% change in interest rate$
Sometimes laws are proposed that seek to increase the quantity of savings by offering tax breaks so that the return on savings is higher. Such a policy will have a comparatively large impact on increasing the quantity saved if the supply curve for financial capital is elastic, because then a given percentage increase in the return to savings will cause a higher percentage increase in the quantity of savings. However, if the supply curve for financial capital is highly inelastic, then a percentage increase in the return to savings will cause only a small increase in the quantity of savings. The evidence on the supply curve of financial capital is controversial but, at least in the short run, the elasticity of savings with respect to the interest rate appears fairly inelastic.
Expanding the Concept of Elasticity
The elasticity concept does not even need to relate to a typical supply or demand curve at all. For example, imagine that you are studying whether the Internal Revenue Service should spend more money on auditing tax returns. We can frame the question in terms of the elasticity of tax collections with respect to spending on tax enforcement; that is, what is the percentage change in tax collections derived from a given percentage change in spending on tax enforcement?
With all of the elasticity concepts that we have just described, some of which are in Table 5.4, the possibility of confusion arises. When you hear the phrases “elasticity of demand” or “elasticity of supply,” they refer to the elasticity with respect to price. Sometimes, either to be extremely clear or because economists are discussing a wide variety of elasticities, we will call the elasticity of demand or the demand elasticity the price elasticity of demand or the “elasticity of demand with respect to price.” Similarly, economists sometimes use the term elasticity of supply or the supply elasticity, to avoid any possibility of confusion, the price elasticity of supply or “the elasticity of supply with respect to price.” However, in whatever context, the idea of elasticity always refers to percentage change in one variable, almost always a price or money variable, and how it causes a percentage change in another variable, typically a quantity variable of some kind.
$Income elasticity of demand=% change in Qd% change in incomeIncome elasticity of demand=% change in Qd% change in income$
$Cross-price elasticity of demand=% change in Qd of good A% change in price of good BCross-price elasticity of demand=% change in Qd of good A% change in price of good B$
$Wage elasticity of labor supply=% change in quantity of labor supplied% change in wageWage elasticity of labor supply=% change in quantity of labor supplied% change in wage$
$Wage elasticity of labor demand=% change in quantity of labor demanded% change in wageWage elasticity of labor demand=% change in quantity of labor demanded% change in wage$
$Interest rate elasticity of savings=% change in quantity of savings% change in interest rateInterest rate elasticity of savings=% change in quantity of savings% change in interest rate$
$Interest rate elasticity of borrowing=% change in quantity of borrowing% change in interest rateInterest rate elasticity of borrowing=% change in quantity of borrowing% change in interest rate$
Table 5.4 Formulas for Calculating Elasticity
Bring It Home
That Will Be How Much?
How did the 60% price increase in 2011 end up for Netflix? It has been a very bumpy ride.
Before the price increase, there were about 24.6 million U.S. subscribers. After the price increase, 810,000 infuriated U.S. consumers canceled their Netflix subscriptions, dropping the total number of subscribers to 23.79 million. Fast forward to June 2013, when there were 36 million streaming Netflix subscribers in the United States. This was an increase of 11.4 million subscribers since the price increase—an average per quarter growth of about 1.6 million. This growth is less than the 2 million per quarter increases Netflix experienced in the fourth quarter of 2010 and the first quarter of 2011.
During the first year after the price increase, the firm’s stock price (a measure of future expectations for the firm) fell from about \$33.60 per share per share to just under \$7.80. By the end of 2016, however, the stock price was at \$123 per share. By the end of 2021, the stock price was just over \$600 per share, and Netflix had more than 214 million subscribers in fifty countries.
What happened? Obviously, Netflix company officials understood the law of demand. Company officials reported, when announcing the price increase, this could result in the loss of about 600,000 existing subscribers. Using the elasticity of demand formula, it is easy to see company officials expected an inelastic response:
$=–600,000/[(24 million + 24.6 million)/2]6/[(10 + 16)/2]=–600,000/24.3 million6/13=–0.0250.46=–0.05=–600,000/[(24 million + 24.6 million)/2]6/[(10 + 16)/2]=–600,000/24.3 million6/13=–0.0250.46=–0.05$
In addition, Netflix officials had anticipated the price increase would have little impact on attracting new customers. Netflix anticipated adding up to 1.29 million new subscribers in the third quarter of 2011. It is true this was slower growth than the firm had experienced—about 2 million per quarter.
Why was the estimate of customers leaving so far off? In the more than two decades since Netflix had been founded, there was an increase in the number of close, but not perfect, substitutes. Consumers now had choices ranging from Vudu, Amazon Prime, Hulu, and Redbox, to retail stores. Jaime Weinman reported in Maclean’s that Redbox kiosks are “a five-minute drive for less from 68 percent of Americans, and it seems that many people still find a five-minute drive more convenient than loading up a movie online.” It seems that in 2012, many consumers still preferred a physical DVD disk over streaming video.
What missteps did the Netflix management make? In addition to misjudging the elasticity of demand, by failing to account for close substitutes, it seems they may have also misjudged customers’ preferences and tastes. However, the very substantial increase over time in the number of Netflix subscribers suggests that the preference for streaming video may well have overtaken the preference for physical DVD disks. Netflix, the source of numerous late night talk show laughs and jabs in 2011, may yet have the last laugh. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/05%3A_Elasticity/5.05%3A_Elasticity_in_Areas_Other_Than_Price.txt |
constant unitary elasticity
when a given percent price change in price leads to an equal percentage change in quantity demanded or supplied
cross-price elasticity of demand
the percentage change in the quantity of good A that is demanded as a result of a percentage change in the price of good B
elastic demand
when the elasticity of demand is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price
elastic supply
when the elasticity of either supply is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price
elasticity
an economics concept that measures responsiveness of one variable to changes in another variable
elasticity of savings
the percentage change in the quantity of savings divided by the percentage change in interest rates
inelastic demand
when the elasticity of demand is less than one, indicating that a 1 percent increase in price paid by the consumer leads to less than a 1 percent change in purchases (and vice versa); this indicates a low responsiveness by consumers to price changes
inelastic supply
when the elasticity of supply is less than one, indicating that a 1 percent increase in price paid to the firm will result in a less than 1 percent increase in production by the firm; this indicates a low responsiveness of the firm to price increases (and vice versa if prices drop)
infinite elasticity
the extremely elastic situation of demand or supply where quantity changes by an infinite amount in response to any change in price; horizontal in appearance
perfect elasticity
see infinite elasticity
perfect inelasticity
see zero elasticity
price elasticity
the relationship between the percent change in price resulting in a corresponding percentage change in the quantity demanded or supplied
price elasticity of demand
percentage change in the quantity demanded of a good or service divided the percentage change in price
price elasticity of supply
percentage change in the quantity supplied divided by the percentage change in price
tax incidence
manner in which the tax burden is divided between buyers and sellers
unitary elasticity
when the calculated elasticity is equal to one indicating that a change in the price of the good or service results in a proportional change in the quantity demanded or supplied
wage elasticity of labor supply
the percentage change in hours worked divided by the percentage change in wages
zero inelasticity
the highly inelastic case of demand or supply in which a percentage change in price, no matter how large, results in zero change in the quantity; vertical in appearance
5.07: Key Concepts and Summary
5.1 Price Elasticity of Demand and Price Elasticity of Supply
Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. We compute it as the percentage change in quantity demanded (or supplied) divided by the percentage change in price. We can describe elasticity as elastic (or very responsive), unit elastic, or inelastic (not very responsive). Elastic demand or supply curves indicate that quantity demanded or supplied respond to price changes in a greater than proportional manner. An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied. A unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.
5.2 Polar Cases of Elasticity and Constant Elasticity
Infinite or perfect elasticity refers to the extreme case where either the quantity demanded or supplied changes by an infinite amount in response to any change in price at all. Zero elasticity refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. Constant unitary elasticity in either a supply or demand curve refers to a situation where a price change of one percent results in a quantity change of one percent.
5.3 Elasticity and Pricing
In the market for goods and services, quantity supplied and quantity demanded are often relatively slow to react to changes in price in the short run, but react more substantially in the long run. As a result, demand and supply often (but not always) tend to be relatively inelastic in the short run and relatively elastic in the long run. A tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden, and when demand is more elastic than supply, producers bear most of the cost of the tax. Tax revenue is larger the more inelastic the demand and supply are.
5.4 Elasticity in Areas Other Than Price
Elasticity is a general term, that reflects responsiveness. It refers to the change of one variable divided by the percentage change of a related variable that we can apply to many economic connections. For instance, the income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. The cross-price elasticity of demand is the percentage change in the quantity demanded of a good divided by the percentage change in the price of another good. Elasticity applies in labor markets and financial capital markets just as it does in markets for goods and services. The wage elasticity of labor supply is the percentage change in the quantity of hours supplied divided by the percentage change in the wage. The elasticity of savings with respect to interest rates is the percentage change in the quantity of savings divided by the percentage change in interest rates.
5.08: Self-Check Questions
1.
From the data in Table 5.5 about demand for smart phones, calculate the price elasticity of demand from: point B to point C, point D to point E, and point G to point H. Classify the elasticity at each point as elastic, inelastic, or unit elastic.
Points P Q
A 60 3,000
B 70 2,800
C 80 2,600
D 90 2,400
E 100 2,200
F 110 2,000
G 120 1,800
H 130 1,600
Table 5.5
2.
From the data in Table 5.6 about supply of alarm clocks, calculate the price elasticity of supply from: point J to point K, point L to point M, and point N to point P. Classify the elasticity at each point as elastic, inelastic, or unit elastic.
Point Price Quantity Supplied
J \$8 50
K \$9 70
L \$10 80
M \$11 88
N \$12 95
P \$13 100
Table 5.6
3.
Why is the demand curve with constant unitary elasticity concave?
4.
Why is the supply curve with constant unitary elasticity a straight line?
5.
The federal government decides to require that automobile manufacturers install new anti-pollution equipment that costs \$2,000 per car. Under what conditions can carmakers pass almost all of this cost along to car buyers? Under what conditions can carmakers pass very little of this cost along to car buyers?
6.
Suppose you are in charge of sales at a pharmaceutical company, and your firm has a new drug that causes bald men to grow hair. Assume that the company wants to earn as much revenue as possible from this drug. If the elasticity of demand for your company’s product at the current price is 1.4, would you advise the company to raise the price, lower the price, or to keep the price the same? What if the elasticity were 0.6? What if it were 1? Explain your answer.
7.
What would the gasoline price elasticity of supply mean to UPS or FedEx?
8.
The average annual income rises from \$25,000 to \$38,000, and the quantity of bread consumed in a year by the average person falls from 30 loaves to 22 loaves. What is the income elasticity of bread consumption? Is bread a normal or an inferior good?
9.
Suppose the cross-price elasticity of apples with respect to the price of oranges is 0.4, and the price of oranges falls by 3%. What will happen to the demand for apples? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/05%3A_Elasticity/5.06%3A_Key_Terms.txt |
10.
What is the formula for calculating elasticity?
11.
What is the price elasticity of demand? Can you explain it in your own words?
12.
What is the price elasticity of supply? Can you explain it in your own words?
13.
Describe the general appearance of a demand or a supply curve with zero elasticity.
14.
Describe the general appearance of a demand or a supply curve with infinite elasticity.
15.
If demand is elastic, will shifts in supply have a larger effect on equilibrium quantity or on price?
16.
If demand is inelastic, will shifts in supply have a larger effect on equilibrium price or on quantity?
17.
If supply is elastic, will shifts in demand have a larger effect on equilibrium quantity or on price?
18.
If supply is inelastic, will shifts in demand have a larger effect on equilibrium price or on quantity?
19.
Would you usually expect elasticity of demand or supply to be higher in the short run or in the long run? Why?
20.
Under which circumstances does the tax burden fall entirely on consumers?
21.
What is the formula for the income elasticity of demand?
22.
What is the formula for the cross-price elasticity of demand?
23.
What is the formula for the wage elasticity of labor supply?
24.
What is the formula for elasticity of savings with respect to interest rates?
5.10: Critical Thinking Questions
25.
Transatlantic air travel in business class has an estimated elasticity of demand of 0.62, while transatlantic air travel in economy class has an estimated price elasticity of 0.12. Why do you think this is the case?
26.
What is the relationship between price elasticity and position on the demand curve? For example, as you move up the demand curve to higher prices and lower quantities, what happens to the measured elasticity? How would you explain that?
27.
Can you think of an industry (or product) with near infinite elasticity of supply in the short term? That is, what is an industry that could increase Qs almost without limit in response to an increase in the price?
28.
Would you expect supply to play a more significant role in determining the price of a basic necessity like food or a luxury like perfume? Explain. Hint: Think about how the price elasticity of demand will differ between necessities and luxuries.
29.
A city has built a bridge over a river and it decides to charge a toll to everyone who crosses. For one year, the city charges a variety of different tolls and records information on how many drivers cross the bridge. The city thus gathers information about elasticity of demand. If the city wishes to raise as much revenue as possible from the tolls, where will the city decide to charge a toll: in the inelastic portion of the demand curve, the elastic portion of the demand curve, or the unit elastic portion? Explain.
30.
In a market where the supply curve is perfectly inelastic, how does an excise tax affect the price paid by consumers and the quantity bought and sold?
31.
Economists define normal goods as having a positive income elasticity. We can divide normal goods into two types: Those whose income elasticity is less than one and those whose income elasticity is greater than one. Think about products that would fall into each category. Can you come up with a name for each category?
32.
Suppose you could buy shoes one at a time, rather than in pairs. What do you predict the cross-price elasticity for left shoes and right shoes would be?
5.11: Problems
33.
The equation for a demand curve is P = 48 – 3Q. What is the elasticity in moving from a quantity of 5 to a quantity of 6?
34.
The equation for a demand curve is P = 2/Q. What is the elasticity of demand as price falls from 5 to 4? What is the elasticity of demand as the price falls from 9 to 8? Would you expect these answers to be the same?
35.
The equation for a supply curve is 4P = Q. What is the elasticity of supply as price rises from 3 to 4? What is the elasticity of supply as the price rises from 7 to 8? Would you expect these answers to be the same?
36.
The equation for a supply curve is P = 3Q – 8. What is the elasticity in moving from a price of 4 to a price of 7?
37.
The supply of paintings by Leonardo Da Vinci, who painted the Mona Lisa and The Last Supper and died in 1519, is highly inelastic. Sketch a supply and demand diagram, paying attention to the appropriate elasticities, to illustrate that demand for these paintings will determine the price.
38.
Say that a certain stadium for professional football has 70,000 seats. What is the shape of the supply curve for tickets to football games at that stadium? Explain.
39.
When someone’s kidneys fail, the person needs to have medical treatment with a dialysis machine (unless or until they receive a kidney transplant) or they will die. Sketch a supply and demand diagram, paying attention to the appropriate elasticities, to illustrate that the supply of such dialysis machines will primarily determine the price.
40.
Assume that the supply of low-skilled workers is fairly elastic, but the employers’ demand for such workers is fairly inelastic. If the policy goal is to expand employment for low-skilled workers, is it better to focus on policy tools to shift the supply of unskilled labor or on tools to shift the demand for unskilled labor? What if the policy goal is to raise wages for this group? Explain your answers with supply and demand diagrams. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/05%3A_Elasticity/5.09%3A_Review_Questions.txt |
Figure 6.1 Investment Choices We generally view higher education as a good investment, if one can afford it, regardless of the state of the economy. (Credit: modification of “Commencement” by roanokecollege/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Consumption Choices
• How Changes in Income and Prices Affect Consumption Choices
• How Consumer Choices Might Not Always be Rational
Bring It Home
Making Choices
The 2008–2009 Great Recession touched families around the globe. In too many countries, workers found themselves out of a job. In developed countries, unemployment compensation provided a safety net, but families still saw a marked decrease in disposable income and had to make tough spending decisions. Of course, non-essential, discretionary spending was the first to go.
Even so, there was one particular category that saw a universal increase in spending world-wide during that time—an 18% uptick in the United States, specifically. You might guess that consumers began eating more meals at home, increasing grocery store spending; however, the Bureau of Labor Statistics’ Consumer Expenditure Survey, which tracks U.S. food spending over time, showed “real total food spending by U.S. households declined five percent between 2006 and 2009.” So, it was not groceries. What product would people around the world demand more of during tough economic times, and more importantly, why? (Find out at chapter’s end.)
That question leads us to this chapter’s topic—analyzing how consumers make choices and how changes affect those choices. For instance, do changes in prices matter more or less than changes in a consumer’s income? Can a small change in circumstances alter the consumers’ perception of a product or even of their own resources? While many choices may seem straightforward, there is often much more to consider.
Microeconomics seeks to understand the behavior of individual economic agents such as individuals and businesses. Economists believe that we can analyze individuals’ decisions, such as what goods and services to buy, as choices we make within certain budget constraints. Generally, consumers are trying to get the most for their limited budget. In economic terms they are trying to maximize total utility, or satisfaction, given their budget constraint.
Everyone has their own personal tastes and preferences. The French say: Chacun à son goût, or “Each to his own taste.” An old Latin saying states, De gustibus non est disputandum or “There’s no disputing about taste.” If people base their decisions on their own tastes and personal preferences, however, then how can economists hope to analyze the choices consumers make?
An economic explanation for why people make different choices begins with accepting the proverbial wisdom that tastes are a matter of personal preference. However, economists also believe that the choices people make are influenced by their incomes, by the prices of goods and services they consume, and by factors like where they live. This chapter introduces the economic theory of how consumers make choices about what goods and services to buy with their limited income.
The analysis in this chapter will build on the budget constraint that we introduced in the Choice in a World of Scarcity chapter. This chapter will also illustrate how economic theory provides a tool to systematically look at the full range of possible consumption choices to predict how consumption responds to changes in prices or incomes. After reading this chapter, consult the appendix Indifference Curves to learn more about representing utility and choice through indifference curves. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/06%3A_Consumer_Choices/6.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate total utility
• Propose decisions that maximize utility
• Explain marginal utility and the significance of diminishing marginal utility
Information on the consumption choices of Americans is available from the Consumer Expenditure Survey carried out by the U.S. Bureau of Labor Statistics. Table 6.1 shows spending patterns for the average U.S. household. The first row shows income and, after taxes and personal savings are subtracted, it shows that, in 2015, the average U.S. household spent \$48,109 on consumption. The table then breaks down consumption into various categories. The average U.S. household spent roughly one-third of its consumption on shelter and other housing expenses, another one-third on food and vehicle expenses, and the rest on a variety of items, as shown. These patterns will vary for specific households by differing levels of family income, by geography, and by preferences.
Average Household Income before Taxes \$62,481
Average Annual Expenditures \$48.109
Food at home \$3,264
Food away from home \$2,505
Housing \$16,557
Apparel and services \$1,700
Transportation \$7,677
Healthcare \$3,157
Entertainment \$2,504
Education \$1,074
Personal insurance and pensions \$5,357
All else: alcohol, tobacco, reading, personal care, cash contributions, miscellaneous \$3,356
Table 6.1 U.S. Consumption Choices in 2015 (Source: www.bls.gov/cex/csxann13.pdf)
Total Utility and Diminishing Marginal Utility
To understand how a household will make its choices, economists look at what consumers can afford, as shown in a budget constraint (or budget line), and the total utility or satisfaction derived from those choices. In a budget constraint line, the quantity of one good is on the horizontal axis and the quantity of the other good on the vertical axis. The budget constraint line shows the various combinations of two goods that are affordable given consumer income. Consider José's situation, shown in Figure 6.2. José likes to collect T-shirts and watch movies.
In Figure 6.2 we show the quantity of T-shirts on the horizontal axis while we show the quantity of movies on the vertical axis. If José had unlimited income or goods were free, then he could consume without limit. However, José, like all of us, faces a budget constraint. José has a total of \$56 to spend. The price of T-shirts is \$14 and the price of movies is \$7. Notice that the vertical intercept of the budget constraint line is at eight movies and zero T-shirts (\$56/\$7=8). The horizontal intercept of the budget constraint is four, where José spends of all of his money on T-shirts and no movies (\$56/14=4). The slope of the budget constraint line is rise/run or –8/4=–2. The specific choices along the budget constraint line show the combinations of affordable T-shirts and movies.
Figure 6.2 A Choice between Consumption Goods José has income of \$56. Movies cost \$7 and T-shirts cost \$14. The points on the budget constraint line show the combinations of affordable movies and T-shirts.
José wishes to choose the combination that will provide him with the greatest utility, which is the term economists use to describe a person’s level of satisfaction or happiness with their choices.
Let’s begin with an assumption, which we will discuss in more detail later, that José can measure his own utility with something called utils. (It is important to note that you cannot make comparisons between the utils of individuals. If one person gets 20 utils from a cup of coffee and another gets 10 utils, this does not mean than the first person gets more enjoyment from the coffee than the other or that they enjoy the coffee twice as much. The reason why is that utils are subjective to an individual. The way one person measures utils is not the same as the way someone else does.) Table 6.2 shows how José’s utility is connected with his T-shirt or movie consumption. The first column of the table shows the quantity of T-shirts consumed. The second column shows the total utility, or total amount of satisfaction, that José receives from consuming that number of T-shirts. The most common pattern of total utility, in this example, is that consuming additional goods leads to greater total utility, but at a decreasing rate. The third column shows marginal utility, which is the additional utility provided by one additional unit of consumption. This equation for marginal utility is:
$MU=change in total utilitychange in quantityMU=change in total utilitychange in quantity$
Notice that marginal utility diminishes as additional units are consumed, which means that each subsequent unit of a good consumed provides less additional utility. For example, the first T-shirt José picks is his favorite and it gives him an addition of 22 utils. The fourth T-shirt is just something to wear when all his other clothes are in the wash and yields only 18 additional utils. This is an example of the law of diminishing marginal utility, which holds that the additional utility decreases with each unit added. Diminishing marginal utility is another example of the more general law of diminishing returns we learned earlier in the chapter on Choice in a World of Scarcity.
The rest of Table 6.2 shows the quantity of movies that José attends, and his total and marginal utility from seeing each movie. Total utility follows the expected pattern: it increases as the number of movies that José watches rises. Marginal utility also follows the expected pattern: each additional movie brings a smaller gain in utility than the previous one. The first movie José attends is the one he wanted to see the most, and thus provides him with the highest level of utility or satisfaction. The fifth movie he attends is just to kill time. Notice that total utility is also the sum of the marginal utilities. Read the next Work It Out feature for instructions on how to calculate total utility.
T-Shirts (Quantity) Total Utility Marginal Utility Movies (Quantity) Total Utility Marginal Utility
1 22 22 1 16 16
2 43 21 2 31 15
3 63 20 3 45 14
4 81 18 4 58 13
5 97 16 5 70 12
6 111 14 6 81 11
7 123 12 7 91 10
8 133 10 8 100 9
Table 6.2 Total and Marginal Utility
Table 6.3 looks at each point on the budget constraint in Figure 6.2, and adds up José’s total utility for five possible combinations of T-shirts and movies.
Point T-Shirts Movies Total Utility
P 4 0 81 + 0 = 81
Q 3 2 63 + 31 = 94
R 2 4 43 + 58 = 101
S 1 6 22 + 81 = 103
T 0 8 0 + 100 = 100
Table 6.3 Finding the Choice with the Highest Utility
Work It Out
Calculating Total Utility
Let’s look at how José makes his decision in more detail.
Step 1. Observe that, at point Q (for example), José consumes three T-shirts and two movies.
Step 2. Look at Table 6.2. You can see from the fourth row/second column that three T-shirts are worth 63 utils. Similarly, the second row/fifth column shows that two movies are worth 31 utils.
Step 3. From this information, you can calculate that point Q has a total utility of 94 (63 + 31).
Step 4. You can repeat the same calculations for each point on Table 6.3, in which the total utility numbers are shown in the last column.
For José, the highest total utility for all possible combinations of goods occurs at point S, with a total utility of 103 from consuming one T-shirt and six movies.
Choosing with Marginal Utility
Most people approach their utility-maximizing combination of choices in a step-by-step way. This approach is based on looking at the tradeoffs, measured in terms of marginal utility, of consuming less of one good and more of another.
For example, say that José starts off thinking about spending all his money on T-shirts and choosing point P, which corresponds to four T-shirts and no movies, as Figure 6.2 illustrates. José chooses this starting point randomly as he has to start somewhere. Then he considers giving up the last T-shirt, the one that provides him the least marginal utility, and using the money he saves to buy two movies instead. Table 6.4 tracks the step-by-step series of decisions José needs to make (Key: T-shirts are \$14, movies are \$7, and income is \$56). The following Work It Out feature explains how marginal utility can affect decision making.
Try Which Has Total Utility Marginal Gain and Loss of Utility, Compared with Previous Choice Conclusion
Choice 1: P 4 T-shirts and 0 movies 81 from 4 T-shirts + 0 from 0 movies = 81
Choice 2: Q 3 T-shirts and 2 movies 63 from 3 T-shirts + 31 from 0 movies = 94 Loss of 18 from 1 less T-shirt, but gain of 31 from 2 more movies, for a net utility gain of 13 Q is preferred over P
Choice 3: R 2 T-shirts and 4 movies 43 from 2 T-shirts + 58 from 4 movies = 101 Loss of 20 from 1 less T-shirt, but gain of 27 from two more movies for a net utility gain of 7 R is preferred over Q
Choice 4: S 1 T-shirt and 6 movies 22 from 1 T-shirt + 81 from 6 movies = 103 Loss of 21 from 1 less T-shirt, but gain of 23 from two more movies, for a net utility gain of 2 S is preferred over R
Choice 5: T 0 T-shirts and 8 movies 0 from 0 T-shirts + 100 from 8 movies = 100 Loss of 22 from 1 less T-shirt, but gain of 19 from two more movies, for a net utility loss of 3 S is preferred over T
Table 6.4 A Step-by-Step Approach to Maximizing Utility
Work It Out
Decision Making by Comparing Marginal Utility
José could use the following thought process (if he thought in utils) to make his decision regarding how many T-shirts and movies to purchase:
Step 1. From Table 6.2, José can see that the marginal utility of the fourth T-shirt is 18. If José gives up the fourth T-shirt, then he loses 18 utils.
Step 2. Giving up the fourth T-shirt, however, frees up \$14 (the price of a T-shirt), allowing José to buy the first two movies (at \$7 each).
Step 3. José knows that the marginal utility of the first movie is 16 and the marginal utility of the second movie is 15. Thus, if José moves from point P to point Q, he gives up 18 utils (from the T-shirt), but gains 31 utils (from the movies).
Step 4. Gaining 31 utils and losing 18 utils is a net gain of 13. This is just another way of saying that the total utility at Q (94 according to the last column in Table 6.3) is 13 more than the total utility at P (81).
Step 5. Thus, for José, it makes sense to give up the fourth T-shirt in order to buy two movies.
José clearly prefers point Q to point P. Now repeat this step-by-step process of decision making with marginal utilities. José thinks about giving up the third T-shirt and surrendering a marginal utility of 20, in exchange for purchasing two more movies that promise a combined marginal utility of 27. José prefers point R to point Q. What if José thinks about going beyond R to point S? Giving up the second T-shirt means a marginal utility loss of 21, and the marginal utility gain from the fifth and sixth movies would combine to make a marginal utility gain of 23, so José prefers point S to R.
However, if José seeks to go beyond point S to point T, he finds that the loss of marginal utility from giving up the first T-shirt is 22, while the marginal utility gain from the last two movies is only a total of 19. If José were to choose point T, his utility would fall to 100. Through these stages of thinking about marginal tradeoffs, José again concludes that S, with one T-shirt and six movies, is the choice that will provide him with the highest level of total utility. This step-by-step approach will reach the same conclusion regardless of José’s starting point.
We can develop a more systematic way of using this approach by focusing on satisfaction per dollar. If an item costing \$5 yields 10 utils, then it’s worth 2 utils per dollar spent. Marginal utility per dollar is the amount of additional utility José receives divided by the product's price. Table 6.5 shows the marginal utility per dollar for José's T shirts and movies.
$marginal utility per dollar=marginal utilitypricemarginal utility per dollar=marginal utilityprice$
If José wants to maximize the utility he gets from his limited budget, he will always purchase the item with the greatest marginal utility per dollar of expenditure (assuming he can afford it with his remaining budget). José starts with no purchases. If he purchases a T-shirt, the marginal utility per dollar spent will be 1.6. If he purchases a movie, the marginal utility per dollar spent will be 2.3. Therefore, José’s first purchase will be the movie. Why? Because it gives him the highest marginal utility per dollar and is affordable. Next, José will purchase another movie. Why? Because the marginal utility of the next movie (2.14) is greater than the marginal utility of the next T-shirt (1.6). Note that when José has no T- shirts, the next one is the first one. José will continue to purchase the next good with the highest marginal utility per dollar until he exhausts his budget. He will continue purchasing movies because they give him a greater "bang for the buck" until the sixth movie which gives the same marginal utility per dollar as the first T-shirt purchase. José has just enough budget to purchase both. So in total, José will purchase six movies and one T-shirt.
Quantity of T-Shirts Total Utility Marginal Utility Marginal Utility per Dollar Quantity of Movies Total Utility Marginal Utility Marginal Utility per Dollar
1 22 22 22/\$14=1.6 1 16 16 16/\$7=2.3
2 43 21 21/\$14=1.5 2 31 15 15/\$7=2.14
3 63 20 20/\$14=1.4 3 45 14 14/\$7=2
4 81 18 18/\$14=1.3 4 58 13 13/\$7=1.9
5 97 16 16/\$14=1.1 5 70 12 12/\$7=1.7
6 111 14 14/\$14=1 6 81 11 11/\$7=1.6
7 123 12 12/\$14=1.2 7 91 10 10/\$7=1.4
Table 6.5 Marginal Utility per Dollar
A Rule for Maximizing Utility
This process of decision making suggests a rule to follow when maximizing utility. Since the price of T-shirts is twice as high as the price of movies, to maximize utility the last T-shirt that José chose needs to provide exactly twice the marginal utility (MU) of the last movie. If the last T-shirt provides less than twice the marginal utility of the last movie, then the T-shirt is providing less “bang for the buck” (i.e., marginal utility per dollar spent) than José would receive from spending the same money on movies. If this is so, José should trade the T-shirt for more movies to increase his total utility.
If the last T-shirt provides more than twice the marginal utility of the last movie, then the T-shirt is providing more “bang for the buck” or marginal utility per dollar, than if the money were spent on movies. As a result, José should buy more T-shirts. Notice that at José’s optimal choice of point S, the marginal utility from the first T-shirt, of 22 is exactly twice the marginal utility of the sixth movie, which is 11. At this choice, the marginal utility per dollar is the same for both goods. This is a tell-tale signal that José has found the point with highest total utility.
We can write this argument as a general rule: If you always choose the item with the greatest marginal utility per dollar spent, when your budget is exhausted, the utility maximizing choice should occur where the marginal utility per dollar spent is the same for both goods.
$MU1P1=MU2P2MU1P1=MU2P2$
A sensible economizer will pay twice as much for something only if, in the marginal comparison, the item confers twice as much utility. Notice that the formula for the table above is:
$2214=1171.6=1.62214=1171.6=1.6$
The following Work It Out feature provides step by step guidance for this concept of utility-maximizing choices.
Work It Out
Maximizing Utility
The general rule, $MU1P1=MU2P2MU1P1=MU2P2$, means that the last dollar spent on each good provides exactly the same marginal utility. This is the case at point S. So:
Step 1. If we traded a dollar more of movies for a dollar more of T-shirts, the marginal utility gained from T-shirts would exactly offset the marginal utility lost from fewer movies. In other words, the net gain would be zero.
Step 2. Products, however, usually cost more than a dollar, so we cannot trade a dollar’s worth of movies. The best we can do is trade two movies for another T-shirt, since in this example T-shirts cost twice what a movie does.
Step 3. If we trade two movies for one T-shirt, we would end up at point R (two T-shirts and four movies).
Step 4. Choice 4 in Table 6.4 shows that if we move to point R, we would gain 21 utils from one more T-shirt, but lose 23 utils from two fewer movies, so we would end up with less total utility at point R.
In short, the general rule shows us the utility-maximizing choice, which is called the consumer equilibrium.
There is another equivalent way to think about this. We can also express the general rule as the ratio of the prices of the two goods should be equal to the ratio of the marginal utilities. When we divide the price of good 1 by the price of good 2, at the utility-maximizing point this will equal the marginal utility of good 1 divided by the marginal utility of good 2.
$P1P2=MU1MU2P1P2=MU1MU2$
Along the budget constraint, the total price of the two goods remains the same, so the ratio of the prices does not change. However, the marginal utility of the two goods changes with the quantities consumed. At the optimal choice of one T-shirt and six movies, point S, the ratio of marginal utility to price for T-shirts (22:14) matches the ratio of marginal utility to price for movies (of 11:7).
Measuring Utility with Numbers
This discussion of utility began with an assumption that it is possible to place numerical values on utility, an assumption that may seem questionable. You can buy a thermometer for measuring temperature at the hardware store, but what store sells a “utilimometer” for measuring utility? While measuring utility with numbers is a convenient assumption to clarify the explanation, the key assumption is not that an outside party can measure utility but only that individuals can decide which of two alternatives they prefer.
To understand this point, think back to the step-by-step process of finding the choice with highest total utility by comparing the marginal utility you gain and lose from different choices along the budget constraint. As José compares each choice along his budget constraint to the previous choice, what matters is not the specific numbers that he places on his utility—or whether he uses any numbers at all—but only that he personally can identify which choices he prefers.
In this way, the step-by-step process of choosing the highest level of utility resembles rather closely how many people make consumption decisions. We think about what will make us the happiest. We think about what things cost. We think about buying a little more of one item and giving up a little of something else. We choose what provides us with the greatest level of satisfaction. The vocabulary of comparing the points along a budget constraint and total and marginal utility is just a set of tools for discussing this everyday process in a clear and specific manner. It is welcome news that specific utility numbers are not central to the argument, since a good utilimometer is hard to find. Do not worry—while we cannot measure utils, by the end of the next module, we will have transformed our analysis into something we can measure—demand. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/06%3A_Consumer_Choices/6.02%3A_Consumption_Choices.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how income, prices, and preferences affect consumer choices
• Contrast the substitution effect and the income effect
• Utilize concepts of demand to analyze consumer choices
• Apply utility-maximizing choices to governments and businesses
Just as we can use utility and marginal utility to discuss making consumer choices along a budget constraint, we can also use these ideas to think about how consumer choices change when the budget constraint shifts in response to changes in income or price. Because we can use the budget constraint framework to analyze how quantities demanded change because of price movements, the budget constraint model can illustrate the underlying logic behind demand curves.
How Changes in Income Affect Consumer Choices
Let’s begin with a concrete example illustrating how changes in income level affect consumer choices. Figure 6.3 shows a budget constraint that represents Kimberly’s choice between concert tickets at \$50 each and getting away overnight to a bed-and-breakfast for \$200 per night. Kimberly has \$1,000 per year to spend between these two choices. After thinking about her total utility and marginal utility and applying the decision rule that the ratio of the marginal utilities to the prices should be equal between the two products, Kimberly chooses point M, with eight concerts and three overnight getaways as her utility-maximizing choice.
Figure 6.3 How a Change in Income Affects Consumption Choices The utility-maximizing choice on the original budget constraint is M. The dashed horizontal and vertical lines extending through point M allow you to see at a glance whether the quantity consumed of goods on the new budget constraint is higher or lower than on the original budget constraint. On the new budget constraint, Kimberly will make a choice like N if both goods are normal goods. If overnight stays is an inferior good, Kimberly will make a choice like P. If concert tickets are an inferior good, Kimberly will make a choice like Q.
Now, assume that the income Kimberly has to spend on these two items rises to \$2,000 per year, causing her budget constraint to shift out to the right. How does this rise in income alter her utility-maximizing choice? Kimberly will again consider the utility and marginal utility that she receives from concert tickets and overnight getaways and seek her utility-maximizing choice on the new budget line, but how will her new choice relate to her original choice?
We can replace the possible choices along the new budget constraint into three groups, which the dashed horizontal and vertical lines that pass through the original choice M in the figure divide. All choices on the upper left of the new budget constraint that are to the left of the vertical dashed line, like choice P with two overnight stays and 32 concert tickets, involve less of the good on the horizontal axis but much more of the good on the vertical axis. All choices to the right of the vertical dashed line and above the horizontal dashed line—like choice N with five overnight getaways and 20 concert tickets—have more consumption of both goods. Finally, all choices that are to the right of the vertical dashed line but below the horizontal dashed line, like choice Q with four concerts and nine overnight getaways, involve less of the good on the vertical axis but much more of the good on the horizontal axis.
All of these choices are theoretically possible, depending on Kimberly’s personal preferences as expressed through the total and marginal utility she would receive from consuming these two goods. When income rises, the most common reaction is to purchase more of both goods, like choice N, which is to the upper right relative to Kimberly’s original choice M, although exactly how much more of each good will vary according to personal taste. Conversely, when income falls, the most typical reaction is to purchase less of both goods. As we defined in the chapter on Demand and Supply and again in the chapter on Elasticity, we call goods and services normal goods when a rise in income leads to a rise in the quantity consumed of that good and a fall in income leads to a fall in quantity consumed.
However, depending on Kimberly’s preferences, a rise in income could cause consumption of one good to increase while consumption of the other good declines. A choice like P means that a rise in income caused her quantity consumed of overnight stays to decline, while a choice like Q would mean that a rise in income caused her quantity of concerts to decline. Goods where demand declines as income rises (or conversely, where the demand rises as income falls) are called “inferior goods.” An inferior good occurs when people trim back on a good as income rises, because they can now afford the more expensive choices that they prefer. For example, a higher-income household might eat fewer hamburgers or be less likely to buy a used car, and instead eat more steak and buy a new car.
How Price Changes Affect Consumer Choices
For analyzing the possible effect of a change in price on consumption, let’s again use a concrete example. Figure 6.4 represents Sergei's consumer choice, who chooses between purchasing baseball bats and cameras. A price increase for baseball bats would have no effect on the ability to purchase cameras, but it would reduce the number of bats Sergei could afford to buy. Thus a price increase for baseball bats, the good on the horizontal axis, causes the budget constraint to rotate inward, as if on a hinge, from the vertical axis. As in the previous section, the point labeled M represents the originally preferred point on the original budget constraint, which Sergei has chosen after contemplating his total utility and marginal utility and the tradeoffs involved along the budget constraint. In this example, the units along the horizontal and vertical axes are not numbered, so the discussion must focus on whether Sergei will consume more or less of certain goods, not on numerical amounts.
Figure 6.4 How a Change in Price Affects Consumption Choices The original utility-maximizing choice is M. When the price rises, the budget constraint rotates clockwise. The dashed lines make it possible to see at a glance whether the new consumption choice involves less of both goods, or less of one good and more of the other. The new possible choices would be fewer baseball bats and more cameras, like point H, or less of both goods, as at point J. Choice K would mean that the higher price of bats led to exactly the same quantity of bat consumption, but fewer cameras. Theoretically possible, but unlikely in the real world, we rule out choices like L because they would mean that a higher price for baseball bats means a greater consumption of baseball bats.
After the price increase, Sergei will make a choice along the new budget constraint. Again, we can divide his choices into three segments by the dashed vertical and horizontal lines. In the upper left portion of the new budget constraint, at a choice like H, Sergei consumes more cameras and fewer bats. In the central portion of the new budget constraint, at a choice like J, he consumes less of both goods. At the right-hand end, at a choice like L, he consumes more bats but fewer cameras.
The typical response to higher prices is that a person chooses to consume less of the product with the higher price. This occurs for two reasons, and both effects can occur simultaneously. The substitution effect occurs when a price changes and consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price. The income effect is that a higher price means, in effect, the buying power of income has been reduced (even though actual income has not changed), which leads to buying less of the good (when the good is normal). In this example, the higher price for baseball bats would cause Sergei to buy fewer bats for both reasons. Exactly how much will a higher price for bats cause Sergei's bat consumption to fall? Figure 6.4 suggests a range of possibilities. Sergei might react to a higher price for baseball bats by purchasing the same quantity of bats, but cutting his camera consumption. This choice is the point K on the new budget constraint, straight below the original choice M. Alternatively, Sergei might react by dramatically reducing his bat purchases and instead buy more cameras.
The key is that it would be imprudent to assume that a change in the price of one good will only affect consumption of that good. In our example, since Sergei purchases all his products out of the same budget, a change in the price of baseball bats can also have a range of effects, either positive or negative, on his purchases of cameras. Since Sergei purchases all his products out of the same budget, a change in the price of one good can also have a range of effects, either positive or negative, on the quantity consumed of other goods.
In short, a higher price typically causes reduced consumption of the good in question, but it can affect the consumption of other goods as well.
Link It Up
Read this article about the potential of variable prices in vending machines.
The Foundations of Demand Curves
Changes in the price of a good lead the budget constraint to rotate. A rotation in the budget constraint means that when individuals are seeking their highest utility, the quantity that is demanded of that good will change. In this way, the logical foundations of demand curves—which show a connection between prices and quantity demanded—are based on the underlying idea of individuals seeking utility. Figure 6.5 (a) shows a budget constraint with a choice between housing and “everything else.” (Putting “everything else” on the vertical axis can be a useful approach in some cases, especially when the focus of the analysis is on one particular good.) We label the preferred choice on the original budget constraint that provides the highest possible utility M0. The other three budget constraints represent successively higher prices for housing of P1, P2, and P3. As the budget constraint rotates in, and in, and in again, we label the utility-maximizing choices M1, M2, and M3, and the quantity demanded of housing falls from Q0 to Q1 to Q2 to Q3.
Figure 6.5 The Foundations of a Demand Curve: An Example of Housing (a) As the price increases from P0 to P1 to P2 to P3, the budget constraint on the upper part of the diagram rotates clockwise. The utility-maximizing choice changes from M0 to M1 to M2 to M3. As a result, the quantity demanded of housing shifts from Q0 to Q1 to Q2 to Q3, ceteris paribus. (b) The demand curve graphs each combination of the price of housing and the quantity of housing demanded, ceteris paribus. The quantities of housing are the same at the points on both (a) and (b). Thus, the original price of housing (P0) and the original quantity of housing (Q0) appear on the demand curve as point E0. The higher price of housing (P1) and the corresponding lower quantity demanded of housing (Q1) appear on the demand curve as point E1.
Thus, as the price of housing rises, the budget constraint rotates clockwise and the quantity consumed of housing falls, ceteris paribus (meaning, with all other things being the same). We graph this relationship—the price of housing rising from P0 to P1 to P2 to P3, while the quantity of housing demanded falls from Q0 to Q1 to Q2 to Q3—on the demand curve in Figure 6.5 (b). The vertical dashed lines stretching between the top and bottom of Figure 6.5 show that the quantity of housing demanded at each point is the same in both (a) and (b). We ultimately determine the shape of a demand curve by the underlying choices about maximizing utility subject to a budget constraint. While economists may not be able to measure “utils,” they can certainly measure price and quantity demanded.
Applications in Government and Business
The budget constraint framework for making utility-maximizing choices offers a reminder that people can react to a change in price or income in a range of different ways. For example, in the winter months of 2005, costs for heating homes increased significantly in many parts of the country as prices for natural gas and electricity soared, due in large part to the disruption caused by Hurricanes Katrina and Rita. Some people reacted by reducing the quantity demanded of energy; for example, by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside. Even so, many home heating bills rose, so people adjusted their consumption in other ways, too. As you learned in the chapter on Elasticity, the short run demand for home heating is generally inelastic. Each household cut back on what it valued least on the margin. For some it might have been some dinners out, or a vacation, or postponing buying a new refrigerator or a new car. Sharply higher energy prices can have effects beyond the energy market, leading to a widespread reduction in purchasing throughout the rest of the economy.
A similar issue arises when the government imposes taxes on certain products, such as on gasoline, cigarettes, and alcohol. Say that a tax on alcohol leads to a higher price at the liquor store. The higher price of alcohol causes the budget constraint to pivot left, and alcoholic beverage consumption is likely to decrease. However, people may also react to the higher price of alcoholic beverages by cutting back on other purchases. For example, they might cut back on snacks at restaurants like chicken wings and nachos. It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages. Read the next Clear It Up to learn about how who controls the household income influences buying decisions.
The Unifying Power of the Utility-Maximizing Budget Set Framework
An interaction between prices, budget constraints, and personal preferences determine household choices. The flexible and powerful terminology of utility-maximizing gives economists a vocabulary for bringing these elements together.
Not even economists believe that people walk around mumbling about their marginal utilities before they walk into a shopping mall, accept a job, or make a deposit in a savings account. However, economists do believe that individuals seek their own satisfaction or utility and that people often decide to try a little less of one thing and a little more of another. If we accept these assumptions, then the idea of utility-maximizing households facing budget constraints becomes highly plausible.
Clear It Up
Does who controls household income make a difference?
In the mid-1970s, the United Kingdom made an interesting policy change in its “child allowance” policy. This program provides a fixed amount of money per child to every family, regardless of family income. Traditionally, the child allowance had been distributed to families by withholding less in taxes from the paycheck of the family wage earner—typically the father in this time period. The new policy instead provided the child allowance as a cash payment to the mother. As a result of this change, households have the same level of income and face the same prices in the market, but the money is more likely to be in the mother's purse than in the father's wallet.
Should this change in policy alter household consumption patterns? Basic models of consumption decisions, of the sort that we examined in this chapter, assume that it does not matter which parent or guardian receives the money, because both seek to maximize the family's utility as a whole. In effect, this model assumes that everyone in the family has the same makeup or has the same preferences.
There has not been extensive research on diverse family structures and guardian/parent sex and gender related to spending. However, the older research on families with one man and one woman parent indicates that gender does affect spending decisions. When the mother controls a larger share of family income a number of studies, in the United Kingdom and in a wide variety of other countries, have found that the family tends to spend more on restaurant meals, child care, and women’s clothing, and less on alcohol and tobacco. As the mother controls a larger share of household resources, children’s health improves, too. These findings suggest that when providing assistance to families, in high-income countries and low-income countries alike, the monetary amount of assistance is not all that matters: it also matters which family member actually receives the money.
The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price, not just effects on the one product that might seem most immediately affected. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/06%3A_Consumer_Choices/6.03%3A_How_Changes_in_Income_and_Prices_Affect_Consumption_Choices.txt |
Learning Objectives
By the end of this section, you will be able to:
• Evaluate the reasons for making intertemporal choices
• Interpret an intertemporal budget constraint
• Analyze why people in America tend to save such a small percentage of their income
As we know, people sometimes make decisions that seem “irrational” and not in their own best interest. People’s decisions can seem inconsistent from one day to the next and they even deliberately ignore ways to save money or time. The traditional economic models assume rationality, which means that people take all available information and make consistent and informed decisions that are in their best interest. (In fact, economics professors often delight in pointing out so-called “irrational behavior” each semester to their new students, and present economics as a way to become more rational.)
However, a new group of economists, known as behavioral economists, argue that the traditional method omits something important: people’s state of mind. For example, one can think differently about money if one is feeling revenge, optimism, or loss. These are not necessarily irrational states of mind, but part of a range of emotions that can affect anyone on a given day. In addition, actions under these conditions are predictable, if one better understands the underlying environment. Behavioral economics seeks to enrich our understanding of decision-making by integrating the insights of psychology into economics. It does this by investigating how given dollar amounts can mean different things to individuals depending on the situation. This can lead to decisions that appear outwardly inconsistent, or irrational, to the outside observer.
The way the mind works, according to this view, may seem inconsistent to traditional economists but is actually far more complex than an unemotional cost-benefit adding machine. For example, a traditional economist would say that if you lost a \$10 bill today, and also received an extra \$10 in your paycheck, you should feel perfectly neutral. After all, –\$10 + \$10 = \$0. You are the same financially as you were before. However, behavioral economists have conducted research that shows many people will feel some negative emotion, such as anger or frustration, after those two things happen. We tend to focus more on the loss than the gain. We call this loss aversion, where a \$1 loss pains us 2.25 times more than a \$1 gain helps us, according to the economists Daniel Kahneman and Amos Tversky in a famous 1979 article in the journal Econometrica. This insight has implications for investing, as people tend to “overplay” the stock market by reacting more to losses than to gains. This behavior looks irrational to traditional economists, but is consistent once we understand better how the mind works, these economists argue.
Traditional economists also assume human beings have complete self control, but, for instance, people will buy cigarettes by the pack instead of the carton even though the carton saves them money, to keep usage down. They purchase locks for their refrigerators and overpay on taxes to force themselves to save. In other words, we protect ourselves from our worst temptations but pay a price to do so. One way behavioral economists are responding to this is by establishing ways for people to keep themselves free of these temptations. This includes what we call “nudges” toward more rational behavior rather than mandatory regulations from government. For example, up to 20 percent of new employees do not enroll in retirement savings plans immediately, because of procrastination or feeling overwhelmed by the different choices. Some companies are now moving to a new system, where employees are automatically enrolled unless they “opt out.” Almost no-one opts out in this program and employees begin saving at the early years, which are most critical for retirement.
Another area that seems illogical is the idea of mental accounting, or putting dollars in different mental categories where they take different values. Economists typically consider dollars to be fungible, or having equal value to the individual, regardless of the situation.
You might, for instance, think of the \$25 you found in the street differently from the \$25 you earned from three hours working in a fast food restaurant. You might treat the street money as “mad money” with little rational regard to getting the best value. This is in one sense strange, since it is still equivalent to three hours of hard work in the restaurant. Yet the “easy come-easy go” mentality replaces the rational economizer because of the situation, or context, in which you attained the money.
In another example of mental accounting that seems inconsistent to a traditional economist, a person could carry a credit card debt of \$1,000 that has a 15% yearly interest cost, and simultaneously have a \$2,000 savings account that pays only 2% per year. That means she pays \$150 a year to the credit card company, while collecting only \$40 annually in bank interest, so she loses \$110 a year. That doesn’t seem wise.
The “rational” decision would be to pay off the debt, since a \$1,000 savings account with \$0 in debt is the equivalent net worth, and she would now net \$20 per year. Curiously, it is not uncommon for people to ignore this advice, since they will treat a loss to their savings account as higher than the benefit of paying off their credit card. They do not treat the dollars as fungible so it looks irrational to traditional economists.
Which view is right, the behavioral economists’ or the traditional view? Both have their advantages, but behavioral economists have at least identified trying to describe and explain behavior that economists have historically dismissed as irrational. If most of us are engaged in some “irrational behavior,” perhaps there are deeper underlying reasons for this behavior in the first place.
Bring It Home
Making Choices
In what category did consumers worldwide increase their spending during the Great Recession? Higher education. According to the United Nations Educational, Scientific, and Cultural Organization (UNESCO), enrollment in colleges and universities rose one-third in China and almost two-thirds in Saudi Arabia, nearly doubled in Pakistan, tripled in Uganda, and surged by three million—18 percent—in the United States. Why were consumers willing to spend on education during lean times? Both individuals and countries view higher education as the way to prosperity. Many feel that increased earnings are a significant benefit of attending college.
U.S. Bureau of Labor Statistics data from May 2012 supports this view, as Figure 6.6 shows. They show a positive correlation between earnings and education. The data also indicate that unemployment rates fall with higher levels of education and training.
Why spend the money to go to college during recession? Because if you are unemployed (or underemployed, working fewer hours than you would like), the opportunity cost of your time is low. If you’re unemployed, you don’t have to give up work hours and income by going to college.
Figure 6.6 The Impact of Education on Earnings and Unemployment Rates, 2012 Those with the highest degrees in 2012 had substantially lower unemployment rates; whereas, those with the least formal education suffered from the highest unemployment rates. The national median average weekly income was \$815, and the nation unemployment average in 2012 was 6.8%. (Source: U.S. Bureau of Labor Statistics, May 22, 2013) | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/06%3A_Consumer_Choices/6.04%3A_Behavioral_Economics-_An_Alternative_Framework_for_Consumer_Choice.txt |
behavioral economics
a branch of economics that seeks to enrich the understanding of decision-making by integrating the insights of psychology and by investigating how given dollar amounts can mean different things to individuals depending on the situation
budget constraint (or budget line)
shows the possible combinations of two goods that are affordable given a consumer’s limited income
consumer equilibrium
point on the budget line where the consumer gets the most satisfaction; this occurs when the ratio of the prices of goods is equal to the ratio of the marginal utilities.
diminishing marginal utility
the common pattern that each marginal unit of a good consumed provides less of an addition to utility than the previous unit
fungible
the idea that units of a good, such as dollars, ounces of gold, or barrels of oil are capable of mutual substitution with each other and carry equal value to the individual
income effect
a higher price means that, in effect, the buying power of income has been reduced, even though actual income has not changed; always happens simultaneously with a substitution effect
marginal utility
the additional utility provided by one additional unit of consumption
marginal utility per dollar
the additional satisfaction gained from purchasing a good given the price of the product; MU/Price
substitution effect
when a price changes, consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price; always happens simultaneously with an income effect
total utility
satisfaction derived from consumer choices
6.06: Key Concepts and Summary
6.1 Consumption Choices
Economic analysis of household behavior is based on the assumption that people seek the highest level of utility or satisfaction. Individuals are the only judge of their own utility. In general, greater consumption of a good brings higher total utility. However, the additional utility people receive from each unit of greater consumption tends to decline in a pattern of diminishing marginal utility.
We can find the utility-maximizing choice on a consumption budget constraint in several ways. You can add up total utility of each choice on the budget line and choose the highest total. You can select a starting point at random and compare the marginal utility gains and losses of moving to neighboring points—and thus eventually seek out the preferred choice. Alternatively, you can compare the ratio of the marginal utility to price of good 1 with the marginal utility to price of good 2 and apply the rule that at the optimal choice, the two ratios should be equal:
$MU1P1=MU2P2MU1P1=MU2P2$
6.2 How Changes in Income and Prices Affect Consumption Choices
The budget constraint framework suggest that when income or price changes, a range of responses are possible. When income rises, households will demand a higher quantity of normal goods, but a lower quantity of inferior goods. When the price of a good rises, households will typically demand less of that good—but whether they will demand a much lower quantity or only a slightly lower quantity will depend on personal preferences. Also, a higher price for one good can lead to more or less demand of the other good.
6.3 Behavioral Economics: An Alternative Framework for Consumer Choice
People regularly make decisions that seem less than rational, decisions that contradict traditional consumer theory. This is because traditional theory ignores people’s state of mind or feelings, which can influence behavior. For example, people tend to value a dollar lost more than a dollar gained, even though the amounts are the same. Similarly, many people over withhold on their taxes, essentially giving the government a free loan until they file their tax returns, so that they are more likely to get money back than have to pay money on their taxes.
6.07: Self-Check Questions
1.
Jeremy is deeply in love with Jasmine. Jasmine lives where cell phone coverage is poor, so he can either call her on the land-line phone for five cents per minute or he can drive to see her, at a round-trip cost of \$2 in gasoline money. He has a total of \$10 per week to spend on staying in touch. To make his preferred choice, Jeremy uses a handy utilimometer that measures his total utility from personal visits and from phone minutes. Using the values in Table 6.6, figure out the points on Jeremy’s consumption choice budget constraint (it may be helpful to do a sketch) and identify his utility-maximizing point.
Round Trips Total Utility Phone Minutes Total Utility
0 0 0 0
1 80 20 200
2 150 40 380
3 210 60 540
4 260 80 680
5 300 100 800
6 330 120 900
7 200 140 980
8 180 160 1040
9 160 180 1080
10 140 200 1100
Table 6.6
2.
Take Jeremy’s total utility information in Exercise 6.1, and use the marginal utility approach to confirm the choice of phone minutes and round trips that maximize Jeremy’s utility.
3.
Explain all the reasons why a decrease in a product's price would lead to an increase in purchases.
4.
As a college student you work at a part-time job, but your parents also send you a monthly “allowance.” Suppose one month your parents forgot to send the check. Show graphically how your budget constraint is affected. Assuming you only buy normal goods, what would happen to your purchases of goods? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/06%3A_Consumer_Choices/6.05%3A_Key_Terms.txt |
5.
Who determines how much utility an individual will receive from consuming a good?
6.
Would you expect total utility to rise or fall with additional consumption of a good? Why?
7.
Would you expect marginal utility to rise or fall with additional consumption of a good? Why?
8.
Is it possible for total utility to increase while marginal utility diminishes? Explain.
9.
If people do not have a complete mental picture of total utility for every level of consumption, how can they find their utility-maximizing consumption choice?
10.
What is the rule relating the ratio of marginal utility to prices of two goods at the optimal choice? Explain why, if this rule does not hold, the choice cannot be utility-maximizing.
11.
As a general rule, is it safe to assume that a change in the price of a good will always have its most significant impact on the quantity demanded of that good, rather than on the quantity demanded of other goods? Explain.
12.
Why does a change in income cause a parallel shift in the budget constraint?
6.09: Critical Thinking Questions
13.
Think back to a purchase that you made recently. How would you describe your thinking before you made that purchase?
14.
The rules of politics are not always the same as the rules of economics. In discussions of setting budgets for government agencies, there is a strategy called “closing the Washington Monument.” When an agency faces the unwelcome prospect of a budget cut, it may decide to close a high-visibility attraction enjoyed by many people (like the Washington Monument). Explain in terms of diminishing marginal utility why the Washington Monument strategy is so misleading. Hint: If you are really trying to make the best of a budget cut, should you cut the items in your budget with the highest marginal utility or the lowest marginal utility? Does the Washington Monument strategy cut the items with the highest marginal utility or the lowest marginal utility?
15.
Income effects depend on the income elasticity of demand for each good that you buy. If one of the goods you buy has a negative income elasticity, that is, it is an inferior good, what must be true of the income elasticity of the other good you buy?
6.10: Problems
16.
Praxilla, who lived in ancient Greece, derives utility from reading poems and from eating cucumbers. Praxilla gets 30 units of marginal utility from her first poem, 27 units of marginal utility from her second poem, 24 units of marginal utility from her third poem, and so on, with marginal utility declining by three units for each additional poem. Praxilla gets six units of marginal utility for each of her first three cucumbers consumed, five units of marginal utility for each of her next three cucumbers consumed, four units of marginal utility for each of the following three cucumbers consumed, and so on, with marginal utility declining by one for every three cucumbers consumed. A poem costs three bronze coins but a cucumber costs only one bronze coin. Praxilla has 18 bronze coins. Sketch Praxilla’s budget set between poems and cucumbers, placing poems on the vertical axis and cucumbers on the horizontal axis. Start off with the choice of zero poems and 18 cucumbers, and calculate the changes in marginal utility of moving along the budget line to the next choice of one poem and 15 cucumbers. Using this step-by-step process based on marginal utility, create a table and identify Praxilla’s utility-maximizing choice. Compare the marginal utility of the two goods and the relative prices at the optimal choice to see if the expected relationship holds. Hint: Label the table columns: 1) Choice, 2) Marginal Gain from More Poems, 3) Marginal Loss from Fewer Cucumbers, 4) Overall Gain or Loss, 5) Is the previous choice optimal? Label the table rows: 1) 0 Poems and 18 Cucumbers, 2) 1 Poem and 15 Cucumbers, 3) 2 Poems and 12 Cucumbers, 4) 3 Poems and 9 Cucumbers, 5) 4 Poems and 6 Cucumbers, 6) 5 Poems and 3 Cucumbers, 7) 6 Poems and 0 Cucumbers.
17.
If a 10% decrease in the price of one product that you buy causes an 8% increase in quantity demanded of that product, will another 10% decrease in the price cause another 8% increase (no more and no less) in quantity demanded? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/06%3A_Consumer_Choices/6.08%3A_Review_Questions.txt |
Figure 7.1 Amazon is an American international electronic commerce company that sells books, among many other things, shipping them directly to the consumer. Until recently there were no brick and mortar Amazon stores. (Credit: modification of “Amazon Prime Delivery Van (50072389511)” by Tony Webster/Wikimedia Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Explicit and Implicit Costs, and Accounting and Economic Profit
• Production in the Short Run
• Costs in the Short Run
• Production in the Long Run
• Costs in the Long Run
Bring It Home
Amazon
In less than two decades, Amazon.com has transformed the way consumers sell, buy, and even read. Prior to Amazon, independent bookstores with limited inventories in small retail locations primarily sold books. There were exceptions, of course. Borders and Barnes & Noble offered larger stores in urban areas. In the last decade, however, independent bookstores have mostly disappeared, Borders has gone out of business, and Barnes & Noble is struggling. Online delivery and purchase of books has overtaken the more traditional business models. How has Amazon changed the book selling industry? How has it managed to crush its competition?
A major reason for the giant retailer’s success is its production model and cost structure, which has enabled Amazon to undercut the competitors' prices even when factoring in the cost of shipping. Read on to see how firms great (like Amazon) and small (like your corner deli) determine what to sell, at what output, and price.
This chapter is the first of four chapters that explores the theory of the firm. This theory explains how firms behave. What does that mean? Let’s define what we mean by the firm. A firm (or producer or business) combines inputs of labor, capital, land, and raw or finished component materials to produce outputs. If the firm is successful, the outputs are more valuable than the inputs. This activity of production goes beyond manufacturing (i.e., making things). It includes any process or service that creates value, including transportation, distribution, wholesale and retail sales.
Production involves a number of important decisions that define a firm's behavior. These decisions include, but are not limited to:
• What product or products should the firm produce?
• How should the firm produce the products (i.e., what production process should the firm use)?
• How much output should the firm produce?
• What price should the firm charge for its products?
• How much labor should the firm employ?
The answers to these questions depend on the production and cost conditions facing each firm. That is the subject of this chapter. The answers also depend on the market structure for the product(s) in question. Market structure is a multidimensional concept that involves how competitive the industry is. We define it by questions such as these:
• How much market power does each firm in the industry possess?
• How similar is each firm’s product to the products of other firms in the industry?
• How difficult is it for new firms to enter the industry?
• Do firms compete on the basis of price, advertising, or other product differences?
Figure 7.2 illustrates the range of different market structures, which we will explore in Perfect Competition, Monopoly, and Monopolistic Competition and Oligopoly.
Figure 7.2 The Spectrum of Competition Firms face different competitive situations. At one extreme—perfect competition—many firms are all trying to sell identical products. At the other extreme—monopoly—only one firm is selling the product, and this firm faces no competition. Monopolistic competition and oligopoly fall between the extremes of perfect competition and monopoly. Monopolistic competition is a situation with many firms selling similar, but not identical products. Oligopoly is a situation with few firms that sell identical or similar products.
Let's examine how firms determine their costs and desired profit levels. Then we will discuss the origins of cost, both in the short and long run. Private enterprise, which can be private individual or group business ownership, characterizes the U.S. economy. In the U.S. system, we have the option to organize private businesses as sole proprietorships (one owner), partners (more than one owner), and corporations (legal entitles separate from the owners.
When people think of businesses, often corporate giants like Wal-Mart, Microsoft, or General Motors come to mind. However, firms come in all sizes, as Table 7.1 shows. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning they employ more than 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Table 7.1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.
Number of Employees Firms (% of total firms) Number of Paid Employees (% of total employment)
Total 5,734,538 112.0 million
0–9 4,543,315 (79.2%) 12.3 million (11.0%)
10–19 617,089 (10.8%) 8.3 million (7.4%)
20–99 475,125 (8.3%) 18.6 million (16.6%)
100–499 81,773 (1.4%) 15.9 million (14.2%)
500 or more 17,236 (0.30%) 50.9 million (49.8%)
Table 7.1 Range in Size of U.S. Firms (Source: U.S. Census, 2010 www.census.gov) | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the difference between explicit costs and implicit costs
• Understand the relationship between cost and revenue
Each business, regardless of size or complexity, tries to earn a profit:
$Profit=Total Revenue – Total CostProfit=Total Revenue – Total Cost$
Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold:
$Total Revenue=Price × QuantityTotal Revenue=Price × Quantity$
We will see in the following chapters that revenue is a function of the demand for the firm’s products.
Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost. We will learn in this chapter that short run costs are different from long run costs.
We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns. Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate. (See the Work It Out feature for an extended example.)
These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.
Work It Out
Calculating Implicit Costs
Consider the following example. Eryn currently works for a corporate law firm. She is considering opening her own legal practice, where she expects to earn \$200,000 per year once she establishes herself. To run her own firm, she would need an office and a law clerk. She has found the perfect office, which rents for \$50,000 per year. She could hire a law clerk for \$35,000 per year. If these figures are accurate, would Eryn’s legal practice be profitable?
Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:
$Office rental: 50,000Law clerk's salary:+35,000____________Total explicit costs: 85,000Office rental: 50,000Law clerk's salary:+35,000____________Total explicit costs: 85,000$
Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.
$Revenues:200,000Explicit costs:–85,000____________Accounting profit:115,000Revenues:200,000Explicit costs:–85,000____________Accounting profit:115,000$
However, these calculations consider only the explicit costs. To open her own practice, Eryn would have to quit her current job, where she is earning an annual salary of \$125,000. This would be an implicit cost of opening her own firm.
Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit:
$Economic profit=total revenues – explicit costs – implicit costs=200,000 – 85,000 – 125,000=–10,000 per yearEconomic profit=total revenues – explicit costs – implicit costs=200,000 – 85,000 – 125,000=–10,000 per year$
Eryn would be losing \$10,000 per year. That does not mean she would not want to open her own business, but it does mean she would be earning \$10,000 less than if she worked for the corporate firm.
Implicit costs can include other things as well. Maybe Eryn values her leisure time, and starting her own firm would require her to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.
Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next few sections. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.02%3A_Explicit_and_Implicit_Costs_and_Accounting_and_Economic_Profit.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the concept of a production function
• Differentiate between the different types of inputs or factors in a production function
• Differentiate between fixed and variable inputs
• Differentiate between production in the short run and in the long run
• Differentiate between total and marginal product
• Understand the concept of diminishing marginal productivity
In this chapter, we want to explore the relationship between the quantity of output a firm produces, and the cost of producing that output. We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost. We can answer the former question by looking at the firm’s production function.
Figure 7.3 The production process for pizza includes inputs such as ingredients, the efforts of the pizza maker, and tools and materials for cooking and serving. (Credit: “Grilled gluten-free BBQ chicken pizza” by Keith McDuffee/Flickr, CC BY 2.0)
Production is the process (or processes) a firm uses to transform inputs (e.g., labor, capital, raw materials) into outputs, i.e. the goods or services the firm wishes to sell. Consider pizza making. The pizzaiolo (pizza maker) takes flour, water, and yeast to make dough. Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce. The cook rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings. The pizzaiolo uses a peel—the shovel-like wooden tool—to put the pizza into the oven to cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the good. What are the inputs (or factors of production) in the production process for this pizza?
Economists divide factors of production into several categories:
• Natural Resources (Land and Raw Materials) - The ingredients for the pizza are raw materials. These include the flour, yeast, and water for the dough, the tomatoes, herbs, and water for the sauce, the cheese, and the toppings. If the pizza place uses a wood-burning oven, we would include the wood as a raw material. If the establishment heats the oven with natural gas, we would count this as a raw material. Don’t forget electricity for lights. If, instead of pizza, we were looking at an agricultural product, like wheat, we would include the land the farmer used for crops here.
• Labor – When we talk about production, labor means human effort, both physical and mental. The pizzaiolo was the primary example of labor here. They need to be strong enough to roll out the dough and to insert and retrieve the pizza from the oven, but they also must know how to make the pizza, how long it cooks in the oven and a myriad of other aspects of pizza-making. The business may also have one or more people to work the counter, take orders, and receive payment.
• Capital – When economists uses the term capital, they do not mean financial capital (money); rather, they mean physical capital, the machines, equipment, and buildings that one uses to produce the product. In the case of pizza, the capital includes the peel, the oven, the building, and any other necessary equipment (for example, tables and chairs).
• Technology – Technology refers to the process or processes for producing the product. How does the pizzaiolo combine ingredients to make pizza? How hot should the oven be? How long should the pizza cook? What is the best oven to use? Gas or wood burning? Should the restaurant make its own dough, sauce, cheese, toppings, or should it buy them?
• Entrepreneurship – Production involves many decisions and much knowledge, even for something as simple as pizza. Who makes those decisions? Ultimately, it is the entrepreneur, the person who creates the business, whose idea it is to combine the inputs to produce the outputs.
The cost of producing pizza (or any output) depends on the amount of labor capital, raw materials, and other inputs required and the price of each input to the entrepreneur. Let’s explore these ideas in more detail.
We can summarize the ideas so far in terms of a production function, a mathematical expression or equation that explains the engineering relationship between inputs and outputs:
$Q=f[NR,L,K, t,E]Q=f[NR,L,K,t,E]$
The production function gives the answer to the question, how much output can the firm produce given different amounts of inputs? Production functions are specific to the product. Different products have different production functions. The amount of labor a farmer uses to produce a bushel of wheat is likely different than that required to produce an automobile. Firms in the same industry may have somewhat different production functions, since each firm may produce a little differently. One pizza restaurant may make its own dough and sauce, while another may buy those pre-made. A sit-down pizza restaurant probably uses more labor (to handle table service) than a purely take-out restaurant.
We can describe inputs as either fixed or variable.
Fixed inputs are those that can’t easily be increased or decreased in a short period of time. In the pizza example, the building is a fixed input. The restaurant owner signs a lease and is stuck in the building until the lease expires. Fixed inputs define the firm’s maximum output capacity. This is analogous to the potential real GDP shown by society’s production possibilities curve, i.e., the maximum quantities of outputs a society can produce at a given time with its available resources.
Variable inputs are those that can easily be increased or decreased in a short period of time. The pizzaiolo can order more ingredients with a phone call, so ingredients would be variable inputs. The owner could hire a new person to work the counter pretty quickly as well.
Economists often use a short-hand form for the production function:
$Q=f[L,K],Q=f[L,K],$
where L represents all the variable inputs, and K represents all the fixed inputs.
Economists differentiate between short and long run production.
The short run is the period of time during which at least some factors of production are fixed. During the period of the pizza restaurant lease, the pizza restaurant is operating in the short run, because it is limited to using the current building—the owner can’t choose a larger or smaller building.
The long run is the period of time during which all factors are variable. Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place.
Let’s explore production in the short run using a specific example: tree cutting (for lumber) with a two-person crosscut saw.
Figure 7.4 Production in the short run may be explored through the example of lumberjacks using a two-person saw. (Credit: “DO - Apple Day Civilian Conservation Corps Demonstration Crosscut Saw (Gladden)” by Virginia State Parks/Flickr, CC BY 2.0)
Since by definition capital is fixed in the short run, our production function becomes
$Q=f[L,K−]orQ=f[L]Q=f[L,K−]orQ=f[L]$
This equation simply indicates that since capital is fixed, the amount of output (e.g., trees cut down per day) depends only on the amount of labor employed (e.g., number of lumberjacks working). We can express this production function numerically as Table 7.2 below shows.
# Lumberjacks 1 2 3 4 5
# Trees (TP) 4 10 12 13 13
MP 4 6 2 1 0
Table 7.2 Short Run Production Function for Trees
Note that we have introduced some new language. We also call Output (Q) Total Product (TP), which means the amount of output produced with a given amount of labor and a fixed amount of capital. In this example, one lumberjack using a two-person saw can cut down four trees in an hour. Two lumberjacks using a two-person saw can cut down ten trees in an hour.
We should also introduce a critical concept: marginal product. Marginal product is the additional output of one more worker. Mathematically, Marginal Product is the change in total product divided by the change in labor: $MP=ΔTP/ΔLMP=ΔTP/ΔL$. In the table above, since 0 workers produce 0 trees, the marginal product of the first worker is four trees per day, but the marginal product of the second worker is six trees per day. Why might that be the case? It’s because of the nature of the capital the workers are using. A two-person saw works much better with two persons than with one. Suppose we add a third lumberjack to the story. What will that person’s marginal product be? What will that person contribute to the team? Perhaps they can oil the saw's teeth to keep it sawing smoothly or they could bring water to the two people sawing. What you see in the table is a critically important conclusion about production in the short run: It may be that as we add workers, the marginal product increases at first, but sooner or later additional workers will have decreasing marginal product. In fact, there may eventually be no effect or a negative effect on output. This is called the Law of Diminishing Marginal Product and it’s a characteristic of production in the short run. Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we learned about in the chapter on consumer choice. Both concepts are examples of the more general concept of diminishing marginal returns. Why does diminishing marginal productivity occur? It’s because of fixed capital. We will see this more clearly when we discuss production in the long run.
We can show these concepts graphically as Figure 7.5 and Figure 7.6 illustrate. Figure 7.5 graphically shows the data from Table 7.2. Figure 7.6 shows the more general cases of total product and marginal product curves.
Figure 7.5
Figure 7.6 | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.03%3A_Production_in_the_Short_Run.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the relationship between production and costs
• Understand that every factor of production has a corresponding factor price
• Analyze short-run costs in terms of total cost, fixed cost, variable cost, marginal cost, and average cost
• Calculate average profit
• Evaluate patterns of costs to determine potential profit
We’ve explained that a firm’s total costs depend on the quantities of inputs the firm uses to produce its output and the cost of those inputs to the firm. The firm’s production function tells us how much output the firm will produce with given amounts of inputs. However, if we think about that backwards, it tells us how many inputs the firm needs to produce a given quantity of output, which is the first thing we need to determine total cost. Let’s move to the second factor we need to determine.
For every factor of production (or input), there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production. From the firm’s perspective, factor payments are costs. From the owner of each factor’s perspective, factor payments are income. Factor payments include:
• Raw materials prices for raw materials
• Rent for land or buildings
• Wages and salaries for labor
• Interest and dividends for the use of financial capital (loans and equity investments)
• Profit for entrepreneurship. Profit is the residual, what’s left over from revenues after the firm pays all the other costs. While it may seem odd to treat profit as a “cost”, it is what entrepreneurs earn for taking the risk of starting a business. You can see this correspondence between factors of production and factor payments in the inside loop of the circular flow diagram in Figure 1.7.
We now have all the information necessary to determine a firm’s costs.
A cost function is a mathematical expression or equation that shows the cost of producing different levels of output.
Q 1 2 3 4
Cost \$32.50 \$44 \$52 \$90
Table 7.3 Cost Function for Producing Widgets
What we observe is that the cost increases as the firm produces higher quantities of output. This is pretty intuitive, since producing more output requires greater quantities of inputs, which cost more dollars to acquire.
What is the origin of these cost figures? They come from the production function and the factor payments. The discussion of costs in the short run above, Costs in the Short Run, was based on the following production function, which is similar to Table 7.3 except for "widgets" instead of trees.
Workers (L) 1 2 3 3.25 4.4 5.2 6 7 8 9
Widgets (Q) 0.2 0.4 0.8 1 2 3 3.5 3.8 3.95 4
Table 7.4
We can use the information from the production function to determine production costs. What we need to know is how many workers are required to produce any quantity of output. If we flip the order of the rows, we “invert” the production function so it shows $L=f(Q)L=f(Q)$.
Widgets (Q) 0.2 0.4 0.8 1 2 3 3.5 3.8 3.95 4
Workers (L) 1 2 3 3.25 4.4 5.2 6 7 8 9
Table 7.5
Now focus on the whole number quantities of output. We’ll eliminate the fractions from the table:
Widgets (Q) 1 2 3 4
Workers (L) 3.25 4.4 5.2 9
Table 7.6
Suppose widget workers receive \$10 per hour. Multiplying the Workers row by \$10 (and eliminating the blanks) gives us the cost of producing different levels of output.
Widgets (Q) 1.00 2.00 3.00 4.00
Workers (L) 3.25 4.4 5.2 9
× Wage Rate per hour \$10 \$10 \$10 \$10
= Cost \$32.50 \$44.00 \$52.00 \$90.00
Table 7.7
This is same cost function with which we began! (shown in Table 7.3)
Now that we have the basic idea of the cost origins and how they are related to production, let’s drill down into the details.
Average and Marginal Costs
The cost of producing a firm’s output depends on how much labor and physical capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals.
We can measure costs in a variety of ways. Each way provides its own insight into costs. Sometimes firms need to look at their cost per unit of output, not just their total cost. There are two ways to measure per unit costs. The most intuitive way is average cost. Average cost is the cost on average of producing a given quantity. We define average cost as total cost divided by the quantity of output produced. $AC=TC/QAC=TC/Q$ If producing two widgets costs a total of \$44, the average cost per widget is $44/2=2244/2=22$ per widget. The other way of measuring cost per unit is marginal cost. If average cost is the cost of the average unit of output produced, marginal cost is the cost of each individual unit produced. More formally, marginal cost is the cost of producing one more unit of output. Mathematically, marginal cost is the change in total cost divided by the change in output: $MC=ΔTC/ΔQMC=ΔTC/ΔQ$. If the cost of the first widget is \$32.50 and the cost of two widgets is \$44, the marginal cost of the second widget is $44−32.50=11.50.44−32.50=11.50.$ We can see the Widget Cost table redrawn below with average and marginal cost added.
Q 1 2 3 4
Total Cost \$32.50 \$44.00 \$52.00 \$90.00
Average Cost \$32.50 \$22.00 \$17.33 \$22.50
Marginal Cost \$32.50 \$11.50 \$8.00 \$38.00
Table 7.8 Extended Cost Function for Producing Widgets
Note that the marginal cost of the first unit of output is always the same as total cost.
Fixed and Variable Costs
We can decompose costs into fixed and variable costs. Fixed costs are the costs of the fixed inputs (e.g., capital). Because fixed inputs do not change in the short run, fixed costs are expenditures that do not change regardless of the level of production. Whether you produce a great deal or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease expires. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. The amount of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.
Variable costs are the costs of the variable inputs (e.g., labor). The only way to increase or decrease output is by increasing or decreasing the variable inputs. Therefore, variable costs increase or decrease with output. We treat labor as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials.
Total costs are the sum of fixed plus variable costs. Let's look at another example. Consider the barber shop called “The Clip Joint” in Figure 7.7. The data for output and costs are in Table 7.9. The fixed costs of operating the barber shop, including the space and equipment, are \$160 per day. The variable costs are the costs of hiring barbers, which in our example is \$80 per barber each day. The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. We calculate these by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost: 2 × \$80 = \$160. Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. For example, with two barbers the total cost is: \$160 + \$160 = \$320.
Labor Quantity Fixed Cost Variable Cost Total Cost
1 16 \$160 \$80 \$240
2 40 \$160 \$160 \$320
3 60 \$160 \$240 \$400
4 72 \$160 \$320 \$480
5 80 \$160 \$400 \$560
6 84 \$160 \$480 \$640
7 82 \$160 \$560 \$720
Table 7.9 Output and Total Costs
Figure 7.7 How Output Affects Total Costs At zero production, the fixed costs of \$160 are still present. As production increases, variable costs are added to fixed costs, and the total cost is the sum of the two.
At zero production, the fixed costs of \$160 are still present. As production increases, we add variable costs to fixed costs, and the total cost is the sum of the two. Figure 7.7 graphically shows the relationship between the quantity of output produced and the cost of producing that output. We always show the fixed costs as the vertical intercept of the total cost curve; that is, they are the costs incurred when output is zero so there are no variable costs.
You can see from the graph that once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by diminishing marginal productivity which we discussed earlier in the Production in the Short Run section of this chapter, which is easiest to see with an example. As the number of barbers increases from zero to one in the table, output increases from 0 to 16 for a marginal gain (or marginal product) of 16. As the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal product diminishes as we add each additional barber. For example, as the number of barbers rises from two to three, the marginal product is only 20; and as the number rises from three to four, the marginal product is only 12.
To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be increasing marginal productivity. However, as the shop adds other barbers, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal productivity. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as the last row of Table 7.9 shows.
This pattern of diminishing marginal productivity is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that the farmer can add to the land is the key variable cost. As the farmer adds water to the land, output increases. However, adding increasingly more water brings smaller increases in output, until at some point the water floods the field and actually reduces output. Diminishing marginal productivity occurs because, with fixed inputs (land in this example), each additional unit of input (e.g., water) contributes less to overall production.
Average Total Cost, Average Variable Cost, Marginal Cost
The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of Table 7.10 duplicate the previous table, but the last three columns show average total costs, average variable costs, and marginal costs. These new measures analyze costs on a per-unit (rather than a total) basis and are reflected in the curves in Figure 7.8.
Figure 7.8 Cost Curves at the Clip Joint We can also present the information on total costs, fixed cost, and variable cost on a per-unit basis. We calculate average total cost (ATC) by dividing total cost by the total quantity produced. The average total cost curve is typically U-shaped. We calculate average variable cost (AVC) by dividing variable cost by the quantity produced. The average variable cost curve lies below the average total cost curve and is also typically U-shaped. We calculate marginal cost (MC) by taking the change in total cost between two levels of output and dividing by the change in output. The marginal cost curve is upward-sloping.
Labor Quantity Fixed Cost Variable Cost Total Cost Marginal Cost Average Total Cost Average Variable Cost
1 16 \$160 \$80 \$240 \$15.00 \$15.00 \$5.00
2 40 \$160 \$160 \$320 \$3.33 \$8.00 \$4.00
3 60 \$160 \$240 \$400 \$4.00 \$6.67 \$4.00
4 72 \$160 \$320 \$480 \$6.67 \$6.67 \$4.44
5 80 \$160 \$400 \$560 \$10.00 \$7.00 \$5.00
6 84 \$160 \$480 \$640 \$20.00 \$7.62 \$5.71
Table 7.10 Different Types of Costs
Average total cost (sometimes referred to simply as average cost) is total cost divided by the quantity of output. Since the total cost of producing 40 haircuts is \$320, the average total cost for producing each of 40 haircuts is \$320/40, or \$8 per haircut. Average cost curves are typically U-shaped, as Figure 7.8 shows. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost. Mathematically, the denominator is so small that average total cost is large. Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced. However, as output expands still further, the average cost begins to rise. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns come into effect.
We obtain average variable cost when we divide variable cost by quantity of output. For example, the variable cost of producing 80 haircuts is \$400, so the average variable cost is \$400/80, or \$5 per haircut. Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost, as Figure 7.8 shows. The reason is that average total cost includes average variable cost and average fixed cost. Thus, for Q = 80 haircuts, the average total cost is \$8 per haircut, while the average variable cost is \$5 per haircut. However, as output grows, fixed costs become relatively less important (since they do not rise with output), so average variable cost sneaks closer to average cost.
Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is somewhat different. Marginal cost is the additional cost of producing one more unit of output. It is not the cost per unit of all units produced, but only the next one (or next few). We calculate marginal cost by taking the change in total cost and dividing it by the change in quantity. For example, as quantity produced increases from 40 to 60 haircuts, total costs rise by 400 – 320, or 80. Thus, the marginal cost for each of those marginal 20 units will be 80/20, or \$4 per haircut. The marginal cost curve is generally upward-sloping, because diminishing marginal returns implies that additional units are more costly to produce. We can see small range of increasing marginal returns in the figure as a dip in the marginal cost curve before it starts rising. There is a point at which marginal and average costs meet, as the following Clear it Up feature discusses.
Clear It Up
Where do marginal and average costs meet?
The marginal cost line intersects the average cost line exactly at the bottom of the average cost curve—which occurs at a quantity of 72 and cost of \$6.60 in Figure 7.8. The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost for producing previous units, as it is for the points to the left of where MC crosses ATC, then producing one more additional unit will reduce average costs overall—and the ATC curve will be downward-sloping in this zone. Conversely, if the marginal cost of production for producing an additional unit is above the average cost for producing the earlier units, as it is for points to the right of where MC crosses ATC, then producing a marginal unit will increase average costs overall—and the ATC curve must be upward-sloping in this zone. The point of transition, between where MC is pulling ATC down and where it is pulling it up, must occur at the minimum point of the ATC curve.
This idea of the marginal cost “pulling down” the average cost or “pulling up” the average cost may sound abstract, but think about it in terms of your own grades. If the score on the most recent quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average. In this same way, low marginal costs of production first pull down average costs and then higher marginal costs pull them up.
The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm. However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change.
Lessons from Alternative Measures of Costs
Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.
Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. As explored in the chapter Choice in a World of Scarcity, fixed costs are often sunk costs that a firm cannot recoup. In thinking about what to do next, typically you should ignore sunk costs, since you have already spent this money and cannot make any changes. However, you can change variable costs, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.
Clear It Up
Why are total cost and average cost not on the same graph?
Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output produced. We measure these costs in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, we measured them as dollars per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since we measure them in different units (\$ versus \$ per unit of output).
It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is \$320. However, the average cost is \$320/40, or \$8. If you graphed both total and average cost on the same axes, the average cost would hardly show.
Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm’s profit margin. Expanding the equation for profit gives:
$average profit=profitquantity produced=total revenue – total costquantity produced=total revenuequantity produced–total costquantity produced=average revenue – average costaverage profit=profitquantity produced=total revenue – total costquantity produced=total revenuequantity produced–total costquantity produced=average revenue – average cost$
However, note that:
$average revenue=price × quantity producedquantity produced=priceaverage revenue=price × quantity producedquantity produced=price$
Thus:
$average profit=price – average costaverage profit=price – average cost$
This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive. If price is below average cost, then profits will be negative.
We can compare this marginal cost of producing an additional unit with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how increasing or decreasing production affects profits.
A Variety of Cost Patterns
The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an internet company that provides medical advice to customers. Consumers might pay such a company directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that the company must undertake before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space.
For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine equipment maintenance, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.
Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other chapters, we will analyze the firm’s cost structure from a long-run perspective.
7.05: Production in the Long Run
Learning Objectives
By the end of this section, you will be able to:
• Understand how long run production differs from short run production.
In the long run, all factors (including capital) are variable, so our production function is $Q=f[L,K]Q=f[L,K]$.
Consider a secretarial firm that does typing for hire using typists for labor and personal computers for capital. To start, the firm has just enough business for one typist and one PC to keep busy for a day. Say that’s five documents. Now suppose the firm receives a rush order from a good customer for 10 documents tomorrow. Ideally, the firm would like to use two typists and two PCs to produce twice their normal output of five documents. However, in the short turn, the firm has fixed capital, i.e. only one PC. The table below shows the situation:
# Typists (L) 1 2 3 4 5 6
Letters/hr (TP) 5 7 8 8 8 8 For K = 1PC
MP 5 2 1 0 0 0
Table 7.11 Short Run Production Function for Typing
In the short run, the only variable factor is labor so the only way the firm can produce more output is by hiring additional workers. What could the second worker do? What can they contribute to the firm? Perhaps they can answer the phone, which is a major impediment to completing the typing assignment. What about a third worker? Perhaps the third worker could bring coffee to the first two workers. You can see both total product and marginal product for the firm above. Now here’s something to think about: At what point (e.g., after how many workers) does diminishing marginal productivity kick in, and more importantly, why?
In this example, marginal productivity starts to decline after the second worker. This is because capital is fixed. The production process for typing works best with one worker and one PC. If you add more than one typist, you get seriously diminishing marginal productivity.
Consider the long run. Suppose the firm’s demand increases to 15 documents per day. What might the firm do to operate more efficiently? If demand has tripled, the firm could acquire two more PCs, which would give us a new short run production function as Table 7.12 below shows.
# Typists (L) 1 2 3 4 5 5
Letters/hr (TP) 5 6 8 8 8 8 For K = 1PC
MP 5 2 1 0 0 0
Letters/hr (TP) 5 10 15 17 18 18 For K = 3PC
MP 5 5 5 2 1 0
Table 7.12 Long Run Production Function for Typing
With more capital, the firm can hire three workers before diminishing productivity comes into effect. More generally, because all factors are variable, the long run production function shows the most efficient way of producing any level of output. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.04%3A_Costs_in_the_Short_Run.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate long run total cost
• Identify economies of scale, diseconomies of scale, and constant returns to scale
• Interpret graphs of long-run average cost curves and short-run average cost curves
• Analyze cost and production in the long run and short run
The long run is the period of time when all costs are variable. The long run depends on the specifics of the firm in question—it is not a precise period of time. If you have a one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no longer bound by the lease. No costs are fixed in the long run. A firm can build new factories and purchase new machinery, or it can close existing facilities. In planning for the long run, the firm will compare alternative production technologies (or processes).
In this context, technology refers to all alternative methods of combining inputs to produce outputs. It does not refer to a specific new invention like the tablet computer. The firm will search for the production technology that allows it to produce the desired level of output at the lowest cost. After all, lower costs lead to higher profits—at least if total revenues remain unchanged. Moreover, each firm must fear that if it does not seek out the lowest-cost methods of production, then it may lose sales to competitor firms that find a way to produce and sell for less.
Choice of Production Technology
A firm can perform many tasks with a range of combinations of labor and physical capital. For example, a firm can have human beings answering phones and taking messages, or it can invest in an automated voicemail system. A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets, or it can invest in a computerized recordkeeping system that will require fewer employees. A firm can hire workers to push supplies around a factory on rolling carts, it can invest in motorized vehicles, or it can invest in robots that carry materials without a driver. Firms often face a choice between buying a many small machines, which need a worker to run each one, or buying one larger and more expensive machine, which requires only one or two workers to operate it. In short, physical capital and labor can often substitute for each other.
Consider the example of local governments hiring a private firm to clean up public parks. Three different combinations of labor and physical capital for cleaning up a single average-sized park appear in Table 7.13. The first production technology is heavy on workers and light on machines, while the next two technologies substitute machines for workers. Since all three of these production methods produce the same thing—one cleaned-up park—a profit-seeking firm will choose the production technology that is least expensive, given the prices of labor and machines.
Production technology 1 10 workers 2 machines
Production technology 2 7 workers 4 machines
Production technology 3 3 workers 7 machines
Table 7.13 Three Ways to Clean a Park
Production technology 1 uses the most labor and least machinery, while production technology 3 uses the least labor and the most machinery. Table 7.14 outlines three examples of how the total cost will change with each production technology as the cost of labor changes. As the cost of labor rises from example A to B to C, the firm will choose to substitute away from labor and use more machinery.
Example A: Workers cost \$40, machines cost \$80
Labor Cost Machine Cost Total Cost
Cost of technology 1 10 × \$40 = \$400 2 × \$80 = \$160 \$560
Cost of technology 2 7 × \$40 = \$280 4 × \$80 = \$320 \$600
Cost of technology 3 3 × \$40 = \$120 7 × \$80 = \$560 \$680
Example B: Workers cost \$55, machines cost \$80
Labor Cost Machine Cost Total Cost
Cost of technology 1 10 × \$55 = \$550 2 × \$80 = \$160 \$710
Cost of technology 2 7 × \$55 = \$385 4 × \$80 = \$320 \$705
Cost of technology 3 3 × \$55 = \$165 7 × \$80 = \$560 \$725
Example C: Workers cost \$90, machines cost \$80
Labor Cost Machine Cost Total Cost
Cost of technology 1 10 × \$90 = \$900 2 × \$80 = \$160 \$1,060
Cost of technology 2 7 × \$90 = \$630 4 × \$80 = \$320 \$950
Cost of technology 3 3 × \$90 = \$270 7 × \$80 = \$560 \$830
Table 7.14 Total Cost with Rising Labor Costs
Example A shows the firm’s cost calculation when wages are \$40 and machines costs are \$80. In this case, technology 1 is the low-cost production technology. In example B, wages rise to \$55, while the cost of machines does not change, in which case technology 2 is the low-cost production technology. If wages keep rising up to \$90, while the cost of machines remains unchanged, then technology 3 clearly becomes the low-cost form of production, as example C shows.
This example shows that as an input becomes more expensive (in this case, the labor input), firms will attempt to conserve on using that input and will instead shift to other inputs that are relatively less expensive. This pattern helps to explain why the demand curve for labor (or any input) slopes down; that is, as labor becomes relatively more expensive, profit-seeking firms will seek to substitute the use of other inputs. When a multinational employer like Coca-Cola or McDonald’s sets up a bottling plant or a restaurant in a high-wage economy like the United States, Canada, Japan, or Western Europe, it is likely to use production technologies that conserve on the number of workers and focuses more on machines. However, that same employer is likely to use production technologies with more workers and less machinery when producing in a lower-wage country like Mexico, China, or South Africa.
Economies of Scale
Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce. Many industries experience economies of scale. Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory.
Figure 7.9 illustrates the idea of economies of scale, showing the average cost of producing an alarm clock falling as the quantity of output rises. For a small-sized factory like S, with an output level of 1,000, the average cost of production is \$12 per alarm clock. For a medium-sized factory like M, with an output level of 2,000, the average cost of production falls to \$8 per alarm clock. For a large factory like L, with an output of 5,000, the average cost of production declines still further to \$4 per alarm clock.
Figure 7.9 Economies of Scale A small factory like S produces 1,000 alarm clocks at an average cost of \$12 per clock. A medium factory like M produces 2,000 alarm clocks at a cost of \$8 per clock. A large factory like L produces 5,000 alarm clocks at a cost of \$4 per clock. Economies of scale exist when the larger scale of production leads to lower average costs.
The average cost curve in Figure 7.9 may appear similar to the average cost curves we presented earlier in this chapter, although it is downward-sloping rather than U-shaped. However, there is one major difference. The economies of scale curve is a long-run average cost curve, because it allows all factors of production to change. The short-run average cost curves we presented earlier in this chapter assumed the existence of fixed costs, and only variable costs were allowed to change.
One prominent example of economies of scale occurs in the chemical industry. Chemical plants have many pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the cross-section area of the pipe determines the volume of chemicals that can flow through it. The calculations in Table 7.15 show that a pipe which uses twice as much material to make (as shown by the circumference) can actually carry four times the volume of chemicals because the pipe's cross-section area rises by a factor of four (as the Area column below shows).
Circumference ($2πr2πr$) Area ($πr2πr2$)
4-inch pipe 12.5 inches 12.5 square inches
8-inch pipe 25.1 inches 50.2 square inches
16-inch pipe 50.2 inches 201.1 square inches
Table 7.15 Comparing Pipes: Economies of Scale in the Chemical Industry
A doubling of the cost of producing the pipe allows the chemical firm to process four times as much material. This pattern is a major reason for economies of scale in chemical production, which uses a large quantity of pipes. Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. However, the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much.
Shapes of Long-Run Average Cost Curves
While in the short run firms are limited to operating on a single average cost curve (corresponding to the level of fixed costs they have chosen), in the long run when all costs are variable, they can choose to operate on any average cost curve. Thus, the long-run average cost (LRAC) curve is actually based on a group of short-run average cost (SRAC) curves, each of which represents one specific level of fixed costs. More precisely, the long-run average cost curve will be the least expensive average cost curve for any level of output. Figure 7.10 shows how we build the long-run average cost curve from a group of short-run average cost curves. Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a different level of fixed costs. For example, you can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra-large. Although this diagram shows only five SRAC curves, presumably there are an infinite number of other SRAC curves between the ones that we show. Think of this family of short-run average cost curves as representing different choices for a firm that is planning its level of investment in fixed cost physical capital—knowing that different choices about capital investment in the present will cause it to end up with different short-run average cost curves in the future.
Figure 7.10 From Short-Run Average Cost Curves to Long-Run Average Cost Curves The five different short-run average cost (SRAC) curves each represents a different level of fixed costs, from the low level of fixed costs at SRAC1 to the high level of fixed costs at SRAC5. Other SRAC curves, not in the diagram, lie between the ones that are here. The long-run average cost (LRAC) curve shows the lowest cost for producing each quantity of output when fixed costs can vary, and so it is formed by the bottom edge of the family of SRAC curves. If a firm wished to produce quantity Q3, it would choose the fixed costs associated with SRAC3.
The long-run average cost curve shows the cost of producing each quantity in the long run, when the firm can choose its level of fixed costs and thus choose which short-run average costs it desires. If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows producing q3 at the lowest cost. A firm that intends to produce Q3 would be foolish to choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2 the level of fixed costs is too low for producing Q3 at lowest possible cost, and producing q3 would require adding a very high level of variable costs and make the average cost very high. At SRAC4, the level of fixed costs is too high for producing q3 at lowest possible cost, and again average costs would be very high as a result.
The shape of the long-run cost curve, in Figure 7.10, is fairly common for many industries. The left-hand portion of the long-run average cost curve, where it is downward- sloping from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in Figure 7.9.
In the middle portion of the long-run average cost curve, the flat portion of the curve around Q3, economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls. The following Clear It Up feature explains where diminishing marginal returns fit into this analysis.
Clear It Up
How do economies of scale compare to diminishing marginal returns?
The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands. However, diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are allowed to increase together. Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has economies of scale when all inputs change together to produce a larger-scale operation.
Finally, the right-hand portion of the long-run average cost curve, running from output level Q4 to Q5, shows a situation where, as the level of output and the scale rises, average costs rise as well. We call this situation diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials. Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.
Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level.
Link It Up
Visit this website to read an article about the complexity of the belief that banks can be “too-big-to-fail.”
The Size and Number of Firms in an Industry
The shape of the long-run average cost curve has implications for how many firms will compete in an industry, and whether the firms in an industry have many different sizes, or tend to be the same size. For example, say that the appliance industry sells one million dishwashers every year at a price of \$500 each and the long-run average cost curve for dishwashers is in Figure 7.11 (a). In Figure 7.11 (a), the lowest point of the LRAC curve occurs at a quantity of 10,000 produced. Thus, the market for dishwashers will consist of 100 different manufacturing plants of this same size. If some firms built a plant that produced 5,000 dishwashers per year or 25,000 dishwashers per year, the average costs of production at such plants would be well above \$500, and the firms would not be able to compete.
Figure 7.11 The LRAC Curve and the Size and Number of Firms (a) Low-cost firms will produce at output level R. When the LRAC curve has a clear minimum point, then any firm producing a different quantity will have higher costs. In this case, a firm producing at a quantity of 10,000 will produce at a lower average cost than a firm producing, say, 5,000 or 20,000 units. (b) Low-cost firms will produce between output levels R and S. When the LRAC curve has a flat bottom, then firms producing at any quantity along this flat bottom can compete. In this case, any firm producing a quantity between 5,000 and 20,000 can compete effectively, although firms producing less than 5,000 or more than 20,000 would face higher average costs and be unable to compete.
Clear It Up
How can we view cities as examples of economies of scale?
Why are people and economic activity concentrated in cities, rather than distributed evenly across a country? The fundamental reason must be related to the idea of economies of scale—that grouping economic activity is more productive in many cases than spreading it out. For example, cities provide a large group of nearby customers, so that businesses can produce at an efficient economy of scale. They also provide a large group of workers and suppliers, so that business can hire easily and purchase whatever specialized inputs they need. Many of the attractions of cities, like sports stadiums and museums, can operate only if they can draw on a large nearby population base. Cities are big enough to offer a wide variety of products, which is what appeals to many shoppers.
These factors are not exactly economies of scale in the narrow sense of the production function of a single firm, but they are related to growth in the overall size of population and market in an area. Cities are sometimes called “agglomeration economies.”
These agglomeration factors help to explain why every economy, as it develops, has an increasing proportion of its population living in urban areas. In the United States, about 80% of the population now lives in metropolitan areas (which include the suburbs around cities), compared to just 40% in 1900. However, in poorer nations of the world, including much of Africa, the proportion of the population in urban areas is only about 30%. One of the great challenges for these countries as their economies grow will be to manage the growth of the great cities that will arise.
If cities offer economic advantages that are a form of economies of scale, then why don’t all or most people live in one giant city? At some point, agglomeration economies must turn into diseconomies. For example, traffic congestion may reach a point where the gains from being geographically nearby are counterbalanced by how long it takes to travel. High densities of people, cars, and factories can mean more garbage and air and water pollution. Facilities like parks or museums may become overcrowded. There may be economies of scale for negative activities like crime, because high densities of people and businesses, combined with the greater impersonality of cities, make it easier for illegal activities as well as legal ones. The future of cities, both in the United States and in other countries around the world, will be determined by their ability to benefit from the economies of agglomeration and to minimize or counterbalance the corresponding diseconomies.
We illustrate a more common case in Figure 7.11 (b), where the LRAC curve has a flat-bottomed area of constant returns to scale. In this situation, any firm with a level of output between 5,000 and 20,000 will be able to produce at about the same level of average cost. Given that the market will demand one million dishwashers per year at a price of \$500, this market might have as many as 200 producers (that is, one million dishwashers divided by firms making 5,000 each) or as few as 50 producers (one million dishwashers divided by firms making 20,000 each). The producers in this market will range in size from firms that make 5,000 units to firms that make 20,000 units. However, firms that produce below 5,000 units or more than 20,000 will be unable to compete, because their average costs will be too high. Thus, if we see an industry where almost all plants are the same size, it is likely that the long-run average cost curve has a unique bottom point as in Figure 7.11 (a). However, if the long-run average cost curve has a wide flat bottom like Figure 7.11 (b), then firms of a variety of different sizes will be able to compete with each other.
We can interpret the flat section of the long-run average cost curve in Figure 7.11 (b) in two different ways. One interpretation is that a single manufacturing plant producing a quantity of 5,000 has the same average costs as a single manufacturing plant with four times as much capacity that produces a quantity of 20,000. The other interpretation is that one firm owns a single manufacturing plant that produces a quantity of 5,000, while another firm owns four separate manufacturing plants, which each produce a quantity of 5,000. This second explanation, based on the insight that a single firm may own a number of different manufacturing plants, is especially useful in explaining why the long-run average cost curve often has a large flat segment—and thus why a seemingly smaller firm may be able to compete quite well with a larger firm. At some point, however, the task of coordinating and managing many different plants raises the cost of production sharply, and the long-run average cost curve slopes up as a result.
In the examples to this point, the quantity demanded in the market is quite large (one million) compared with the quantity produced at the bottom of the long-run average cost curve (5,000, 10,000 or 20,000). In such a situation, the market is set for competition between many firms. However, what if the bottom of the long-run average cost curve is at a quantity of 10,000 and the total market demand at that price is only slightly higher than that quantity—or even somewhat lower?
Return to Figure 7.11 (a), where the bottom of the long-run average cost curve is at 10,000, but now imagine that the total quantity of dishwashers demanded in the market at that price of \$500 is only 30,000. In this situation, the total number of firms in the market would be three. We call a handful of firms in a market an “oligopoly,” and the chapter on Monopolistic Competition and Oligopoly will discuss the range of competitive strategies that can occur when oligopolies compete.
Alternatively, consider a situation, again in the setting of Figure 7.11 (a), where the bottom of the long-run average cost curve is 10,000, but total demand for the product is only 5,000. (For simplicity, imagine that this demand is highly inelastic, so that it does not vary according to price.) In this situation, the market may well end up with a single firm—a monopoly—producing all 5,000 units. If any firm tried to challenge this monopoly while producing a quantity lower than 5,000 units, the prospective competitor firm would have a higher average cost, and so it would not be able to compete in the longer term without losing money. The chapter on Monopoly discusses the situation of a monopoly firm.
Thus, the shape of the long-run average cost curve reveals whether competitors in the market will be different sizes. If the LRAC curve has a single point at the bottom, then the firms in the market will be about the same size, but if the LRAC curve has a flat-bottomed segment of constant returns to scale, then firms in the market may be a variety of different sizes.
The relationship between the quantity at the minimum of the long-run average cost curve and the quantity demanded in the market at that price will predict how much competition is likely to exist in the market. If the quantity demanded in the market far exceeds the quantity at the minimum of the LRAC, then many firms will compete. If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the LRAC, a few firms will compete. If the quantity demanded in the market is less than the quantity at the minimum of the LRAC, a single-producer monopoly is a likely outcome.
Shifting Patterns of Long-Run Average Cost
New developments in production technology can shift the long-run average cost curve in ways that can alter the size distribution of firms in an industry.
For much of the twentieth century, the most common change had been to see alterations in technology, like the assembly line or the large department store, where large-scale producers seemed to gain an advantage over smaller ones. In the long-run average cost curve, the downward-sloping economies of scale portion of the curve stretched over a larger quantity of output.
However, new production technologies do not inevitably lead to a greater average size for firms. For example, in recent years some new technologies for generating electricity on a smaller scale have appeared. The traditional coal-burning electricity plants needed to produce 300 to 600 megawatts of power to exploit economies of scale fully. However, high-efficiency turbines to produce electricity from burning natural gas can produce electricity at a competitive price while producing a smaller quantity of 100 megawatts or less. These new technologies create the possibility for smaller companies or plants to generate electricity as efficiently as large ones. Another example of a technology-driven shift to smaller plants may be taking place in the tire industry. A traditional mid-size tire plant produces about six million tires per year. However, in 2000, the Italian company Pirelli introduced a new tire factory that uses many robots. The Pirelli tire plant produced only about one million tires per year, but did so at a lower average cost than a traditional mid-sized tire plant.
Controversy has simmered in recent years over whether the new information and communications technologies will lead to a larger or smaller size for firms. On one side, the new technology may make it easier for small firms to reach out beyond their local geographic area and find customers across a state, or the nation, or even across international boundaries. This factor might seem to predict a future with a larger number of small competitors. On the other side, perhaps the new information and communications technology will create “winner-take-all” markets where one large company will tend to command a large share of total sales, as Microsoft has done producing of software for personal computers or Amazon has done in online bookselling. Moreover, improved information and communication technologies might make it easier to manage many different plants and operations across the country or around the world, and thus encourage larger firms. This ongoing battle between the forces of smallness and largeness will be of great interest to economists, businesspeople, and policymakers.
Bring It Home
Amazon
Traditionally, bookstores have operated in retail locations with inventories held either on the shelves or in the back of the store. These retail locations were very pricey in terms of rent. Until recently, Amazon had no retail locations. It only sold online and delivered by mail. Amazon now has retail stores in California, Oregon and Washington State and retail stores are coming to Illinois, Massachusetts, New Jersey, and New York. Amazon offers almost any book in print, convenient purchasing, and prompt delivery by mail. Amazon holds its inventories in huge warehouses in low-rent locations around the world. The warehouses are highly computerized using robots and relatively low-skilled workers, making for low average costs per sale. Amazon demonstrates the significant advantages economies of scale can offer to a firm that exploits those economies. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.06%3A_Costs_in_the_Long_Run.txt |
accounting profit
total revenues minus explicit costs, including depreciation
average profit
profit divided by the quantity of output produced; also known as profit margin
average total cost
total cost divided by the quantity of output
average variable cost
variable cost divided by the quantity of output
constant returns to scale
expanding all inputs proportionately does not change the average cost of production
diminishing marginal productivity
general rule that as a firm employs more labor, eventually the amount of additional output produced declines
diseconomies of scale
the long-run average cost of producing output increases as total output increases
economic profit
total revenues minus total costs (explicit plus implicit costs)
economies of scale
the long-run average cost of producing output decreases as total output increases
economies of scale
the long-run average cost of producing output decreases as total output increases
explicit costs
out-of-pocket costs for a firm, for example, payments for wages and salaries, rent, or materials
factors of production (or inputs)
resources that firms use to produce their products, for example, labor and capital
firm
an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs.
fixed cost
cost of the fixed inputs; expenditure that a firm must make before production starts and that does not change regardless of the production level
fixed inputs
factors of production that can’t be easily increased or decreased in a short period of time
implicit costs
opportunity cost of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned
long run
period of time during which all of a firm’s inputs are variable
long-run average cost (LRAC) curve
shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology
marginal cost
the additional cost of producing one more unit; mathematically, $MC=ΔTC/ΔLMC=ΔTC/ΔL$
marginal product
change in a firm’s output when it employees more labor; mathematically, $MP=ΔTP/ΔLMP=ΔTP/ΔL$
private enterprise
the ownership of businesses by private individuals
production
the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs
production function
mathematical equation that tells how much output a firm can produce with given amounts of the inputs
production technologies
alternative methods of combining inputs to produce output
revenue
income from selling a firm’s product; defined as price times quantity sold
short run
period of time during which at least one or more of the firm’s inputs is fixed
short-run average cost (SRAC) curve
the average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs
total cost
the sum of fixed and variable costs of production
total product
synonym for a firm’s output
variable cost
cost of production that increases with the quantity produced; the cost of the variable inputs
variable inputs
factors of production that a firm can easily increase or decrease in a short period of time
7.08: Key Concepts and Summary
7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only explicit costs, economic profit considers both explicit and implicit costs.
7.2 Production in the Short Run
Production is the process a firm uses to transform inputs (e.g., labor, capital, raw materials, etc.) into outputs. It is not possible to vary fixed inputs (e.g., capital) in a short period of time. Thus, in the short run the only way to change output is to change the variable inputs (e.g., labor). Marginal product is the additional output a firm obtains by employing more labor in production. At some point, employing additional labor leads to diminishing marginal productivity, meaning the additional output obtained is less than for the previous increment to labor. Mathematically, marginal product is the slope of the total product curve.
7.3 Costs in the Short Run
For every input (e.g., labor), there is an associated factor payment (e.g., wages and salaries). The cost of production for a given quantity of output is the sum of the amount of each input required to produce that quantity of output times the associated factor payment.
In a short-run perspective, we can divide a firm’s total costs into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and the firm cannot alter them, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises.
We calculate marginal cost by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit.
We calculate average total cost by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits.
We calculate average variable cost by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture.
7.4 Production in the Long Run
In the long run, all inputs are variable. Since diminishing marginal productivity is caused by fixed capital, there are no diminishing returns in the long run. Firms can choose the optimal capital stock to produce their desired level of output.
7.5 Costs in the Long Run
A production technology refers to a specific combination of labor, physical capital, and technology that makes up a particular method of production.
In the long run, firms can choose their production technology, and so all costs become variable costs. In making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible, so as to produce at the lowest possible long-run average cost.
Economies of scale refers to a situation where as the level of output increases, the average cost decreases. Constant returns to scale refers to a situation where average cost does not change as output increases. Diseconomies of scale refers to a situation where as output increases, average costs also increase.
The long-run average cost curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology. A downward-sloping LRAC shows economies of scale; a flat LRAC shows constant returns to scale; an upward-sloping LRAC shows diseconomies of scale. If the long-run average cost curve has only one quantity produced that results in the lowest possible average cost, then all of the firms competing in an industry should be the same size. However, if the LRAC has a flat segment at the bottom, so that a firm can produce a range of different quantities at the lowest average cost, the firms competing in the industry will display a range of sizes. The market demand in conjunction with the long-run average cost curve determines how many firms will exist in a given industry.
If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the long-run average cost curve, where the cost of production is lowest, the market will have many firms competing. If the quantity demanded in the market is less than the quantity at the bottom of the LRAC, there will likely be only one firm. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.07%3A_Key_Terms.txt |
1.
A firm had sales revenue of \$1 million last year. It spent \$600,000 on labor, \$150,000 on capital and \$200,000 on materials. What was the firm’s accounting profit?
2.
Continuing from Exercise 7.1, the firm’s factory sits on land owned by the firm that it could rent for \$30,000 per year. What was the firm’s economic profit last year?
3.
The WipeOut Ski Company manufactures skis for beginners. Fixed costs are \$30. Fill in Table 7.16 for total cost, average variable cost, average total cost, and marginal cost.
Quantity Variable Cost Fixed Cost Total Cost Average Variable Cost Average Total Cost Marginal Cost
0 0 \$30
1 \$10 \$30
2 \$25 \$30
3 \$45 \$30
4 \$70 \$30
5 \$100 \$30
6 \$135 \$30
Table 7.16
4.
Based on your answers to the WipeOut Ski Company in Exercise 7.3, now imagine a situation where the firm produces a quantity of 5 units that it sells for a price of \$25 each.
1. What will be the company’s profits or losses?
2. How can you tell at a glance whether the company is making or losing money at this price by looking at average cost?
3. At the given quantity and price, is the marginal unit produced adding to profits?
5.
If two painters can paint 200 square feet of wall in an hour, and three painters can paint 275 square feet, what is the marginal product of the third painter?
6.
Return to the problem explained in Table 7.13 and Table 7.14. If the cost of labor remains at \$40, but the cost of a machine decreases to \$50, what would be the total cost of each method of production? Which method should the firm use, and why?
7.
Suppose the cost of machines increases to \$55, while the cost of labor stays at \$40. How would that affect the total cost of the three methods? Which method should the firm choose now?
8.
Automobile manufacturing is an industry subject to significant economies of scale. Suppose there are four domestic auto manufacturers, but the demand for domestic autos is no more than 2.5 times the quantity produced at the bottom of the long-run average cost curve. What do you expect will happen to the domestic auto industry in the long run?
7.10: Review Questions
9.
What are explicit and implicit costs?
10.
Would you consider an interest payment on a loan to a firm an explicit or implicit cost?
11.
What is the difference between accounting and economic profit?
12.
What is a production function?
13.
What is the difference between a fixed input and a variable input?
14.
How do we calculate marginal product?
15.
What shapes would you generally expect a total product curve and a marginal product curve to have?
16.
What are the factor payments for land, labor, and capital?
17.
What is the difference between fixed costs and variable costs?
18.
How do we calculate each of the following: marginal cost, average total cost, and average variable cost?
19.
What shapes would you generally expect each of the following cost curves to have: fixed costs, variable costs, marginal costs, average total costs, and average variable costs?
20.
Are there fixed costs in the long-run? Explain briefly.
21.
Are fixed costs also sunk costs? Explain.
22.
What are diminishing marginal returns as they relate to costs?
23.
Which costs are measured on per-unit basis: fixed costs, average cost, average variable cost, variable costs, and marginal cost?
24.
What is a production technology?
25.
In choosing a production technology, how will firms react if one input becomes relatively more expensive?
26.
What is a long-run average cost curve?
27.
What is the difference between economies of scale, constant returns to scale, and diseconomies of scale?
28.
What shape of a long-run average cost curve illustrates economies of scale, constant returns to scale, and diseconomies of scale?
29.
Why will firms in most markets be located at or close to the bottom of the long-run average cost curve? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.09%3A_Self-Check_Questions.txt |
30.
Small “Mom and Pop firms,” like inner city grocery stores, sometimes exist even though they do not earn economic profits. How can you explain this?
31.
A common name for fixed cost is “overhead.” If you divide fixed cost by the quantity of output produced, you get average fixed cost. Suppose fixed cost is \$1,000. What does the average fixed cost curve look like? Use your response to explain what “spreading the overhead” means.
32.
How does fixed cost affect marginal cost? Why is this relationship important?
33.
Average cost curves (except for average fixed cost) tend to be U-shaped, decreasing and then increasing. Marginal cost curves have the same shape, though this may be harder to see since most of the marginal cost curve is increasing. Why do you think that average and marginal cost curves have the same general shape?
34.
What is the relationship between marginal product and marginal cost? (Hint: Look at the curves.) Why do you suppose that is? Is this relationship the same in the long run as in the short run?
35.
It is clear that businesses operate in the short run, but do they ever operate in the long run? Discuss.
36.
Return to Table 7.12. In the top half of the table, at what point does diminishing marginal productivity kick in? What about in the bottom half of the table? How do you explain this?
37.
How would an improvement in technology, like the high-efficiency gas turbines or Pirelli tire plant, affect the long-run average cost curve of a firm? Can you draw the old curve and the new one on the same axes? How might such an improvement affect other firms in the industry?
38.
Do you think that the taxicab industry in large cities would be subject to significant economies of scale? Why or why not?
7.12: Problems
39.
A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan, but it currently has the cash, so it will not need to borrow. Should the firm make the investment? Show your work.
40.
Return to Figure 7.7. What is the marginal gain in output from increasing the number of barbers from 4 to 5 and from 5 to 6? Does it continue the pattern of diminishing marginal returns?
41.
Compute the average total cost, average variable cost, and marginal cost of producing 60 and 72 haircuts. Draw the graph of the three curves between 60 and 72 haircuts.
42.
A small company that shovels sidewalks and driveways has 100 homes signed up for its services this winter. It can use various combinations of capital and labor: intensive labor with hand shovels, less labor with snow blowers, and still less labor with a pickup truck that has a snowplow on front. To summarize, the method choices are:
Method 1: 50 units of labor, 10 units of capital
Method 2: 20 units of labor, 40 units of capital
Method 3: 10 units of labor, 70 units of capital
If hiring labor for the winter costs \$100/unit and a unit of capital costs \$400, what is the best production method? What method should the company use if the cost of labor rises to \$200/unit? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/07%3A_Production_Costs_and_Industry_Structure/7.11%3A_Critical_Thinking_Questions.txt |
Figure 8.1 Depending on the competition and prices offered, a soybean farmer may choose to grow a different crop. (Credit: modification “Agronomist & Farmer Inspecting Weeds” by United Soybean Board/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Perfect Competition and Why It Matters
• How Perfectly Competitive Firms Make Output Decisions
• Entry and Exit Decisions in the Long Run
• Efficiency in Perfectly Competitive Markets
Bring It Home
A Dime a Dozen
When you were younger did you babysit, deliver papers, or mow the lawn for money? If so, you faced stiff competition from many other competitors who offered identical services. There was nothing to stop others from also offering their services.
All of you charged the “going rate.” If you tried to charge more, your customers would simply buy from someone else. These conditions are very similar to the conditions agricultural growers face.
Growing a crop may be more difficult to start than a babysitting or lawn mowing service, but growers face the same fierce competition. In the grand scale of world agriculture, farmers face competition from thousands of others because they sell an identical product. After all, winter wheat is winter wheat, but if they find it hard to make money with that crop, it is relatively easy for farmers to leave the marketplace for another crop. In this case, they do not sell the family farm, they switch crops.
Take the case of the upper Midwest region of the United States—for many generations the area was called “King Wheat.” According to the United States Department of Agriculture National Agricultural Statistics Service, statistics by state, in 1997, 11.6 million acres of wheat and 780,000 acres of corn were planted in North Dakota. In the intervening 25 or so years has the mix of crops changed? Since it is relatively easy to switch crops, did farmers change what they planted in response to changes in relative crop prices? We will find out at chapter’s end.
In the meantime, let's consider the topic of this chapter—the perfectly competitive market. This is a market in which entry and exit are relatively easy and competitors are “a dime a dozen.”
Most businesses face two realities: no one is required to buy their products, and even customers who might want those products may buy from other businesses instead. Firms that operate in perfectly competitive markets face this reality. In this chapter, you will learn how such firms make decisions about how much to produce, how much profit they make, whether to stay in business or not, and many others. Industries differ from one another in terms of how many sellers there are in a specific market, how easy or difficult it is for a new firm to enter, and the type of products that they sell. Economists refer to this as an industry's market structure. In this chapter, we focus on perfect competition. However, in other chapters we will examine other industry types: Monopoly and Monopolistic Competition and Oligopoly.
8.02: Perfect Competition and Why It Matters
Learning Objectives
By the end of this section, you will be able to:
• Explain the characteristics of a perfectly competitive market
• Discuss how perfectly competitive firms react in the short run and in the long run
Firms are in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product that they are buying and selling; and (4) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market.
A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces it to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as we discussed in the Bring It Home feature, wants to know the going price of wheat, they have to check on the computer or listen to the radio. Supply and demand in the entire market solely determine the market price, not the individual farmer. A perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Economists often use agricultural markets as an example. The same crops that different farmers grow are largely interchangeable. According to the United States Department of Agriculture monthly reports, in December 2021, U.S. corn farmers received an average of \$5.47 per bushel. A corn farmer who attempted to sell at \$6.00 per bushel would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.
Link It Up
Visit this website that reveals the current value of various commodities.
This chapter examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs as we discussed in the chapter on Production, Costs and Industry Structure. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest.
In the long run, positive economic profits will attract competition as other firms enter the market. Economic losses will cause firms to exit the market. Ultimately, perfectly competitive markets will attain long-run equilibrium when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/08%3A_Perfect_Competition/8.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate profits by comparing total revenue and total cost
• Identify profits and losses with the average cost curve
• Explain the shutdown point
• Determine the price at which a firm should continue producing in the short run
A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand this, consider a different way of writing out the basic definition of profit:
$Profit=Total revenue−Total cost =(Price)(Quantity produced)−(Average cost)(Quantity produced) Profit=Total revenue−Total cost =(Price)(Quantity produced)−(Average cost)(Quantity produced)$
Since a perfectly competitive firm must accept the price for its output as determined by the product’s market demand and supply, it cannot choose the price it charges. This is already determined in the profit equation, and so the perfectly competitive firm can sell any number of units at exactly the same price. It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm’s total revenue, total costs, and ultimately, level of profits.
Determining the Highest Profit by Comparing Total Revenue and Total Cost
A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. The formula above shows that total revenue depends on the quantity sold and the price charged. If the firm sells a higher quantity of output, then total revenue will increase. If the market price of the product increases, then total revenue also increases whatever the quantity of output sold. As an example of how a perfectly competitive firm decides what quantity to produce, consider the case of a small farmer who produces raspberries and sells them frozen for \$4 per pack. Sales of one pack of raspberries will bring in \$4, two packs will be \$8, three packs will be \$12, and so on. If, for example, the price of frozen raspberries doubles to \$8 per pack, then sales of one pack of raspberries will be \$8, two packs will be \$16, three packs will be \$24, and so on.
Table 8.1 shows total revenue and total costs for the raspberry farm; these data also appear in Figure 8.2. The horizontal axis shows the quantity of frozen raspberries produced in packs. The vertical axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward. All these cost curves follow the same characteristics as the curves that we covered in the Production, Costs and Industry Structure chapter.
Figure 8.2 Total Cost and Total Revenue at the Raspberry Farm Total revenue for a perfectly competitive firm is a straight line sloping up. The slope is equal to the price of the good. Total cost also slopes up, but with some curvature. At higher levels of output, total cost begins to slope upward more steeply because of diminishing marginal returns. The maximum profit will occur at the quantity where the difference between total revenue and total cost is largest.
Quantity
(Q)
Total Cost
(TC)
Total Revenue
(TR)
Profit
0 \$62 \$0 −\$62
10 \$90 \$40 −\$50
20 \$110 \$80 −\$30
30 \$126 \$120 −\$6
40 \$138 \$160 \$22
50 \$150 \$200 \$50
60 \$165 \$240 \$75
70 \$190 \$280 \$90
80 \$230 \$320 \$90
90 \$296 \$360 \$64
100 \$400 \$400 \$0
110 \$550 \$440 \$−110
120 \$715 \$480 \$−235
Table 8.1 Total Cost and Total Revenue at the Raspberry Farm
Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry farm can calculate the quantity of output that will provide the highest level of profit. At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount. Figure 8.2 shows total revenue, total cost and profit using the data from Table 8.1. The vertical gap between total revenue and total cost is profit, for example, at Q = 60, TR = 240 and TC = 165. The difference is 75, which is the height of the profit curve at that output level. The firm doesn’t make a profit at every level of output. In this example, total costs will exceed total revenues at output levels from 0 to approximately 30, and so over this range of output, the firm will be making losses. At output levels from 40 to 100, total revenues exceed total costs, so the firm is earning profits. However, at any output greater than 100, total costs again exceed total revenues and the firm is making increasing losses. Total profits appear in the final column of Table 8.1. Maximum profit occurs at an output between 70 and 80, when profit equals \$90.
A higher price would mean that total revenue would be higher for every quantity sold. A lower price would mean that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses. However, a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest.
(Later we will see that sometimes it will make sense for the firm to close, rather than stay in operation producing output.)
Comparing Marginal Revenue and Marginal Costs
The approach that we described in the previous section, using total revenue and total cost, is not the only approach to determining the profit maximizing level of output. In this section, we provide an alternative approach which uses marginal revenue and marginal cost.
Firms often do not have the necessary data they need to draw a complete total cost curve for all levels of production. They cannot be sure of what total costs would look like if they, say, doubled production or cut production in half, because they have not tried it. Instead, firms experiment. They produce a slightly greater or lower quantity and observe how it affects profits. In economic terms, this practical approach to maximizing profits means examining how changes in production affect marginal revenue and marginal cost.
Figure 8.3 presents the marginal revenue and marginal cost curves based on the total revenue and total cost in Table 8.1. The marginal revenue curve shows the additional revenue gained from selling one more unit. As mentioned before, a firm in perfect competition faces a perfectly elastic demand curve for its product—that is, the firm’s demand curve is a horizontal line drawn at the market price level. This also means that the firm’s marginal revenue curve is the same as the firm’s demand curve: Every time a consumer demands one more unit, the firm sells one more unit and revenue increases by exactly the same amount equal to the market price. In this example, every time the firm sells a pack of frozen raspberries, the firm’s revenue increases by \$4. Table 8.2 shows an example of this. This condition only holds for price taking firms in perfect competition where:
$marginal revenue = price marginal revenue = price$
The formula for marginal revenue is:
$marginal revenue = change in total revenue change in quantity marginal revenue = change in total revenue change in quantity$
Price Quantity Total Revenue Marginal Revenue
\$4 1 \$4 -
\$4 2 \$8 \$4
\$4 3 \$12 \$4
\$4 4 \$16 \$4
Table 8.2
Notice that marginal revenue does not change as the firm produces more output. That is because under perfect competition, the price is determined through the interaction of supply and demand in the market and does not change as the farmer produces more (keeping in mind that, due to the relative small size of each firm, increasing their supply has no impact on the total market supply where price is determined).
Since a perfectly competitive firm is a price taker, it can sell whatever quantity it wishes at the market-determined price. We calculate marginal cost, the cost per additional unit sold, by dividing the change in total cost by the change in quantity. The formula for marginal cost is:
$marginal cost = change in total cost change in quantity marginal cost = change in total cost change in quantity$
Ordinarily, marginal cost changes as the firm produces a greater quantity.
In the raspberry farm example, in Figure 8.3 and Table 8.3, marginal cost at first declines as production increases from 10 to 20 to 30 to 40 packs of raspberries—which represents the area of increasing marginal returns that is not uncommon at low levels of production. At some point, though, marginal costs start to increase, displaying the typical pattern of diminishing marginal returns. If the firm is producing at a quantity where MR > MC, like 40 or 50 packs of raspberries, then it can increase profit by increasing output because the marginal revenue is exceeding the marginal cost. If the firm is producing at a quantity where MC > MR, like 90 or 100 packs, then it can increase profit by reducing output because the reductions in marginal cost will exceed the reductions in marginal revenue. The firm’s profit-maximizing choice of output will occur where MR = MC (or at a choice close to that point).
Figure 8.3 Marginal Revenues and Marginal Costs at the Raspberry Farm: Individual Farmer For a perfectly competitive firm, the marginal revenue (MR) curve is a horizontal line because it is equal to the price of the good, which is determined by the market, as Figure 8.4 illustrates. The marginal cost (MC) curve is sometimes initially downward-sloping, if there is a region of increasing marginal returns at low levels of output, but is eventually upward-sloping at higher levels of output as diminishing marginal returns kick in.
Figure 8.4 Supply, Demand, and Equilibrium Price in the Market for Raspberries The equilibrium price of raspberries is determined through the interaction of market supply and market demand at \$4.00.
Quantity Total Cost Marginal Cost Total Revenue Marginal Revenue Profit
0 \$62 - \$0 \$4 -\$62
10 \$90 \$2.80 \$40 \$4 -\$50
20 \$110 \$2.00 \$80 \$4 -\$30
30 \$126 \$1.60 \$120 \$4 -\$6
40 \$138 \$1.20 \$160 \$4 \$22
50 \$150 \$1.20 \$200 \$4 \$50
60 \$165 \$1.50 \$240 \$4 \$75
70 \$190 \$2.50 \$280 \$4 \$90
80 \$230 \$4.00 \$320 \$4 \$90
90 \$296 \$6.60 \$360 \$4 \$64
100 \$400 \$10.40 \$400 \$4 \$0
110 \$550 \$15.00 \$440 \$4 -\$110
120 \$715 \$16.50 \$480 \$4 -\$235
Table 8.3 Marginal Revenues and Marginal Costs at the Raspberry Farm
In this example, the marginal revenue and marginal cost curves cross at a price of \$4 and a quantity of 80 produced. If the farmer started out producing at a level of 60, and then experimented with increasing production to 70, marginal revenues from the increase in production would exceed marginal costs—and so profits would rise. The farmer has an incentive to keep producing. At a level of output of 80, marginal cost and marginal revenue are equal so profit doesn’t change. If the farmer then experimented further with increasing production from 80 to 90, he would find that marginal costs from the increase in production are greater than marginal revenues, and so profits would decline.
The profit-maximizing choice for a perfectly competitive firm will occur at the level of output where marginal revenue is equal to marginal cost—that is, where MR = MC. This occurs at Q = 80 in the figure.
Work It Out
Does Profit Maximization Occur at a Range of Output or a Specific Level of Output?
Table 8.1 shows that maximum profit occurs at any output level between 70 and 80 units of output. But MR = MC occurs only at 80 units of output. How can we explain this slight discrepancy? As long as MR > MC, a profit-seeking firm should keep expanding production. Expanding production into the zone where MR < MC reduces economic profits. It’s true that profit is the same at Q = 70 and Q = 80, but it’s only when the firm goes beyond that Q that it will see that profits fall. Thus, MR = MC is the signal to stop expanding, so that is the level of output they should target.
Because the marginal revenue received by a perfectly competitive firm is equal to the price P, we can also write the profit-maximizing rule for a perfectly competitive firm as a recommendation to produce at the quantity of output where P = MC.
Profits and Losses with the Average Cost Curve
Does maximizing profit (producing where MR = MC) imply an actual economic profit? The answer depends on the relationship between price and average total cost, which is the average profit or profit margin. If the market price is higher than the firm's average cost of production for that quantity produced, then the profit margin is positive and the firm will earn profits. Conversely, if the market price is lower than the average cost of production, the profit margin is negative and the firm will suffer losses. You might think that, in this situation, the firm may want to shut down immediately. Remember, however, that the firm has already paid for fixed costs, such as equipment, so it may continue to produce for a while and incur a loss. Table 8.3 continues the raspberry farm example. Figure 8.5 illustrates the three possible scenarios: (a) where price intersects marginal cost at a level above the average cost curve, (b) where price intersects marginal cost at a level equal to the average cost curve, and (c) where price intersects marginal cost at a level below the average cost curve.
Figure 8.5 Price and Average Cost at the Raspberry Farm In (a), price intersects marginal cost above the average cost curve. Since price is greater than average cost, the firm is making a profit. In (b), price intersects marginal cost at the minimum point of the average cost curve. Since price is equal to average cost, the firm is breaking even. In (c), price intersects marginal cost below the average cost curve. Since price is less than average cost, the firm is making a loss.
First consider a situation where the price is equal to \$5 for a pack of frozen raspberries. The rule for a profit-maximizing perfectly competitive firm is to produce the level of output where Price= MR = MC, so the raspberry farmer will produce a quantity of approximately 85, which is labeled as E' in Figure 8.5 (a). Remember that the area of a rectangle is equal to its base multiplied by its height. The farm’s total revenue at this price will be shown by the rectangle from the origin over to a quantity of 85 packs (the base) up to point E' (the height), over to the price of \$5, and back to the origin. The average cost of producing 80 packs is shown by point C or about \$3.50. Total costs will be the quantity of 85 times the average cost of \$3.50, which is shown by the area of the rectangle from the origin to a quantity of 90, up to point C, over to the vertical axis and down to the origin. The difference between total revenues and total costs is profits. Thus, profits will be the blue shaded rectangle on top.
We calculate this as:
$profit = total revenue−total cost = (85)(5.00)−(85)(3.50) =127.50 profit = total revenue−total cost = (85)(5.00)−(85)(3.50) =127.50$
Or, we can calculate it as:
$profit= (price–average cost) × quantity = (5.00–3.50) × 85 = 127.50 profit= (price–average cost) × quantity = (5.00–3.50) × 85 = 127.50$
Now consider Figure 8.5 (b), where the price has fallen to \$2.75 for a pack of frozen raspberries. Again, the perfectly competitive firm will choose the level of output where Price = MR = MC, but in this case, the quantity produced will be 75. At this price and output level, where the marginal cost curve is crossing the average cost curve, the price the firm receives is exactly equal to its average cost of production. We call this the break even point.
The farm’s total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 75 packs (the base) up to point E (the height), over to the price of \$2.75, and back to the origin. The height of the average cost curve at Q = 75, i.e. point E, shows the average cost of producing this quantity. Total costs will be the quantity of 75 times the average cost of \$2.75, which is shown by the area of the rectangle from the origin to a quantity of 75, up to point E, over to the vertical axis and down to the origin. It should be clear that the rectangles for total revenue and total cost are the same. Thus, the firm is making zero profit. The calculations are as follows:
$profit = total revenue–total cost = (75)(2.75)–(75)(2.75) = 0 profit = total revenue–total cost = (75)(2.75)–(75)(2.75) = 0$
Or, we can calculate it as:
$profit = (price–average cost)×quantity = (2.75–2.75)×75 = 0 profit = (price–average cost)×quantity = (2.75–2.75)×75 = 0$
In Figure 8.5 (c), the market price has fallen still further to \$2.00 for a pack of frozen raspberries. At this price, marginal revenue intersects marginal cost at a quantity of 65. The farm’s total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 65 packs (the base) up to point E” (the height), over to the price of \$2, and back to the origin. The average cost of producing 65 packs is shown by Point C” or shows the average cost of producing 50 packs is about \$2.73. Total costs will be the quantity of 65 times the average cost of \$2.73, which the area of the rectangle from the origin to a quantity of 50, up to point C”, over to the vertical axis and down to the origin shows. It should be clear from examining the two rectangles that total revenue is less than total cost. Thus, the firm is losing money and the loss (or negative profit) will be the rose-shaded rectangle.
The calculations are:
$profit= (total revenue– total cost) = (65)(2.00)–(65)(2.73) = –47.45 profit= (total revenue– total cost) = (65)(2.00)–(65)(2.73) = –47.45$
Or:
$profit = (price–average cost) × quantity = (2.00–2.73) × 65 = –47.45 profit = (price–average cost) × quantity = (2.00–2.73) × 65 = –47.45$
If the market price that perfectly competitive firm receives leads it to produce at a quantity where the price is greater than average cost, the firm will earn profits. If the price the firm receives causes it to produce at a quantity where price equals average cost, which occurs at the minimum point of the AC curve, then the firm earns zero profits. Finally, if the price the firm receives leads it to produce at a quantity where the price is less than average cost, the firm will earn losses. Table 8.4 summarizes this.
If... Then...
Price > ATC Firm earns an economic profit
Price = ATC Firm earns zero economic profit
Price < ATC Firm earns a loss
Table 8.4
Clear It Up
Which intersection should a firm choose?
At a price of \$2, MR intersects MC at two points: Q = 20 and Q = 65. It never makes sense for a firm to choose a level of output on the downward sloping part of the MC curve, because the profit is lower (the loss is bigger). Thus, the correct choice of output is Q = 65.
The Shutdown Point
The possibility that a firm may earn losses raises a question: Why can the firm not avoid losses by shutting down and not producing at all? The answer is that shutting down can reduce variable costs to zero, but in the short run, the firm has already paid for fixed costs. As a result, if the firm produces a quantity of zero, it would still make losses because it would still need to pay for its fixed costs. Therefore when a firm is experiencing losses, it must face a question: should it continue producing or should it shut down?
As an example, consider the situation of the Yoga Center, which has signed a contract to rent space that costs \$10,000 per month. If the firm decides to operate, its marginal costs for hiring yoga teachers is \$15,000 for the month. If the firm shuts down, it must still pay the rent, but it would not need to hire labor. Table 8.5 shows three possible scenarios. In the first scenario, the Yoga Center does not have any clients, and therefore does not make any revenues, in which case it faces losses of \$10,000 equal to the fixed costs. In the second scenario, the Yoga Center has clients that earn the center revenues of \$10,000 for the month, but ultimately experiences losses of \$15,000 due to having to hire yoga instructors to cover the classes. In the third scenario, the Yoga Center earns revenues of \$20,000 for the month, but experiences losses of \$5,000.
In all three cases, the Yoga Center loses money. In all three cases, when the rental contract expires in the long run, assuming revenues do not improve, the firm should exit this business. In the short run, though, the decision varies depending on the level of losses and whether the firm can cover its variable costs. In scenario 1, the center does not have any revenues, so hiring yoga teachers would increase variable costs and losses, so it should shut down and only incur its fixed costs. In scenario 2, the center’s losses are greater because it does not make enough revenue to offset the increased variable costs, so it should shut down immediately and only incur its fixed costs. If price is below the minimum average variable cost, the firm must shut down. In contrast, in scenario 3 the revenue that the center can earn is high enough that the losses diminish when it remains open, so the center should remain open in the short run.
Scenario 1
If the center shuts down now, revenues are zero but it will not incur any variable costs and would only need to pay fixed costs of \$10,000.
$profit = total revenue–(fixed costs + variable cost) = 0 –10,000 = –10,000 profit = total revenue–(fixed costs + variable cost) = 0 –10,000 = –10,000$
Scenario 2
The center earns revenues of \$10,000, and variable costs are \$15,000. The center should shut down now.
$profit = total revenue – (fixed costs + variable cost) = 10,000 – (10,000 + 15,000) = –15,000 profit = total revenue – (fixed costs + variable cost) = 10,000 – (10,000 + 15,000) = –15,000$
Scenario 3
The center earns revenues of \$20,000, and variable costs are \$15,000. The center should continue in business.
$profit = total revenue – (fixed costs + variable cost) = 20,000 – (10,000 + 15,000) = –5,000 profit = total revenue – (fixed costs + variable cost) = 20,000 – (10,000 + 15,000) = –5,000$
Table 8.5 Should the Yoga Center Shut Down Now or Later?
Figure 8.6 illustrates the lesson that remaining open requires the price to exceed the firm’s average variable cost. When the firm is operating below the break-even point, where price equals average cost, it is operating at a loss so it faces two options: continue to produce and lose money or shutdown. Which option is preferable? The one that loses the least money is the best choice.
At a price of \$2.00 per pack, as Figure 8.6 (a) illustrates, if the farm stays in operation it will produce at a level of 65 packs of raspberries, and it will make losses of \$47.45 (as explained earlier). The alternative would be to shut down and lose all the fixed costs of \$62.00. Since losing \$47.45 is preferable to losing \$62.00, the profit maximizing (or in this case the loss minimizing) choice is to stay in operation. The key reason is because price is above average variable cost. This means that at the current price the farm can pay all its variable costs, and have some revenue left over to pay some of the fixed costs. So the loss represents the part of the fixed costs the farm can’t pay, which is less than the entire fixed costs. However, if the price declined to \$1.50 per pack, as Figure 8.6 (b) shows, and if the firm applied its rule of producing where P = MR = MC, it would produce a quantity of 60. This price is below average variable cost for this level of output. If the farmer cannot pay workers (the variable costs), then it has to shut down. At this price and output, total revenues would be \$90 (quantity of 60 times price of \$1.50) and total cost would be \$165, for overall losses of \$75. If the farm shuts down, it must pay only its fixed costs of \$62, so shutting down is preferable to selling at a price of \$1.50 per pack.
Figure 8.6 The Shutdown Point for the Raspberry Farm In (a), the farm produces at a level of 65. It is making losses of \$47.50, but price is above average variable cost, so it continues to operate. In (b), total revenues are \$90 and total cost is \$165, for overall losses of \$75. If the farm shuts down, it must pay only its fixed costs of \$62. Shutting down is preferable to selling at a price of \$1.50 per pack.
Looking at Table 8.6, if the price falls below about \$1.72, the minimum average variable cost, the firm must shut down.
Quantity
Q
Average Variable Cost
AVC
Average Cost
AC
Marginal Cost
MC
0 - - -
10 \$2.80 \$9.00 \$2.80
20 \$2.40 \$5.50 \$2.00
30 \$2.13 \$4.20 \$1.60
40 \$1.90 \$3.45 \$1.20
50 \$1.76 \$3.00 \$1.20
60 \$1.72 \$2.75 \$1.50
70 \$1.83 \$2.71 \$2.50
80 \$2.10 \$2.88 \$4.00
90 \$2.60 \$3.29 \$6.60
100 \$3.38 \$4.00 \$10.40
110 \$4.44 \$5.00 \$15.00
120 \$5.44 \$5.96 \$31.50
Table 8.6 Cost of Production for the Raspberry Farm
The intersection of the average variable cost curve and the marginal cost curve, which shows the price below which the firm would lack enough revenue to cover its variable costs, is called the shutdown point. If the perfectly competitive firm faces a market price above the shutdown point, then the firm is at least covering its average variable costs. At a price above the shutdown point, the firm is also making enough revenue to cover at least a portion of fixed costs, so it should limp ahead even if it is making losses in the short run, since at least those losses will be smaller than if the firm shuts down immediately and incurs a loss equal to total fixed costs. However, if the firm is receiving a price below the price at the shutdown point, then the firm is not even covering its variable costs. In this case, staying open is making the firm’s losses larger, and it should shut down immediately. To summarize, if:
• price < minimum average variable cost, then firm shuts down
• price > minimum average variable cost, then firm stays in business
Short-Run Outcomes for Perfectly Competitive Firms
The average cost and average variable cost curves divide the marginal cost curve into three segments, as Figure 8.7 shows. At the market price, which the perfectly competitive firm accepts as given, the profit-maximizing firm chooses the output level where price or marginal revenue, which are the same thing for a perfectly competitive firm, is equal to marginal cost: P = MR = MC.
Figure 8.7 Profit, Loss, Shutdown We can divide the marginal cost curve into three zones, based on where it is crossed by the average cost and average variable cost curves. We call the point where MC crosses AC the break even point. If the firm is operating where the market price is at a level higher than the break even point, then price will be greater than average cost and the firm is earning profits. If the price is exactly at the break even point, then the firm is making zero profits. If price falls in the zone between the shutdown point and the break even point, then the firm is making losses but will continue to operate in the short run, since it is covering its variable costs, and more if price is above the shutdown-point price. However, if price falls below the price at the shutdown point, then the firm will shut down immediately, since it is not even covering its variable costs.
First consider the upper zone, where prices are above the level where marginal cost (MC) crosses average cost (AC) at the zero profit point. At any price above that level, the firm will earn profits in the short run. If the price falls exactly on the break even point where the MC and AC curves cross, then the firm earns zero profits. If a price falls into the zone between the break even point, where MC crosses AC, and the shutdown point, where MC crosses AVC, the firm will be making losses in the short run—but since the firm is more than covering its variable costs, the losses are smaller than if the firm shut down immediately. Finally, consider a price at or below the shutdown point where MC crosses AVC. At any price like this one, the firm will shut down immediately, because it cannot even cover its variable costs.
Marginal Cost and the Firm’s Supply Curve
For a perfectly competitive firm, the marginal cost curve is identical to the firm’s supply curve starting from the minimum point on the average variable cost curve. To understand why this perhaps surprising insight holds true, first think about what the supply curve means. A firm checks the market price and then looks at its supply curve to decide what quantity to produce. Now, think about what it means to say that a firm will maximize its profits by producing at the quantity where P = MC. This rule means that the firm checks the market price, and then looks at its marginal cost to determine the quantity to produce—and makes sure that the price is greater than the minimum average variable cost. In other words, the marginal cost curve above the minimum point on the average variable cost curve becomes the firm’s supply curve.
Link It Up
Watch this video that addresses how drought in the United States can impact food prices across the world.
As we discussed in the chapter on Demand and Supply, many of the reasons that supply curves shift relate to underlying changes in costs. For example, a lower price of key inputs or new technologies that reduce production costs cause supply to shift to the right. In contrast, bad weather or added government regulations can add to costs of certain goods in a way that causes supply to shift to the left. We can also interpret these shifts in the firm’s supply curve as shifts of the marginal cost curve. A shift in costs of production that increases marginal costs at all levels of output—and shifts MC upward and to the left—will cause a perfectly competitive firm to produce less at any given market price. Conversely, a shift in costs of production that decreases marginal costs at all levels of output will shift MC downward and to the right and as a result, a competitive firm will choose to expand its level of output at any given price. The following Work It Out feature will walk you through an example.
Work It Out
At What Price Should the Firm Continue Producing in the Short Run?
To determine the short-run economic condition of a firm in perfect competition, follow the steps outlined below. Use the data in Table 8.7.
Q P TFC TVC TC AVC ATC MC TR Profits
0 \$28 \$20 \$0 - - - - - -
1 \$28 \$20 \$20 - - - - - -
2 \$28 \$20 \$25 - - - - - -
3 \$28 \$20 \$35 - - - - - -
4 \$28 \$20 \$52 - - - - - -
5 \$28 \$20 \$80 - - - - - -
Table 8.7
Step 1. Determine the cost structure for the firm. For a given total fixed costs and variable costs, calculate total cost, average variable cost, average total cost, and marginal cost. Follow the formulas given in the Production, Costs, and Industry Structure chapter. These calculations are in Table 8.8.
Q P TFC TVC TC
(TFC+TVC)
AVC
(TVC/Q)
ATC
(TC/Q)
MC
(TC2−TC1)/
(Q2−Q1)
0 \$28 \$20 \$0 \$20+\$0=\$20 - - -
1 \$28 \$20 \$20 \$20+\$20=\$40 \$20/1=\$20.00 \$40/1=\$40.00 (\$40−\$20)/
(1−0)= \$20
2 \$28 \$20 \$25 \$20+\$25=\$45 \$25/2=\$12.50 \$45/2=\$22.50 (\$45−\$40)/
(2−1)= \$5
3 \$28 \$20 \$35 \$20+\$35=\$55 \$35/3=\$11.67 \$55/3=\$18.33 (\$55−\$45)/
(3−2)= \$10
4 \$28 \$20 \$52 \$20+\$52=\$72 \$52/4=\$13.00 \$72/4=\$18.00 (\$72−\$55)/
(4−3)= \$17
5 \$28 \$20 \$80 \$20+\$80=\$100 \$80/5=\$16.00 \$100/5=\$20.00 (\$100−\$72)/
(5−4)= \$28
Table 8.8
Step 2. Determine the market price that the firm receives for its product. Since the firm in perfect competition is a price taker, the market price is constant. With the given price, calculate total revenue as equal to price multiplied by quantity for all output levels produced. In this example, the given price is \$28. You can see that in the second column of Table 8.9.
Quantity Price Total Revenue (P × Q)
0 \$28 \$28×0=\$0
1 \$28 \$28×1=\$28
2 \$28 \$28×2=\$56
3 \$28 \$28×3=\$84
4 \$28 \$28×4=\$112
5 \$28 \$28×5=\$140
Table 8.9
Step 3. Calculate profits as total cost subtracted from total revenue, as Table 8.10 shows.
Quantity Total Revenue Total Cost Profits (TR−TC)
0 \$0 \$20 \$0−\$20=−\$20
1 \$28 \$40 \$28−\$40=−\$12
2 \$56 \$45 \$56−\$45=\$11
3 \$84 \$55 \$84−\$55=\$29
4 \$112 \$72 \$112−\$72=\$40
5 \$140 \$100 \$140−\$100=\$40
Table 8.10
Step 4. To find the profit-maximizing output level, look at the Marginal Cost column (at every output level produced), as Table 8.11 shows, and determine where it is equal to the market price. The output level where price equals the marginal cost is the output level that maximizes profits.
Q P TFC TVC TC AVC ATC MC TR Profits
0 \$28 \$20 \$0 \$20 - - - \$0 −\$20
1 \$28 \$20 \$20 \$40 \$20.00 \$40.00 \$20 \$28 −\$12
2 \$28 \$20 \$25 \$45 \$12.50 \$22.50 \$5 \$56 \$11
3 \$28 \$20 \$35 \$55 \$11.67 \$18.33 \$10 \$84 \$29
4 \$28 \$20 \$52 \$72 \$13.00 \$18.00 \$17 \$112 \$40
5 \$28 \$20 \$80 \$100 \$16.40 \$20.40 \$28 \$140 \$40
Table 8.11
Step 5. Once you have determined the profit-maximizing output level (in this case, output quantity 5), you can look at the amount of profits made (in this case, \$40).
Step 6. If the firm is making economic losses, the firm needs to determine whether it produces the output level where price equals marginal revenue and equals marginal cost or it shuts down and only incurs its fixed costs.
Step 7. For the output level where marginal revenue is equal to marginal cost, check if the market price is greater than the average variable cost of producing that output level.
• If P > AVC but P < ATC, then the firm continues to produce in the short-run, making economic losses.
• If P < AVC, then the firm stops producing and only incurs its fixed costs.
In this example, the price of \$28 is greater than the AVC (\$16.40) of producing 5 units of output, so the firm continues producing. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/08%3A_Perfect_Competition/8.03%3A_How_Perfectly_Competitive_Firms_Make_Output_Decisions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how entry and exit lead to zero profits in the long run
• Discuss the long-run adjustment process
It is impossible to precisely define the line between the short run and the long run with a stopwatch, or even with a calendar. It varies according to the specific business. Therefore, the distinction between the short run and the long run is more technical: in the short run, firms cannot change the usage of fixed inputs, while in the long run, the firm can adjust all factors of production.
In a competitive market, profits are a red cape that incites businesses to charge. If a business is making a profit in the short run, it has an incentive to expand existing factories or to build new ones. New firms may start production, as well. When new firms enter the industry in response to increased industry profits it is called entry.
Losses are the black thundercloud that causes businesses to flee. If a business is making losses in the short run, it will either keep limping along or just shut down, depending on whether its revenues are covering its variable costs. But in the long run, firms that are facing losses will cease production altogether. The long-run process of reducing production in response to a sustained pattern of losses is called exit. The following Clear It Up feature discusses where some of these losses might come from, and the reasons why some firms go out of business.
Clear It Up
Why do firms cease to exist?
Can we say anything about what causes a firm to exit an industry? Profits are the measurement that determines whether a business stays operating or not. Individuals start businesses with the purpose of making profits. They invest their money, time, effort, and many other resources to produce and sell something that they hope will give them something in return. Unfortunately, not all businesses are successful, and many new startups soon realize that their “business venture” must eventually end.
In the model of perfectly competitive firms, those that consistently cannot make money will “exit,” which is a nice, bloodless word for a more painful process. When a business fails, after all, workers lose their jobs, investors lose their money, and owners and managers can lose their dreams. Many businesses fail. The U.S. Small Business Administration indicates that in 2011, 534,907 new firms "entered," and 575,691 firms failed.
Sometimes a business fails because of poor management or workers who are not very productive, or because of tough domestic or foreign competition. Businesses also fail from a variety of causes. For example, conditions of demand and supply in the market may shift in an unexpected way, so that the prices that a business charges for outputs fall or the prices for inputs rise. With millions of businesses in the U.S. economy, even a small fraction of them failing will affect many people—and business failures can be very hard on the workers and managers directly involved. However, from the standpoint of the overall economic system, business exits are sometimes a necessary evil if a market-oriented system is going to offer a flexible mechanism for satisfying customers, keeping costs low, and inventing new products.
How Entry and Exit Lead to Zero Profits in the Long Run
No perfectly competitive firm acting alone can affect the market price. However, the combination of many firms entering or exiting the market will affect overall supply in the market. In turn, a shift in supply for the market as a whole will affect the market price. Entry and exit to and from the market are the driving forces behind a process that, in the long run, pushes the price down to minimum average total costs so that all firms are earning a zero profit.
To understand how short-run profits for a perfectly competitive firm will evaporate in the long run, imagine the following situation. The market is in long-run equilibrium, where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC. No firm has the incentive to enter or leave the market. Let’s say that the product’s demand increases, and with that, the market price goes up. The existing firms in the industry are now facing a higher price than before, so they will increase production to the new output level where P = MR = MC.
This will temporarily make the market price rise above the minimum point on the average cost curve, and therefore, the existing firms in the market will now be earning economic profits. However, these economic profits attract other firms to enter the market. Entry of many new firms causes the market supply curve to shift to the right. As the supply curve shifts to the right, the market price starts decreasing, and with that, economic profits fall for new and existing firms. As long as there are still profits in the market, entry will continue to shift supply to the right. This will stop whenever the market price is driven down to the zero-profit level, where no firm is earning economic profits.
Short-run losses will fade away by reversing this process. Say that the market is in long-run equilibrium. This time, instead, demand decreases, and with that, the market price starts falling. The existing firms in the industry are now facing a lower price than before, and as it will be below the average cost curve, they will now be making economic losses. Some firms will continue producing where the new P = MR = MC, as long as they are able to cover their average variable costs. Some firms will have to shut down immediately as they will not be able to cover their average variable costs, and will then only incur their fixed costs, minimizing their losses. Exit of many firms causes the market supply curve to shift to the left. As the supply curve shifts to the left, the market price starts rising, and economic losses start to be lower. This process ends whenever the market price rises to the zero-profit level, where the existing firms are no longer losing money and are at zero profits again. Thus, while a perfectly competitive firm can earn profits in the short run, in the long run the process of entry will push down prices until they reach the zero-profit level. Conversely, while a perfectly competitive firm may earn losses in the short run, firms will not continually lose money. In the long run, firms making losses are able to escape from their fixed costs, and their exit from the market will push the price back up to the zero-profit level. In the long run, this process of entry and exit will drive the price in perfectly competitive markets to the zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost.
The Long-Run Adjustment and Industry Types
Whenever there are expansions in an industry, costs of production for the existing and new firms could either stay the same, increase, or even decrease. Therefore, we can categorize an industry as being (1) a constant-cost industry (as demand increases, the cost of production for firms stays the same), (2) an increasing cost industry (as demand increases, the cost of production for firms increases), or (3) a decreasing cost industry (as demand increases the costs of production for the firms decreases).
For a constant-cost industry, whenever there is an increase in market demand and price, then the supply curve shifts to the right with new firms’ entry and stops at the point where the new long-run equilibrium intersects at the same market price as before. This is the case of constant returns to scale, which we discussed earlier in the chapter on Production, Costs, and Industry Structure. However, why will costs remain the same? In this type of industry, the supply curve is very elastic. Firms can easily supply any quantity that consumers demand. In addition, there is a perfectly elastic supply of inputs—firms can easily increase their demand for employees, for example, with no increase to wages. Tying in to our Bring it Home discussion, an increased demand for ethanol in recent years has caused the demand for corn to increase. Consequently, many farmers switched from growing wheat to growing corn. Agricultural markets are generally good examples of constant-cost industries.
For an increasing cost industry, as the market expands, the old and new firms experience increases in their costs of production, which makes the new zero-profit level intersect at a higher price than before. Here companies may have to deal with limited inputs, such as skilled labor. As the demand for these workers rises, wages rise and this increases the cost of production for all firms. The industry supply curve in this type of industry is more inelastic.
For a decreasing cost industry, as the market expands, the old and new firms experience lower costs of production, which makes the new zero-profit level intersect at a lower price than before. In this case, the industry and all the firms in it are experiencing falling average total costs. This can be due to an improvement in technology in the entire industry or an increase in the education of employees. High-tech industries may be a good example of a decreasing cost market.
Figure 8.8 (a) presents the case of an adjustment process in a constant-cost industry. Whenever there are output expansions in this type of industry, the long-run outcome implies more output produced at exactly the same original price. Note that supply was able to increase to meet the increased demand. When we join the before and after long-run equilibriums, the resulting line is the long run supply (LRS) curve in perfectly competitive markets. In this case, it is a flat curve. Figure 8.8 (b) and Figure 8.8 (c) present the cases for an increasing cost and decreasing cost industry, respectively. For an increasing cost industry, the LRS is upward sloping, while for a decreasing cost industry, the LRS is downward sloping.
Figure 8.8 Adjustment Process in a Constant-Cost Industry In (a), demand increased and supply met it. Notice that the supply increase is equal to the demand increase. The result is that the equilibrium price stays the same as quantity sold increases. In (b), notice that sellers were not able to increase supply as much as demand. Some inputs were scarce, or wages were rising. The equilibrium price rises. In (c), sellers easily increased supply in response to the demand increase. Here, new technology or economies of scale caused the large increase in supply, resulting in declining equilibrium price. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/08%3A_Perfect_Competition/8.04%3A_Entry_and_Exit_Decisions_in_the_Long_Run.txt |
Learning Objectives
By the end of this section, you will be able to:
• Apply concepts of productive efficiency and allocative efficiency to perfectly competitive markets
• Compare the model of perfect competition to real-world markets
When profit-maximizing firms in perfectly competitive markets combine with utility-maximizing consumers, something remarkable happens: the resulting quantities of outputs of goods and services demonstrate both productive and allocative efficiency (terms that we first introduced in (Choice in a World of Scarcity) .
Productive efficiency means producing without waste, so that the choice is on the production possibility frontier. In the long run in a perfectly competitive market, because of the process of entry and exit, the price in the market is equal to the minimum of the long-run average cost curve. In other words, firms produce and sell goods at the lowest possible average cost.
Allocative efficiency means that among the points on the production possibility frontier, the chosen point is socially preferred—at least in a particular and specific sense. In a perfectly competitive market, price will be equal to the marginal cost of production. Think about the price that one pays for a good as a measure of the social benefit one receives for that good; after all, willingness to pay conveys what the good is worth to a buyer. Then think about the marginal cost of producing the good as representing not just the cost for the firm, but more broadly as the social cost of producing that good. When perfectly competitive firms follow the rule that profits are maximized by producing at the quantity where price is equal to marginal cost, they are thus ensuring that the social benefits they receive from producing a good are in line with the social costs of production.
To explore what economists mean by allocative efficiency, it is useful to walk through an example. Begin by assuming that the market for wholesale flowers is perfectly competitive, and so P = MC. Now, consider what it would mean if firms in that market produced a lesser quantity of flowers. At a lesser quantity, marginal costs will not yet have increased as much, so that price will exceed marginal cost; that is, P > MC. In that situation, the benefit to society as a whole of producing additional goods, as measured by the willingness of consumers to pay for marginal units of a good, would be higher than the cost of the inputs of labor and physical capital needed to produce the marginal good. In other words, the gains to society as a whole from producing additional marginal units will be greater than the costs.
Conversely, consider what it would mean if, compared to the level of output at the allocatively efficient choice when P = MC, firms produced a greater quantity of flowers. At a greater quantity, marginal costs of production will have increased so that P < MC. In that case, the marginal costs of producing additional flowers is greater than the benefit to society as measured by what people are willing to pay. For society as a whole, since the costs are outstripping the benefits, it will make sense to produce a lower quantity of such goods.
When perfectly competitive firms maximize their profits by producing the quantity where P = MC, they also assure that the benefits to consumers of what they are buying, as measured by the price they are willing to pay, is equal to the costs to society of producing the marginal units, as measured by the marginal costs the firm must pay—and thus that allocative efficiency holds.
We should view the statements that a perfectly competitive market in the long run will feature both productive and allocative efficiency with a degree of skepticism about its truth. Remember, economists are using the concept of “efficiency” in a particular and specific sense, not as a synonym for “desirable in every way.” For one thing, consumers’ ability to pay reflects the income distribution in a particular society. For example, a person with a low income may not be able to purchase their own car because they have insufficient income.
Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as monopoly, monopolistic competition, and oligopoly, which are more frequently observed in the real world than perfect competition, firms will not always produce at the minimum of average cost, nor will they always set price equal to marginal cost. Thus, these other competitive situations will not produce productive and allocative efficiency.
Moreover, real-world markets include many issues that are assumed away in the model of perfect competition, including pollution, inventions of new technology, poverty which may make some people unable to pay for basic necessities of life, government programs like national defense or education, discrimination in labor markets, and buyers and sellers who must deal with imperfect and unclear information. We explore these issues in other chapters. However, the theoretical efficiency of perfect competition does provide a useful benchmark for comparing the issues that arise from these real-world problems.
Bring It Home
A Dime a Dozen
A quick glance at Table 8.12 reveals the dramatic increase in North Dakota corn production—almost a tenfold increase since 1972. Recent allocation of land to corn (as of mid-2019) is estimated to have increased to more than 4 million acres. Taking into consideration that corn typically yields two to three times as many bushels per acre as wheat, it is obvious there has been a significant increase in bushels of corn. Why the increase in corn acreage? Converging prices.
Year Corn (millions of acres)
1972 495,000
2013 3,850,000
Table 8.12 (Source: USDA National Agricultural Statistics Service)
Historically, wheat prices have been higher than corn prices, offsetting wheat’s lower yield per acre. However, in recent years wheat and corn prices have been converging. In April 2013, Agweek reported the gap was just 71 cents per bushel. As the difference in price narrowed, switching to the production of higher yield per acre of corn simply made good business sense. Erik Younggren, president of the National Association of Wheat Growers said in the Agweek article, “I don't think we're going to see mile after mile of waving amber fields [of wheat] anymore." (Until wheat prices rise, we will probably be seeing field after field of tasseled corn.)
8.06: Key Terms
break even point
level of output where the marginal cost curve intersects the average cost curve at the minimum point of AC; if the price is at this point, the firm is earning zero economic profits
entry
the long-run process of firms entering an industry in response to industry profits
exit
the long-run process of firms reducing production and shutting down in response to industry losses
long-run equilibrium
where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC
marginal revenue
the additional revenue gained from selling one more unit
market structure
the conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold
perfect competition
each firm faces many competitors that sell identical products
price taker
a firm in a perfectly competitive market that must take the prevailing market price as given
shutdown point
level of output where the marginal cost curve intersects the average variable cost curve at the minimum point of AVC; if the price is below this point, the firm should shut down immediately | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/08%3A_Perfect_Competition/8.05%3A_Efficiency_in_Perfectly_Competitive_Markets.txt |
8.1 Perfect Competition and Why It Matters
A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales. In a perfectly competitive market there are thousands of sellers, easy entry, and identical products. A short-run production period is when firms are producing with some fixed inputs. Long-run equilibrium in a perfectly competitive industry occurs after all firms have entered and exited the industry and seller profits are driven to zero.
Perfect competition means that there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.
8.2 How Perfectly Competitive Firms Make Output Decisions
As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases at a constant rate determined by the given market price. Profits will be highest (or losses will be smallest) at the quantity of output where total revenues exceed total costs by the greatest amount (or where total revenues fall short of total costs by the smallest amount). Alternatively, profits will be highest where marginal revenue, which is price for a perfectly competitive firm, is equal to marginal cost. If the market price faced by a perfectly competitive firm is above average cost at the profit-maximizing quantity of output, then the firm is making profits. If the market price is below average cost at the profit-maximizing quantity of output, then the firm is making losses.
If the market price is equal to average cost at the profit-maximizing level of output, then the firm is making zero profits. We call the point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve, the “zero profit point.” If the market price that a perfectly competitive firm faces is below average variable cost at the profit-maximizing quantity of output, then the firm should shut down operations immediately. If the market price that a perfectly competitive firm faces is above average variable cost, but below average cost, then the firm should continue producing in the short run, but exit in the long run. We call the point where the marginal cost curve crosses the average variable cost curve the shutdown point.
8.3 Entry and Exit Decisions in the Long Run
In the long run, firms will respond to profits through a process of entry, where existing firms expand output and new firms enter the market. Conversely, firms will react to losses in the long run through a process of exit, in which existing firms cease production altogether. Through the process of entry in response to profits and exit in response to losses, the price level in a perfectly competitive market will move toward the zero-profit point, where the marginal cost curve crosses the AC curve at the minimum of the average cost curve.
The long-run supply curve shows the long-run output supplied by firms in three different types of industries: constant cost, increasing cost, and decreasing cost.
8.4 Efficiency in Perfectly Competitive Markets
Long-run equilibrium in perfectly competitive markets meets two important conditions: allocative efficiency and productive efficiency. These two conditions have important implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society.
8.08: Self-Check Questions
1.
Firms in a perfectly competitive market are said to be “price takers”—that is, once the market determines an equilibrium price for the product, firms must accept this price. If you sell a product in a perfectly competitive market, but you are not happy with its price, would you raise the price, even by a cent?
2.
Would independent trucking fit the characteristics of a perfectly competitive industry?
3.
Look at Table 8.13. What would happen to the firm’s profits if the market price increases to \$6 per pack of raspberries?
Quantity Total Cost Fixed Cost Variable Cost Total Revenue Profit
0 \$62 \$62 - \$0 −\$62
10 \$90 \$62 \$28 \$60 −\$30
20 \$110 \$62 \$48 \$120 \$10
30 \$126 \$62 \$64 \$180 \$54
40 \$144 \$62 \$82 \$240 \$96
50 \$166 \$62 \$104 \$300 \$134
60 \$192 \$62 \$130 \$360 \$168
70 \$224 \$62 \$162 \$420 \$196
80 \$264 \$62 \$202 \$480 \$216
90 \$324 \$62 \$262 \$540 \$216
100 \$404 \$62 \$342 \$600 \$196
Table 8.13
4.
Suppose that the market price increases to \$6, as Table 8.14 shows. What would happen to the profit-maximizing output level?
Quantity Total Cost Fixed Cost Variable Cost Marginal Cost Total Revenue Marginal Revenue
0 \$62 \$62 - - \$0 -
10 \$90 \$62 \$28 \$2.80 \$60 \$6.00
20 \$110 \$62 \$48 \$2.00 \$120 \$6.00
30 \$126 \$62 \$64 \$1.60 \$180 \$6.00
40 \$144 \$62 \$82 \$1.80 \$240 \$6.00
50 \$166 \$62 \$104 \$2.20 \$300 \$6.00
60 \$192 \$62 \$130 \$2.60 \$360 \$6.00
70 \$224 \$62 \$162 \$3.20 \$420 \$6.00
80 \$264 \$62 \$202 \$4.00 \$480 \$6.00
90 \$324 \$62 \$262 \$6.00 \$540 \$6.00
100 \$404 \$62 \$342 \$8.00 \$600 \$6.00
Table 8.14
5.
Explain in words why a profit-maximizing firm will not choose to produce at a quantity where marginal cost exceeds marginal revenue.
6.
A firm’s marginal cost curve above the average variable cost curve is equal to the firm’s individual supply curve. This means that every time a firm receives a price from the market it will be willing to supply the amount of output where the price equals marginal cost. What happens to the firm’s individual supply curve if marginal costs increase?
7.
If new technology in a perfectly competitive market brings about a substantial reduction in costs of production, how will this affect the market?
8.
A market in perfect competition is in long-run equilibrium. What happens to the market if labor unions are able to increase wages for workers?
9.
Productive efficiency and allocative efficiency are two concepts achieved in the long run in a perfectly competitive market. These are the two reasons why we call them “perfect.” How would you use these two concepts to analyze other market structures and label them “imperfect?”
10.
Explain how the profit-maximizing rule of setting P = MC leads a perfectly competitive market to be allocatively efficient. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/08%3A_Perfect_Competition/8.07%3A_Key_Concepts_and_Summary.txt |
11.
A single firm in a perfectly competitive market is relatively small compared to the rest of the market. What does this mean? How “small” is “small”?
12.
What are the four basic assumptions of perfect competition? Explain in words what they imply for a perfectly competitive firm.
13.
What is a “price taker” firm?
14.
How does a perfectly competitive firm decide what price to charge?
15.
What prevents a perfectly competitive firm from seeking higher profits by increasing the price that it charges?
16.
How does a perfectly competitive firm calculate total revenue?
17.
Briefly explain the reason for the shape of a marginal revenue curve for a perfectly competitive firm.
18.
What two rules does a perfectly competitive firm apply to determine its profit-maximizing quantity of output?
19.
How does the average cost curve help to show whether a firm is making profits or losses?
20.
What two lines on a cost curve diagram intersect at the zero-profit point?
21.
Should a firm shut down immediately if it is making losses?
22.
How does the average variable cost curve help a firm know whether it should shut down immediately?
23.
What two lines on a cost curve diagram intersect at the shutdown point?
24.
Why does entry occur?
25.
Why does exit occur?
26.
Do entry and exit occur in the short run, the long run, both, or neither?
27.
What price will a perfectly competitive firm end up charging in the long run? Why?
28.
Will a perfectly competitive market display productive efficiency? Why or why not?
29.
Will a perfectly competitive market display allocative efficiency? Why or why not?
8.10: Critical Thinking Questions
30.
Finding a life partner is a complicated process that may take many years. It is hard to think of this process as being part of a very complex market, with a demand and a supply for partners. Think about how this market works and some of its characteristics, such as search costs. Would you consider it a perfectly competitive market?
31.
Can you name five examples of perfectly competitive markets? Why or why not?
32.
Your company operates in a perfectly competitive market. You have been told that advertising can help you increase your sales in the short run. Would you create an aggressive advertising campaign for your product?
33.
Since a perfectly competitive firm can sell as much as it wishes at the market price, why can the firm not simply increase its profits by selling an extremely high quantity?
34.
Many firms in the United States file for bankruptcy every year, yet they still continue operating. Why would they do this instead of completely shutting down?
35.
Why will profits for firms in a perfectly competitive industry tend to vanish in the long run?
36.
Why will losses for firms in a perfectly competitive industry tend to vanish in the long run?
37.
Assuming that the market for cigarettes is in perfect competition, what does allocative and productive efficiency imply in this case? What does it not imply?
38.
In the argument for why perfect competition is allocatively efficient, the price that people are willing to pay represents the gains to society and the marginal cost to the firm represents the costs to society. Can you think of some social costs or issues that are not included in the marginal cost to the firm? Or some social gains that are not included in what people pay for a good?
8.11: Problems
39.
The AAA Aquarium Co. sells aquariums for \$20 each. Fixed costs of production are \$20. The total variable costs are \$20 for one aquarium, \$25 for two units, \$35 for the three units, \$50 for four units, and \$80 for five units. In the form of a table, calculate total revenue, marginal revenue, total cost, and marginal cost for each output level (one to five units). What is the profit-maximizing quantity of output? On one diagram, sketch the total revenue and total cost curves. On another diagram, sketch the marginal revenue and marginal cost curves.
40.
Perfectly competitive firm Doggies Paradise Inc. sells winter coats for dogs. Dog coats sell for \$72 each. The fixed costs of production are \$100. The total variable costs are \$64 for one unit, \$84 for two units, \$114 for three units, \$184 for four units, and \$270 for five units. In the form of a table, calculate total revenue, marginal revenue, total cost and marginal cost for each output level (one to five units). On one diagram, sketch the total revenue and total cost curves. On another diagram, sketch the marginal revenue and marginal cost curves. What is the profit maximizing quantity?
41.
A computer company produces affordable, easy-to-use home computer systems and has fixed costs of \$250. The marginal cost of producing computers is \$700 for the first computer, \$250 for the second, \$300 for the third, \$350 for the fourth, \$400 for the fifth, \$450 for the sixth, and \$500 for the seventh.
1. Create a table that shows the company’s output, total cost, marginal cost, average cost, variable cost, and average variable cost.
2. At what price is the zero-profit point? At what price is the shutdown point?
3. If the company sells the computers for \$500, is it making a profit or a loss? How big is the profit or loss? Sketch a graph with AC, MC, and AVC curves to illustrate your answer and show the profit or loss.
4. If the firm sells the computers for \$300, is it making a profit or a loss? How big is the profit or loss? Sketch a graph with AC, MC, and AVC curves to illustrate your answer and show the profit or loss. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/08%3A_Perfect_Competition/8.09%3A_Review_Questions.txt |
Figure 9.1 Political Power from a Cotton Monopoly In the mid-nineteenth century, the United States, specifically the Southern states, had a near monopoly in the cotton that they supplied to Great Britain. These states attempted to leverage this economic power into political power—trying to sway Great Britain to formally recognize the Confederate States of America. (Credit: modification of "cotton!" by ashley/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• How Monopolies form: Barriers to Entry
• How a Profit-Maximizing Monopoly Chooses Output and Price
Bring It Home
The Rest is History
Many of the opening case studies have focused on current events. This one steps into the past to observe how monopoly, or near monopolies, have helped shape history. In spring 1773, the East India Company, a firm that, in its time, was designated “too big to fail,” was experiencing financial difficulties. To help shore up the failing firm, the British Parliament authorized the Tea Act. The act continued the tax on teas and made the East India Company the sole legal supplier of tea to the American colonies. By November, the citizens of Boston had had enough. They refused to permit the unloading of tea, citing their main complaint: “No taxation without representation.” Several newspapers, including The Massachusetts Gazette, warned arriving tea-bearing ships, “We are prepared, and shall not fail to pay them an unwelcome visit by The Mohawks.”
Step forward in time to 1860—the eve of the American Civil War—to another near monopoly supplier of historical significance: the U.S. cotton industry. At that time, the Southern states provided the majority of the cotton Britain imported. The South, wanting to secede from the Union, hoped to leverage Britain’s high dependency on its cotton into formal diplomatic recognition of the Confederate States of America.
This leads us to this chapter's topic: a firm that controls all (or nearly all) of the supply of a good or service—a monopoly. How do monopoly firms behave in the marketplace? Do they have “power?” Does this power potentially have unintended consequences? We’ll return to this case at the end of the chapter to see how the tea and cotton monopolies influenced U.S. history.
Many believe that top executives at firms are the strongest supporters of market competition, but this belief is far from the truth. Think about it this way: If you very much wanted to win an Olympic gold medal, would you rather be far better than everyone else, or locked in competition with many athletes just as good as you? Similarly, if you would like to attain a very high level of profits, would you rather manage a business with little or no competition, or struggle against many tough competitors who are trying to sell to your customers? By now, you might have read the chapter on Perfect Competition. In this chapter, we explore the opposite extreme: monopoly.
If perfect competition is a market where firms have no market power and they simply respond to the market price, monopoly is a market with no competition at all, and firms have a great deal of market power. In the case of monopoly, one firm produces all of the output in a market. Since a monopoly faces no significant competition, it can charge any price it wishes, subject to the demand curve. While a monopoly, by definition, refers to a single firm, in practice people often use the term to describe a market in which one firm merely has a very high market share. This tends to be the definition that the U.S. Department of Justice uses.
Even though there are very few true monopolies in existence, we do deal with some of those few every day, often without realizing it: The U.S. Postal Service, your electric, and garbage collection companies are a few examples. Some new drugs are produced by only one pharmaceutical firm—and no close substitutes for that drug may exist.
From the mid-1990s until 2004, the U.S. Department of Justice prosecuted the Microsoft Corporation for including Internet Explorer as the default web browser with its operating system. The Justice Department’s argument was that, since Microsoft possessed an extremely high market share in the industry for operating systems, the inclusion of a free web browser constituted unfair competition to other browsers, such as Netscape Navigator. Since nearly everyone was using Windows, including Internet Explorer eliminated the incentive for consumers to explore other browsers and made it impossible for competitors to gain a foothold in the market. In 2013, the Windows system ran on more than 90% of the most commonly sold personal computers. In 2015, a U.S. federal court tossed out antitrust charges that Google had an agreement with mobile device makers to set Google as the default search engine.
This chapter begins by describing how monopolies are protected from competition, including laws that prohibit competition, technological advantages, and certain configurations of demand and supply. It then discusses how a monopoly will choose its profit-maximizing quantity to produce and what price to charge. While a monopoly must be concerned about whether consumers will purchase its products or spend their money on something altogether different, the monopolist need not worry about the actions of other competing firms producing its products. As a result, a monopoly is not a price taker like a perfectly competitive firm, but instead exercises some power to choose its market price. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/09%3A_Monopoly/9.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Distinguish between a natural monopoly and a legal monopoly.
• Explain how economies of scale and the control of natural resources led to the necessary formation of legal monopolies
• Analyze the importance of trademarks and patents in promoting innovation
• Identify examples of predatory pricing
Because of the lack of competition, monopolies tend to earn significant economic profits. These profits should attract vigorous competition as we described in Perfect Competition, and yet, because of one particular characteristic of monopoly, they do not. Barriers to entry are the legal, technological, or market forces that discourage or prevent potential competitors from entering a market. Barriers to entry can range from the simple and easily surmountable, such as the cost of renting retail space, to the extremely restrictive. For example, there are a finite number of radio frequencies available for broadcasting. Once an entrepreneur or firm has purchased the rights to all of them, no new competitors can enter the market.
In some cases, barriers to entry may lead to monopoly. In other cases, they may limit competition to a few firms. Barriers may block entry even if the firm or firms currently in the market are earning profits. Thus, in markets with significant barriers to entry, it is not necessarily true that abnormally high profits will attract new firms, and that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a normal level of profit in the long run.
There are five types of monopoly, based on the types of barriers to entry they exploit.
Natural Monopoly
Economies of scale can combine with the size of the market to limit competition. (We introduced this theme in Production, Cost and Industry Structure). Figure 9.2 presents a long-run average cost curve for the airplane manufacturing industry. It shows economies of scale up to an output of 8,000 planes per year and a price of P0, then constant returns to scale from 8,000 to 20,000 planes per year, and diseconomies of scale at a quantity of production greater than 20,000 planes per year.
Now consider the market demand curve in the diagram, which intersects the long-run average cost (LRAC) curve at an output level of 5,000 planes per year and at a price P1, which is higher than P0. In this situation, the market has room for only one producer. If a second firm attempts to enter the market at a smaller size, say by producing a quantity of 4,000 planes, then its average costs will be higher than those of the existing firm, and it will be unable to compete. If the second firm attempts to enter the market at a larger size, like 8,000 planes per year, then it could produce at a lower average cost—but it could not sell all 8,000 planes that it produced because of insufficient demand in the market.
Figure 9.2 Economies of Scale and Natural Monopoly In this market, the demand curve intersects the long-run average cost (LRAC) curve at its downward-sloping part. A natural monopoly occurs when the quantity demanded is less than the minimum quantity it takes to be at the bottom of the long-run average cost curve.
Economists call this situation, when economies of scale are large relative to the quantity demanded in the market, a natural monopoly. Natural monopolies often arise in industries where the marginal cost of adding an additional customer is very low, once the fixed costs of the overall system are in place. This results in situations where there are substantial economies of scale. For example, once a water company lays the main water pipes through a neighborhood, the marginal cost of providing water service to another home is fairly low. Once the electric company installs lines in a new subdivision, the marginal cost of providing additional electrical service to one more home is minimal. It would be costly and duplicative for a second water company to enter the market and invest in a whole second set of main water pipes, or for a second electricity company to enter the market and invest in a whole new set of electrical wires. These industries offer an example where, because of economies of scale, one producer can serve the entire market more efficiently than a number of smaller producers that would need to make duplicate physical capital investments.
A natural monopoly can also arise in smaller local markets for products that are difficult to transport. For example, cement production exhibits economies of scale, and the quantity of cement demanded in a local area may not be much larger than what a single plant can produce. Moreover, the costs of transporting cement over land are high, and so a cement plant in an area without access to water transportation may be a natural monopoly.
Control of a Physical Resource
Another type of monopoly occurs when a company has control of a scarce physical resource. In the U.S. economy, one historical example of this pattern occurred when ALCOA—the Aluminum Company of America—controlled most of the supply of bauxite, a key mineral used in making aluminum. Back in the 1930s, when ALCOA controlled most of the bauxite, other firms were simply unable to produce enough aluminum to compete.
As another example, the majority of global diamond production is controlled by DeBeers, a multi-national company that has mining and production operations in South Africa, Botswana, Namibia, and Canada. It also has exploration activities on four continents, while directing a worldwide distribution network of rough cut diamonds. Although in recent years they have experienced growing competition, their impact on the rough diamond market is still considerable.
Legal Monopoly
For some products, the government erects barriers to entry by prohibiting or limiting competition. Under U.S. law, no organization but the U.S. Postal Service is legally allowed to deliver first-class mail. Many states or cities have laws or regulations that allow households a choice of only one electric company, one water company, and one company to pick up the garbage. Most legal monopolies are utilities—products necessary for everyday life—that are socially beneficial. As a consequence, the government allows producers to become regulated monopolies, to ensure that customers have access to an appropriate amount of these products or services. Additionally, legal monopolies are often subject to economies of scale, so it makes sense to allow only one provider.
Promoting Innovation
Innovation takes time and resources to achieve. Suppose a company invests in research and development and finds the cure for the common cold. In this world of near ubiquitous information, other companies could take the formula, produce the drug, and because they did not incur the costs of research and development (R&D), undercut the price of the company that discovered the drug. Given this possibility, many firms would choose not to invest in research and development, and as a result, the world would have less innovation. To prevent this from happening, the Constitution of the United States specifies in Article I, Section 8: “The Congress shall have Power . . . to Promote the Progress of Science and Useful Arts, by securing for limited Times to Authors and Inventors the Exclusive Right to their Writings and Discoveries.” Congress used this power to create the U.S. Patent and Trademark Office, as well as the U.S. Copyright Office. A patent gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time. In the United States, exclusive patent rights last for 20 years. The idea is to provide limited monopoly power so that innovative firms can recoup their investment in R&D, but then to allow other firms to produce the product more cheaply once the patent expires.
A trademark is an identifying symbol or name for a particular good, like Chiquita bananas, Chevrolet cars, or the Nike “swoosh” that appears on shoes and athletic gear. Between 2003 and 2019, roughly 6.8 million trademarks were registered with the U.S. government. A firm can renew a trademark repeatedly, as long as it remains in active use.
A copyright, according to the U.S. Copyright Office, “is a form of protection provided by the laws of the United States for ‘original works of authorship’ including literary, dramatic, musical, architectural, cartographic, choreographic, pantomimic, pictorial, graphic, sculptural, and audiovisual creations.” No one can reproduce, display, or perform a copyrighted work without the author's permission. Copyright protection ordinarily lasts for the life of the author plus 70 years.
Roughly speaking, patent law covers inventions and copyright protects books, songs, and art. However, in certain areas, like the invention of new software, it has been unclear whether patent or copyright protection should apply. There is also a body of law known as trade secrets. Even if a company does not have a patent on an invention, competing firms are not allowed to steal their secrets. One famous trade secret is the formula for Coca-Cola, which is not protected under copyright or patent law, but is simply kept secret by the company.
Taken together, we call this combination of patents, trademarks, copyrights, and trade secret law intellectual property, because it implies ownership over an idea, concept, or image, not a physical piece of property like a house or a car. Countries around the world have enacted laws to protect intellectual property, although the time periods and exact provisions of such laws vary across countries. There are ongoing negotiations, both through the World Intellectual Property Organization (WIPO) and through international treaties, to bring greater harmony to the intellectual property laws of different countries to determine the extent to which those in other countries will respect patents and copyrights of those in other countries.
Government limitations on competition used to be more common in the United States. For most of the twentieth century, only one phone company—AT&T—was legally allowed to provide local and long distance service. From the 1930s to the 1970s, one set of federal regulations limited which destinations airlines could choose to fly to and what fares they could charge. Another set of regulations limited the interest rates that banks could pay to depositors; yet another specified how much trucking firms could charge customers.
What products we consider utilities depends, in part, on the available technology. Fifty years ago, telephone companies provided local and long distance service over wires. It did not make much sense to have many companies building multiple wiring systems across towns and the entire country. AT&T lost its monopoly on long distance service when the technology for providing phone service changed from wires to microwave and satellite transmission, so that multiple firms could use the same transmission mechanism. The same thing happened to local service, especially in recent years, with the growth in cellular phone systems.
The combination of improvements in production technologies and a general sense that the markets could provide services adequately led to a wave of deregulation, starting in the late 1970s and continuing into the 1990s. This wave eliminated or reduced government restrictions on the firms that could enter, the prices that they could charge, and the quantities that many industries could produce, including telecommunications, airlines, trucking, banking, and electricity.
Around the world, from Europe to Latin America to Africa and Asia, many governments continue to control and limit competition in what those governments perceive to be key industries, including airlines, banks, steel companies, oil companies, and telephone companies.
Link It Up
Vist this website for examples of some pretty bizarre patents.
Intimidating Potential Competition
Businesses have developed a number of schemes for creating barriers to entry by deterring potential competitors from entering the market. One method is known as predatory pricing, in which a firm uses the threat of sharp price cuts to discourage competition. Predatory pricing is a violation of U.S. antitrust law, but it is difficult to prove.
Consider a large airline that provides most of the flights between two particular cities. A new, small start-up airline decides to offer service between these two cities. The large airline immediately slashes prices on this route to the bone, so that the new entrant cannot make any money. After the new entrant has gone out of business, the incumbent firm can raise prices again.
After the company repeats this pattern once or twice, potential new entrants may decide that it is not wise to try to compete. Small airlines often accuse larger airlines of predatory pricing: in the early 2000s, for example, ValuJet accused Delta of predatory pricing, Frontier accused United, and Reno Air accused Northwest. In 2015, the Justice Department ruled against American Express and Mastercard for imposing restrictions on retailers that encouraged customers to use lower swipe fees on credit transactions.
In some cases, large advertising budgets can also act as a way of discouraging the competition. If the only way to launch a successful new national cola drink is to spend more than the promotional budgets of Coca-Cola and Pepsi Cola, not too many companies will try. A firmly established brand name can be difficult to dislodge.
Summing Up Barriers to Entry
Table 9.1 lists the barriers to entry that we have discussed. This list is not exhaustive, since firms have proved to be highly creative in inventing business practices that discourage competition. When barriers to entry exist, perfect competition is no longer a reasonable description of how an industry works. When barriers to entry are high enough, monopoly can result.
Barrier to Entry Government Role? Example
Natural monopoly Government often responds with regulation (or ownership) Water and electric companies
Control of a physical resource No DeBeers for diamonds
Legal monopoly Yes Post office, past regulation of airlines and trucking
Patent, trademark, and copyright Yes, through protection of intellectual property New drugs or software
Intimidating potential competitors Somewhat Predatory pricing; well-known brand names
Table 9.1 Barriers to Entry | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/09%3A_Monopoly/9.02%3A_How_Monopolies_Form-_Barriers_to_Entry.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the perceived demand curve for a perfect competitor and a monopoly
• Analyze a demand curve for a monopoly and determine the output that maximizes profit and revenue
• Calculate marginal revenue and marginal cost
• Explain allocative efficiency as it pertains to the efficiency of a monopoly
Consider a monopoly firm, comfortably surrounded by barriers to entry so that it need not fear competition from other producers. How will this monopoly choose its profit-maximizing quantity of output, and what price will it charge? Profits for the monopolist, like any firm, will be equal to total revenues minus total costs. We can analyze the pattern of costs for the monopoly within the same framework as the costs of a perfectly competitive firm—that is, by using total cost, fixed cost, variable cost, marginal cost, average cost, and average variable cost. However, because a monopoly faces no competition, its situation and its decision process will differ from that of a perfectly competitive firm. (The Clear It Up feature discusses how hard it is sometimes to define “market” in a monopoly situation.)
Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly
A perfectly competitive firm acts as a price taker, so we calculate total revenue taking the given market price and multiplying it by the quantity of output that the firm chooses. The demand curve as it is perceived by a perfectly competitive firm appears in Figure 9.3 (a). The flat perceived demand curve means that, from the viewpoint of the perfectly competitive firm, it could sell either a relatively low quantity like Ql or a relatively high quantity like Qh at the market price P.
Figure 9.3 The Perceived Demand Curve for a Perfect Competitor and a Monopolist (a) A perfectly competitive firm perceives the demand curve that it faces to be flat. The flat shape means that the firm can sell either a low quantity (Ql) or a high quantity (Qh) at exactly the same price (P). (b) A monopolist perceives the demand curve that it faces to be the same as the market demand curve, which for most goods is downward-sloping. Thus, if the monopolist chooses a high level of output (Qh), it can charge only a relatively low price (PI). Conversely, if the monopolist chooses a low level of output (Ql), it can then charge a higher price (Ph). The challenge for the monopolist is to choose the combination of price and quantity that maximizes profits.
Clear It Up
What defines the market?
A monopoly is a firm that sells all or nearly all of the goods and services in a given market. However, what defines the “market”?
In a famous 1947 case, the federal government accused the DuPont company of having a monopoly in the cellophane market, pointing out that DuPont produced 75% of the cellophane in the United States. DuPont countered that even though it had a 75% market share in cellophane, it had less than a 20% share of the “flexible packaging materials,” which includes all other moisture-proof papers, films, and foils. In 1956, after years of legal appeals, the U.S. Supreme Court held that the broader market definition was more appropriate, and it dismissed the case against DuPont.
Questions over how to define the market continue today. True, Microsoft in the 1990s had a dominant share of the software for computer operating systems, but in the total market for all computer software and services, including everything from games to scientific programs, the Microsoft share was only about 14% in 2014. The Greyhound bus company may have a near-monopoly on the market for intercity bus transportation, but it is only a small share of the market for intercity transportation if that market includes private cars, airplanes, and railroad service. DeBeers has a monopoly in diamonds, but it is a much smaller share of the total market for precious gemstones and an even smaller share of the total market for jewelry. A small town in the country may have only one gas station: is this gas station a “monopoly,” or does it compete with gas stations that might be five, 10, or 50 miles away?
In general, if a firm produces a product without close substitutes, then we can consider the firm a monopoly producer in a single market. However, if buyers have a range of similar—even if not identical—options available from other firms, then the firm is not a monopoly. Still, arguments over whether substitutes are close or not close can be controversial.
While a monopolist can charge any price for its product, nonetheless the demand for the firm’s product constrains the price. No monopolist, even one that is thoroughly protected by high barriers to entry, can require consumers to purchase its product. Because the monopolist is the only firm in the market, its demand curve is the same as the market demand curve, which is, unlike that for a perfectly competitive firm, downward-sloping.
Figure 9.3 illustrates this situation. The monopolist can either choose a point like R with a low price (Pl) and high quantity (Qh), or a point like S with a high price (Ph) and a low quantity (Ql), or some intermediate point. Setting the price too high will result in a low quantity sold, and will not bring in much revenue. Conversely, setting the price too low may result in a high quantity sold, but because of the low price, it will not bring in much revenue either. The challenge for the monopolist is to strike a profit-maximizing balance between the price it charges and the quantity that it sells. However, why isn’t the perfectly competitive firm’s demand curve also the market demand curve? See the following Clear It Up feature for the answer to this question.
Clear It Up
What is the difference between perceived demand and market demand?
The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product. However, the firm’s demand curve as perceived by a monopoly is the same as the market demand curve. The reason for the difference is that each perfectly competitive firm perceives the demand for its products in a market that includes many other firms. In effect, the demand curve perceived by a perfectly competitive firm is a tiny slice of the entire market demand curve. In contrast, a monopoly perceives demand for its product in a market where the monopoly is the only producer.
Total Cost and Total Revenue for a Monopolist
We can illustrate profits for a monopolist with a graph of total revenues and total costs, with the example of the hypothetical HealthPill firm in Figure 9.4. The total cost curve has its typical shape that we learned about in Production, Costs and Industry Structure, and that we used in Perfect Competition; that is, total costs rise and the curve grows steeper as output increases, as the final column of Table 9.2 shows.
Figure 9.4 Total Revenue and Total Cost for the HealthPill Monopoly Total revenue for the monopoly firm called HealthPill first rises, then falls. Low levels of output bring in relatively little total revenue, because the quantity is low. High levels of output bring in relatively less revenue, because the high quantity pushes down the market price. The total cost curve is upward-sloping. Profits will be highest at the quantity of output where total revenue is most above total cost. The profit-maximizing level of output is not the same as the revenue-maximizing level of output, which should make sense, because profits take costs into account and revenues do not.
Quantity
Q
Price
P
Total Revenue
TR
Total Cost
TC
1 1,200 1,200 500
2 1,100 2,200 750
3 1,000 3,000 1,000
4 900 3,600 1,250
5 800 4,000 1,650
6 700 4,200 2,500
7 600 4,200 4,000
8 500 4,000 6,400
Table 9.2 Total Costs and Total Revenues of HealthPill
Total revenue, though, is different. Since a monopolist faces a downward sloping demand curve, the only way it can sell more output is by reducing its price. Selling more output raises revenue, but lowering price reduces it. Thus, the shape of total revenue isn’t clear. Let’s explore this using the data in Table 9.2, which shows quantities along the demand curve and the price at each quantity demanded, and then calculates total revenue by multiplying price times quantity at each level of output. (In this example, we give the output as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer a dash of greater realism, you can imagine that the pharmaceutical company measures these output levels and the corresponding prices per 1,000 or 10,000 pills.) As the figure illustrates, total revenue for a monopolist has the shape of a hill, first rising, next flattening out, and then falling. In this example, total revenue is highest at a quantity of 6 or 7.
However, the monopolist is not seeking to maximize revenue, but instead to earn the highest possible profit. In the HealthPill example in Figure 9.4, the highest profit will occur at the quantity where total revenue is the farthest above total cost. This looks to be somewhere in the middle of the graph, but where exactly? It is easier to see the profit maximizing level of output by using the marginal approach, to which we turn next.
Marginal Revenue and Marginal Cost for a Monopolist
In the real world, a monopolist often does not have enough information to analyze its entire total revenues or total costs curves. After all, the firm does not know exactly what would happen if it were to alter production dramatically. However, a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs, because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience. A monopolist can use information on marginal revenue and marginal cost to seek out the profit-maximizing combination of quantity and price.
Table 9.3 expands Table 9.2 using the figures on total costs and total revenues from the HealthPill example to calculate marginal revenue and marginal cost. This monopoly faces typical upward-sloping marginal cost and downward-sloping marginal revenue curves, as Figure 9.5 shows.
Notice that marginal revenue is zero at a quantity of 7, and turns negative at quantities higher than 7. It may seem counterintuitive that marginal revenue could ever be zero or negative: after all, doesn't an increase in quantity sold not always mean more revenue? For a perfect competitor, each additional unit sold brought a positive marginal revenue, because marginal revenue was equal to the given market price. However, a monopolist can sell a larger quantity and see a decline in total revenue. When a monopolist increases sales by one unit, it gains some marginal revenue from selling that extra unit, but also loses some marginal revenue because it must now sell every other unit at a lower price. As the quantity sold becomes higher, at some point the drop in price is proportionally more than the increase in greater quantity of sales, causing a situation where more sales bring in less revenue. In other words, marginal revenue is negative.
Figure 9.5 Marginal Revenue and Marginal Cost for the HealthPill Monopoly For a monopoly like HealthPill, marginal revenue decreases as it sells additional units of output. The marginal cost curve is upward-sloping. The profit-maximizing choice for the monopoly will be to produce at the quantity where marginal revenue is equal to marginal cost: that is, MR = MC. If the monopoly produces a lower quantity, then MR > MC at those levels of output, and the firm can make higher profits by expanding output. If the firm produces at a greater quantity, then MC > MR, and the firm can make higher profits by reducing its quantity of output.
Quantity
Q
Total Revenue
TR
Marginal Revenue
MR
Total Cost
TC
Marginal Cost
MC
1 1,200 1,200 500 500
2 2,200 1,000 775 275
3 3,000 800 1,000 225
4 3,600 600 1,250 250
5 4,000 400 1,650 400
6 4,200 200 2,500 850
7 4,200 0 4,000 1,500
8 4,000 –200 6,400 2,400
Table 9.3 Costs and Revenues of HealthPill
A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit.
For example, at an output of 4 in Figure 9.5, marginal revenue is 600 and marginal cost is 250, so producing this unit will clearly add to overall profits. At an output of 5, marginal revenue is 400 and marginal cost is 400, so producing this unit still means overall profits are unchanged. However, expanding output from 5 to 6 would involve a marginal revenue of 200 and a marginal cost of 850, so that sixth unit would actually reduce profits. Thus, the monopoly can tell from the marginal revenue and marginal cost that of the choices in the table, the profit-maximizing level of output is 5.
The monopoly could seek out the profit-maximizing level of output by increasing quantity by a small amount, calculating marginal revenue and marginal cost, and then either increasing output as long as marginal revenue exceeds marginal cost or reducing output if marginal cost exceeds marginal revenue. This process works without any need to calculate total revenue and total cost. Thus, a profit-maximizing monopoly should follow the rule of producing up to the quantity where marginal revenue is equal to marginal cost—that is, MR = MC. This quantity is easy to identify graphically, where MR and MC intersect.
Work It Out
Maximizing Profits
If you find it counterintuitive that producing where marginal revenue equals marginal cost will maximize profits, working through the numbers will help.
Step 1. Remember, we define marginal cost as the change in total cost from producing a small amount of additional output.
$MC=change in total costchange in quantity producedMC=change in total costchange in quantity produced$
Step 2. Note that in Table 9.3, as output increases from 1 to 2 units, total cost increases from \$500 to \$775. As a result, the marginal cost of the second unit will be:
$MC=775–5001=275MC=775–5001=275$
Step 3. Remember that, similarly, marginal revenue is the change in total revenue from selling a small amount of additional output.
$MR=change in total revenuechange in quantity soldMR=change in total revenuechange in quantity sold$
Step 4. Note that in Table 9.3, as output increases from 1 to 2 units, total revenue increases from \$1200 to \$2200. As a result, the marginal revenue of the second unit will be:
$MR=2200–12001=1000MR=2200–12001=1000$
Quantity
Q
Marginal Revenue
MR
Marginal Cost
MC
Marginal Profit
MP
Total Profit
P
1 1,200 500 700 700
2 1,000 275 725 1,425
3 800 225 575 2,000
4 600 250 350 2,350
5 400 400 0 2,350
6 200 850 −650 1,700
7 0 1,500 −1,500 200
8 −200 2,400 −2,600 −2,400
Table 9.4 Marginal Revenue, Marginal Cost, Marginal and Total Profit
Table 9.4 repeats the marginal cost and marginal revenue data from Table 9.3, and adds two more columns: Marginal profit is the profitability of each additional unit sold. We define it as marginal revenue minus marginal cost. Finally, total profit is the sum of marginal profits. As long as marginal profit is positive, producing more output will increase total profits. When marginal profit turns negative, producing more output will decrease total profits. Total profit is maximized where marginal revenue equals marginal cost. In this example, maximum profit occurs at 5 units of output.
A perfectly competitive firm will also find its profit-maximizing level of output where MR = MC. The key difference with a perfectly competitive firm is that in the case of perfect competition, marginal revenue is equal to price (MR = P), while for a monopolist, marginal revenue is not equal to the price, because changes in quantity of output affect the price.
Illustrating Monopoly Profits
It is straightforward to calculate profits of given numbers for total revenue and total cost. However, the size of monopoly profits can also be illustrated graphically with Figure 9.6, which takes the marginal cost and marginal revenue curves from the previous exhibit and adds an average cost curve and the monopolist’s perceived demand curve. Table 9.5 shows the data for these curves.
Quantity
Q
Demand
P
Marginal Revenue
MR
Marginal Cost
MC
Average Cost
AC
1 1,200 1,200 500 500
2 1,100 1,000 275 388
3 1,000 800 225 333
4 900 600 250 313
5 800 400 400 330
6 700 200 850 417
7 600 0 1,500 571
8 500 –200 2,400 800
Table 9.5
Figure 9.6 Illustrating Profits at the HealthPill Monopoly This figure begins with the same marginal revenue and marginal cost curves from the HealthPill monopoly from Figure 9.5. It then adds an average cost curve and the demand curve that the monopolist faces. The HealthPill firm first chooses the quantity where MR = MC. In this example, the quantity is 5. The monopolist then decides what price to charge by looking at the demand curve it faces. The large box, with quantity on the horizontal axis and demand (which shows the price) on the vertical axis, shows total revenue for the firm. The lighter-shaded box, which is quantity on the horizontal axis and average cost of production on the vertical axis shows the firm's total costs. The large total revenue box minus the smaller total cost box leaves the darkly shaded box that shows total profits. Since the price charged is above average cost, the firm is earning positive profits.
Figure 9.7 illustrates the three-step process where a monopolist: selects the profit-maximizing quantity to produce; decides what price to charge; determines total revenue, total cost, and profit.
Step 1: The Monopolist Determines Its Profit-Maximizing Level of Output
The firm can use the points on the demand curve D to calculate total revenue, and then, based on total revenue, calculate its marginal revenue curve. The profit-maximizing quantity will occur where MR = MC—or at the last possible point before marginal costs start exceeding marginal revenue. On Figure 9.6, MR = MC occurs at an output of 5.
Step 2: The Monopolist Decides What Price to Charge
The monopolist will charge what the market is willing to pay. A dotted line drawn straight up from the profit-maximizing quantity to the demand curve shows the profit-maximizing price which, in Figure 9.6, is \$800. This price is above the average cost curve, which shows that the firm is earning profits.
Step 3: Calculate Total Revenue, Total Cost, and Profit
Total revenue is the overall shaded box, where the width of the box is the quantity sold and the height is the price. In Figure 9.6, this is 5 x \$800 = \$4000. In Figure 9.6, the bottom part of the shaded box, which is shaded more lightly, shows total costs; that is, quantity on the horizontal axis multiplied by average cost on the vertical axis or 5 x \$330 = \$1650. The larger box of total revenues minus the smaller box of total costs will equal profits, which the darkly shaded box shows. Using the numbers gives \$4000 - \$1650 = \$2350. In a perfectly competitive market, the forces of entry would erode this profit in the long run. However, a monopolist is protected by barriers to entry. In fact, one obvious sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing increased competition eroding those profits.
Figure 9.7 How a Profit-Maximizing Monopoly Decides Price In Step 1, the monopoly chooses the profit-maximizing level of output Q1, by choosing the quantity where MR = MC. In Step 2, the monopoly decides how much to charge for output level Q1 by drawing a line straight up from Q1 to point R on its perceived demand curve. Thus, the monopoly will charge a price (P1). In Step 3, the monopoly identifies its profit. Total revenue will be Q1 multiplied by P1. Total cost will be Q1 multiplied by the average cost of producing Q1, which point S shows on the average cost curve to be P2. Profits will be the total revenue rectangle minus the total cost rectangle, which the shaded zone in the figure shows.
Clear It Up
Why is a monopolist’s marginal revenue always less than the price?
The marginal revenue curve for a monopolist always lies beneath the market demand curve. To understand why, think about increasing the quantity along the demand curve by one unit, so that you take one step down the demand curve to a slightly higher quantity but a slightly lower price. A demand curve is not sequential: It is not that first we sell Q1 at a higher price, and then we sell Q2 at a lower price. Rather, a demand curve is conditional: If we charge the higher price, we would sell Q1. If, instead, we charge a lower price (on all the units that we sell), we would sell Q2.
When we think about increasing the quantity sold by one unit, marginal revenue is affected in two ways. First, we sell one additional unit at the new market price. Second, all the previous units, which we sold at the higher price, now sell for less. Because of the lower price on all units sold, the marginal revenue of selling a unit is less than the price of that unit—and the marginal revenue curve is below the demand curve. Tip: For a straight-line demand curve, MR and demand have the same vertical intercept. As output increases, marginal revenue decreases twice as fast as demand, so that the horizontal intercept of MR is halfway to the horizontal intercept of demand. You can see this in the Figure 9.8.
Figure 9.8 The Monopolist’s Marginal Revenue Curve versus Demand Curve Because the market demand curve is conditional, the marginal revenue curve for a monopolist lies beneath the demand curve.
The Inefficiency of Monopoly
Most people criticize monopolies because they charge too high a price, but what economists object to is that monopolies do not supply enough output to be allocatively efficient. To understand why a monopoly is inefficient, it is useful to compare it with the benchmark model of perfect competition.
Allocative efficiency is an economic concept regarding efficiency at the social or societal level. It refers to producing the optimal quantity of some output, the quantity where the marginal benefit to society of one more unit just equals the marginal cost. The rule of profit maximization in a world of perfect competition was for each firm to produce the quantity of output where P = MC, where the price (P) is a measure of how much buyers value the good and the marginal cost (MC) is a measure of what marginal units cost society to produce. Following this rule assures allocative efficiency. If P > MC, then the marginal benefit to society (as measured by P) is greater than the marginal cost to society of producing additional units, and a greater quantity should be produced. However, in the case of monopoly, price is always greater than marginal cost at the profit-maximizing level of output, as you can see by looking back at Figure 9.6. Thus, consumers do not benefit from a monopoly because it will sell a lower quantity in the market, at a higher price, than would have been the case in a perfectly competitive market.
The problem of inefficiency for monopolies often runs even deeper than these issues, and also involves incentives for efficiency over longer periods of time. There are counterbalancing incentives here. On one side, firms may strive for new inventions and new intellectual property because they want to become monopolies and earn high profits—at least for a few years until the competition catches up. In this way, monopolies may come to exist because of competitive pressures on firms. However, once a barrier to entry is in place, a monopoly that does not need to fear competition can just produce the same old products in the same old way—while still ringing up a healthy rate of profit. John Hicks, who won the Nobel Prize for economics in 1972, wrote in 1935: “The best of all monopoly profits is a quiet life.” He did not mean the comment in a complimentary way. He meant that monopolies may bank their profits and slack off on trying to please their customers.
When AT&T provided all of the local and long-distance phone service in the United States, along with manufacturing most of the phone equipment, the payment plans and types of phones did not change much. The old joke was that you could have any color phone you wanted, as long as it was black. However, in 1982, government litigation split up AT&T into a number of local phone companies, a long-distance phone company, and a phone equipment manufacturer. An explosion of innovation followed. Services like call waiting, caller ID, three-way calling, voice mail through the phone company, mobile phones, and wireless connections to the internet all became available. Companies offered a wide range of payment plans, as well. It was no longer true that all phones were black. Instead, phones came in a wide variety of shapes and colors. The end of the telephone monopoly brought lower prices, a greater quantity of services, and also a wave of innovation aimed at attracting and pleasing customers.
Bring It Home
The Rest is History
In the opening case, we presented the East India Company and the Confederate States as a monopoly or near monopoly provider of a good. Nearly every American schoolchild knows the result of the “unwelcome visit” the “Mohawks” bestowed upon Boston Harbor’s tea-bearing ships—the Boston Tea Party. Regarding the cotton industry, we also know Great Britain remained neutral during the Civil War, taking neither side during the conflict.
Did the monopoly nature of these business have unintended and historical consequences? Might the American Revolution have been deterred, if the East India Company had sailed the tea-bearing ships back to England? Might the southern states have made different decisions had they not been so confident “King Cotton” would force diplomatic recognition of the Confederate States of America? Of course, it is not possible to definitively answer these questions. We cannot roll back the clock and try a different scenario. We can, however, consider the monopoly nature of these businesses and the roles they played and hypothesize about what might have occurred under different circumstances.
Perhaps if there had been legal free tea trade, the colonists would have seen things differently. There was smuggled Dutch tea in the colonial market. If the colonists had been able to freely purchase Dutch tea, they would have paid lower prices and avoided the tax.
What about the cotton monopoly? With one in five jobs in Great Britain depending on Southern cotton and the Confederate States as nearly the sole provider of that cotton, why did Great Britain remain neutral during the Civil War? At the beginning of the war, Britain simply drew down massive stores of cotton. These stockpiles lasted until near the end of 1862. Why did Britain not recognize the Confederacy at that point? Two reasons: The Emancipation Proclamation and new sources of cotton. Having outlawed slavery throughout the United Kingdom in 1833, it was politically impossible for Great Britain, empty cotton warehouses or not, to recognize, diplomatically, the Confederate States. In addition, during the two years it took to draw down the stockpiles, Britain expanded cotton imports from India, Egypt, and Brazil.
Monopoly sellers often see no threats to their superior marketplace position. In these examples did the power of the monopoly hide other possibilities from the decision makers? Perhaps. As a result of their actions, this is how history unfolded. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/09%3A_Monopoly/9.03%3A_How_a_Profit-Maximizing_Monopoly_Chooses_Output_and_Price.txt |
allocative efficiency
producing the optimal quantity of some output; the quantity where the marginal benefit to society of one more unit just equals the marginal cost
barriers to entry
the legal, technological, or market forces that may discourage or prevent potential competitors from entering a market
copyright
a form of legal protection to prevent copying, for commercial purposes, original works of authorship, including books and music
deregulation
removing government controls over setting prices and quantities in certain industries
intellectual property
the body of law including patents, trademarks, copyrights, and trade secret law that protect the right of inventors to produce and sell their inventions
legal monopoly
legal prohibitions against competition, such as regulated monopolies and intellectual property protection
marginal profit
profit of one more unit of output, computed as marginal revenue minus marginal cost
monopoly
a situation in which one firm produces all of the output in a market
natural monopoly
economic conditions in the industry, for example, economies of scale or control of a critical resource, that limit effective competition
patent
a government rule that gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time
predatory pricing
when an existing firm uses sharp but temporary price cuts to discourage new competition
trade secrets
methods of production kept secret by the producing firm
trademark
an identifying symbol or name for a particular good and can only be used by the firm that registered that trademark
9.05: Key Concepts and Summary
9.1 How Monopolies Form: Barriers to Entry
Barriers to entry prevent or discourage competitors from entering the market. These barriers include: economies of scale that lead to natural monopoly; control of a physical resource; legal restrictions on competition; patent, trademark and copyright protection; and practices to intimidate the competition like predatory pricing. Intellectual property refers to legally guaranteed ownership of an idea, rather than a physical item. The laws that protect intellectual property include patents, copyrights, trademarks, and trade secrets. A natural monopoly arises when economies of scale persist over a large enough range of output that if one firm supplies the entire market, no other firm can enter without facing a cost disadvantage.
9.2 How a Profit-Maximizing Monopoly Chooses Output and Price
A monopolist is not a price taker, because when it decides what quantity to produce, it also determines the market price. For a monopolist, total revenue is relatively low at low quantities of output, because it is not selling much. Total revenue is also relatively low at very high quantities of output, because a very high quantity will sell only at a low price. Thus, total revenue for a monopolist will start low, rise, and then decline. The marginal revenue for a monopolist from selling additional units will decline. Each additional unit a monopolist sells will push down the overall market price, and as it sells more units, this lower price applies to increasingly more units.
The monopolist will select the profit-maximizing level of output where MR = MC, and then charge the price for that quantity of output as determined by the market demand curve. If that price is above average cost, the monopolist earns positive profits.
Monopolists are not productively efficient, because they do not produce at the minimum of the average cost curve. Monopolists are not allocatively efficient, because they do not produce at the quantity where P = MC. As a result, monopolists produce less, at a higher average cost, and charge a higher price than would a combination of firms in a perfectly competitive industry. Monopolists also may lack incentives for innovation, because they need not fear entry.
9.06: Self-Check Questions
1.
Classify the following as a government-enforced barrier to entry, a barrier to entry that is not government-enforced, or a situation that does not involve a barrier to entry.
1. A patented invention
2. A popular but easily copied restaurant recipe
3. An industry where economies of scale are very small compared to the size of demand in the market
4. A well-established reputation for slashing prices in response to new entry
5. A well-respected brand name that has been carefully built up over many years
2.
Classify the following as a government-enforced barrier to entry, a barrier to entry that is not government-enforced, or a situation that does not involve a barrier to entry.
1. A city passes a law on how many licenses it will issue for taxicabs
2. A city passes a law that all taxicab drivers must pass a driving safety test and have insurance
3. A well-known trademark
4. Owning a spring that offers very pure water
5. An industry where economies of scale are very large compared to the size of demand in the market
3.
Suppose the local electrical utility, a legal monopoly based on economies of scale, was split into four firms of equal size, with the idea that eliminating the monopoly would promote competitive pricing of electricity. What do you anticipate would happen to prices?
4.
If Congress reduced the period of patent protection from 20 years to 10 years, what would likely happen to the amount of private research and development?
5.
Suppose demand for a monopoly’s product falls so that its profit-maximizing price is below average variable cost. How much output should the firm supply? Hint: Draw the graph.
6.
Imagine a monopolist could charge a different price to every customer based on how much the customer is willing to pay. How would this affect monopoly profits? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/09%3A_Monopoly/9.04%3A_Key_Terms.txt |
7.
How is monopoly different from perfect competition?
8.
What is a barrier to entry? Give some examples.
9.
What is a natural monopoly?
10.
What is a legal monopoly?
11.
What is predatory pricing?
12.
How is intellectual property different from other property?
13.
What legal mechanisms protect intellectual property?
14.
In what sense is a natural monopoly “natural”?
15.
How is the demand curve perceived by a perfectly competitive firm different from the demand curve perceived by a monopolist?
16.
How does the demand curve perceived by a monopolist compare with the market demand curve?
17.
Is a monopolist a price taker? Explain briefly.
18.
What is the usual shape of a total revenue curve for a monopolist? Why?
19.
What is the usual shape of a marginal revenue curve for a monopolist? Why?
20.
How can a monopolist identify the profit-maximizing level of output if it knows its total revenue and total cost curves?
21.
How can a monopolist identify the profit-maximizing level of output if it knows its marginal revenue and marginal costs?
22.
When a monopolist identifies its profit-maximizing quantity of output, how does it decide what price to charge?
23.
Is a monopolist allocatively efficient? Why or why not?
24.
How does the quantity produced and price charged by a monopolist compare to that of a perfectly competitive firm?
9.08: Critical Thinking Questions
25.
ALCOA does not have the monopoly power it once had. How do you suppose their barriers to entry were weakened?
26.
Why are generic pharmaceuticals significantly cheaper than name brand ones?
27.
For many years, the Justice Department has tried to break up large firms like IBM, Microsoft, and most recently Google, on the grounds that their large market share made them essentially monopolies. In a global market, where U.S. firms compete with firms from other countries, would this policy make the same sense as it might in a purely domestic context?
28.
Intellectual property laws are intended to promote innovation, but some economists, such as Milton Friedman, have argued that such laws are not desirable. In the United States, there is no intellectual property protection for food recipes or for fashion designs. Considering the state of these two industries, and bearing in mind the discussion of the inefficiency of monopolies, can you think of any reasons why intellectual property laws might hinder innovation in some cases?
29.
Imagine that you are managing a small firm and thinking about entering the market of a monopolist. The monopolist is currently charging a high price, and you have calculated that you can make a nice profit charging 10% less than the monopolist. Before you go ahead and challenge the monopolist, what possibility should you consider for how the monopolist might react?
30.
If a monopoly firm is earning profits, how much would you expect these profits to be diminished by entry in the long run?
9.09: Problems
31.
Return to Figure 9.2. Suppose P0 is \$10 and P1 is \$11. Suppose a new firm with the same LRAC curve as the incumbent tries to break into the market by selling 4,000 units of output. Estimate from the graph what the new firm’s average cost of producing output would be. If the incumbent continues to produce 6,000 units, how much output would the two firms supply to the market? Estimate what would happen to the market price as a result of the supply of both the incumbent firm and the new entrant. Approximately how much profit would each firm earn?
32.
Draw the demand curve, marginal revenue, and marginal cost curves from Figure 9.6, and identify the quantity of output the monopoly wishes to supply and the price it will charge. Suppose demand for the monopoly’s product increases dramatically. Draw the new demand curve. What happens to the marginal revenue as a result of the increase in demand? What happens to the marginal cost curve? Identify the new profit-maximizing quantity and price. Does the answer make sense to you?
33.
Draw a monopolist’s demand curve, marginal revenue, and marginal cost curves. Identify the monopolist’s profit-maximizing output level. Now, think about a slightly higher level of output (say Q0 + 1). According to the graph, is there any consumer willing to pay more than the marginal cost of that new level of output? If so, what does this mean? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/09%3A_Monopoly/9.07%3A_Review_Questions.txt |
Figure 10.1 Competing Brands? The laundry detergent market is one that is characterized neither as perfect competition nor monopoly. (Credit: modification of “DSC_7174” by Pixel Drip/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Monopolistic Competition
• Oligopoly
Bring It Home
The Temptation to Defy the Law
Laundry detergent and bags of ice—products of industries that seem pretty mundane, maybe even boring. Hardly! Both have been the center of clandestine meetings and secret deals worthy of a spy novel. In France, between 1997 and 2004, the top four laundry detergent producers (Proctor & Gamble, Henkel, Unilever, and Colgate-Palmolive) controlled about 90 percent of the French soap market. Officials from the soap firms were meeting secretly, in out-of-the-way, small cafés around Paris. Their goals: Stamp out competition and set prices.
Around the same time, the top five Midwest ice makers (Home City Ice, Lang Ice, Tinley Ice, Sisler’s Dairy, and Products of Ohio) had similar goals in mind when they secretly agreed to divide up the bagged ice market.
If both groups could meet their goals, it would enable each to act as though they were a single firm—in essence, a monopoly—and enjoy monopoly-size profits. The problem? In many parts of the world, including the European Union and the United States, it is illegal for firms to divide markets and set prices collaboratively.
These two cases provide examples of markets that are characterized neither as perfect competition nor monopoly. Instead, these firms are competing in market structures that lie between the extremes of monopoly and perfect competition. How do they behave? Why do they exist? We will revisit this case later, to find out what happened.
Perfect competition and monopoly are at opposite ends of the competition spectrum. A perfectly competitive market has many firms selling identical products, who all act as price takers in the face of the competition. If you recall, price takers are firms that have no market power. They simply have to take the market price as given.
Monopoly arises when a single firm sells a product for which there are no close substitutes. We consider Microsoft, for instance, as a monopoly because it dominates the operating systems market.
What about the vast majority of real world firms and organizations that fall between these extremes, firms that we could describe as imperfectly competitive? What determines their behavior? They have more influence over the price they charge than perfectly competitive firms, but not as much as a monopoly. What will they do?
One type of imperfectly competitive market is monopolistic competition. Monopolistically competitive markets feature a large number of competing firms, but the products that they sell are not identical. Consider, as an example, the Mall of America in Minnesota, the largest shopping mall in the United States. In 2010, the Mall of America had 24 stores that sold women’s “ready-to-wear” clothing (like Ann Taylor and Urban Outfitters), another 50 stores that sold clothing for both men and women (like Banana Republic, J. Crew, and Nordstrom’s), plus 14 more stores that sold women’s specialty clothing (like Motherhood Maternity and Victoria’s Secret). Most of the markets that consumers encounter at the retail level are monopolistically competitive.
The other type of imperfectly competitive market is oligopoly. Oligopolistic markets are those which a small number of firms dominate. Commercial aircraft provides a good example: Boeing and Airbus each produce slightly less than 50% of the large commercial aircraft in the world. Another example is the U.S. soft drink industry, which Coca-Cola and Pepsi dominate. We characterize oligopolies by high barriers to entry with firms choosing output, pricing, and other decisions strategically based on the decisions of the other firms in the market. In this chapter, we first explore how monopolistically competitive firms will choose their profit-maximizing level of output. We will then discuss oligopolistic firms, which face two conflicting temptations: to collaborate as if they were a single monopoly, or to individually compete to gain profits by expanding output levels and cutting prices. Oligopolistic markets and firms can also take on elements of monopoly and of perfect competition. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/10%3A_Monopolistic_Competition_and_Oligopoly/10.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the significance of differentiated products
• Describe how a monopolistic competitor chooses price and quantity
• Discuss entry, exit, and efficiency as they pertain to monopolistic competition
• Analyze how advertising can impact monopolistic competition
Monopolistic competition involves many firms competing against each other, but selling products that are distinctive in some way. Examples include stores that sell different styles of clothing; restaurants or grocery stores that sell a variety of food; and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. There are over 600,000 restaurants in the United States. When products are distinctive, each firm has a mini-monopoly on its particular style or flavor or brand name. However, firms producing such products must also compete with other styles and flavors and brand names. The term “monopolistic competition” captures this mixture of mini-monopoly and tough competition, and the following Clear It Up feature introduces its derivation.
Clear It Up
Who invented the theory of imperfect competition?
Two economists independently but simultaneously developed the theory of imperfect competition in 1933. The first was Edward Chamberlin of Harvard University who published The Economics of Monopolistic Competition. The second was Joan Robinson of Cambridge University who published The Economics of Imperfect Competition. Robinson subsequently became interested in macroeconomics and she became a prominent Keynesian, and later a post-Keynesian economist. (See the Welcome to Economics! and The Keynesian Perspective chapters for more on Keynes.)
Differentiated Products
A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, location from which it sells the product, intangible aspects of the product, and perceptions of the product. We call products that are distinctive in one of these ways differentiated products.
Physical aspects of a product include all the phrases you hear in advertisements: unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort. A firm's location can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably sell more gas, because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory.
Intangible aspects can differentiate a product, too. Some intangible aspects may be promises like a guarantee of satisfaction or money back, a reputation for high quality, services like free delivery, or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of ketchup or mayonnaise if they were blindfolded but, because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences.
The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition.
Perceived Demand for a Monopolistic Competitor
A monopolistically competitive firm perceives a demand for its goods that is an intermediate case between monopoly and competition. Figure 10.2 offers a reminder that the demand curve that a perfectly competitive firm faces is perfectly elastic or flat, because the perfectly competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is the only firm in the market, and hence is downward sloping.
Figure 10.2 Perceived Demand for Firms in Different Competitive Settings The demand curve that a perfectly competitive firm faces is perfectly elastic, meaning it can sell all the output it wishes at the prevailing market price. The demand curve that a monopoly faces is the market demand. It can sell more output only by decreasing the price it charges. The demand curve that a monopolistically competitive firm faces falls in between.
The demand curve as a monopolistic competitor faces is not flat, but rather downward-sloping, which means that the monopolistic competitor can raise its price without losing all of its customers or lower the price and gain more customers. Since there are substitutes, the demand curve facing a monopolistically competitive firm is more elastic than that of a monopoly where there are no close substitutes. If a monopolist raises its price, some consumers will choose not to purchase its product—but they will then need to buy a completely different product. However, when a monopolistic competitor raises its price, some consumers will choose not to purchase the product at all, but others will choose to buy a similar product from another firm. If a monopolistic competitor raises its price, it will not lose as many customers as would a perfectly competitive firm, but it will lose more customers than would a monopoly that raised its prices.
At a glance, the demand curves that a monopoly and a monopolistic competitor face look similar—that is, they both slope down. However, the underlying economic meaning of these perceived demand curves is different, because a monopolist faces the market demand curve and a monopolistic competitor does not. Rather, a monopolistically competitive firm’s demand curve is but one of many firms that make up the “before” market demand curve. Are you following? If so, how would you categorize the market for golf balls? Take a swing, then see the following Clear It Up feature.
Clear It Up
Are golf balls really differentiated products?
Monopolistic competition refers to an industry that has more than a few firms, each offering a product which, from the consumer’s perspective, is different from its competitors. The U.S. Golf Association runs a laboratory that tests 20,000 golf balls a year. There are strict rules for what makes a golf ball legal. A ball's weight cannot exceed 1.620 ounces and its diameter cannot be less than 1.680 inches (which is a weight of 45.93 grams and a diameter of 42.67 millimeters, in case you were wondering). The Association also tests the balls by hitting them at different speeds. For example, the distance test involves having a mechanical golfer hit the ball with a titanium driver and a swing speed of 120 miles per hour. As the testing center explains: “The USGA system then uses an array of sensors that accurately measure the flight of a golf ball during a short, indoor trajectory from a ball launcher. From this flight data, a computer calculates the lift and drag forces that are generated by the speed, spin, and dimple pattern of the ball. ... The distance limit is 317 yards.”
Over 1800 golf balls made by more than 100 companies meet the USGA standards. The balls do differ in various ways, such as the pattern of dimples on the ball, the types of plastic on the cover and in the cores, and other factors. Since all balls need to conform to the USGA tests, they are much more alike than different. In other words, golf ball manufacturers are monopolistically competitive.
However, retail sales of golf balls are about \$500 million per year, which means that many large companies have a powerful incentive to persuade players that golf balls are highly differentiated and that it makes a huge difference which one you choose. Sure, Tiger Woods can tell the difference. For the average amateur golfer who plays a few times a summer—and who loses many golf balls to the woods and lake and needs to buy new ones—most golf balls are pretty much indistinguishable.
How a Monopolistic Competitor Chooses Price and Quantity
The monopolistically competitive firm decides on its profit-maximizing quantity and price in much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a downward-sloping demand curve, and so it will choose some combination of price and quantity along its perceived demand curve.
As an example of a profit-maximizing monopolistic competitor, consider the Authentic Chinese Pizza store, which serves pizza with cheese, sweet and sour sauce, and your choice of vegetables and meats. Although Authentic Chinese Pizza must compete against other pizza businesses and restaurants, it has a differentiated product. The firm’s perceived demand curve is downward sloping, as Figure 10.3 shows and the first two columns of Table 10.1.
Figure 10.3 How a Monopolistic Competitor Chooses its Profit Maximizing Output and Price To maximize profits, the Authentic Chinese Pizza shop would choose a quantity where marginal revenue equals marginal cost, or Q where MR = MC. Here it would choose a quantity of 40 and a price of \$16.
Quantity Price Total Revenue Marginal Revenue Total Cost Marginal Cost Average Cost
10 \$23 \$230 \$23 \$340 \$34 \$34
20 \$20 \$400 \$17 \$400 \$6 \$20
30 \$18 \$540 \$14 \$480 \$8 \$16
40 \$16 \$640 \$10 \$580 \$10 \$14.50
50 \$14 \$700 \$6 \$700 \$12 \$14
60 \$12 \$720 \$2 \$840 \$14 \$14
70 \$10 \$700 –\$2 \$1,020 \$18 \$14.57
80 \$8 \$640 –\$6 \$1,280 \$26 \$16
Table 10.1 Revenue and Cost Schedule
We can multiply the combinations of price and quantity at each point on the demand curve to calculate the total revenue that the firm would receive, which is in the third column of Table 10.1. We calculate marginal revenue, in the fourth column, as the change in total revenue divided by the change in quantity. The final columns of Table 10.1 show total cost, marginal cost, and average cost. As always, we calculate marginal cost by dividing the change in total cost by the change in quantity, while we calculate average cost by dividing total cost by quantity. The following Work It Out feature shows how these firms calculate how much of their products to supply at what price.
Work It Out
How a Monopolistic Competitor Determines How Much to Produce and at What Price
The process by which a monopolistic competitor chooses its profit-maximizing quantity and price resembles closely how a monopoly makes these decisions process. First, the firm selects the profit-maximizing quantity to produce. Then the firm decides what price to charge for that quantity.
Step 1. The monopolistic competitor determines its profit-maximizing level of output. In this case, the Authentic Chinese Pizza company will determine the profit-maximizing quantity to produce by considering its marginal revenues and marginal costs. Two scenarios are possible:
• If the firm is producing at a quantity of output where marginal revenue exceeds marginal cost, then the firm should keep expanding production, because each marginal unit is adding to profit by bringing in more revenue than its cost. In this way, the firm will produce up to the quantity where MR = MC.
• If the firm is producing at a quantity where marginal costs exceed marginal revenue, then each marginal unit is costing more than the revenue it brings in, and the firm will increase its profits by reducing the quantity of output until MR = MC.
In this example, MR and MC intersect at a quantity of 40, which is the profit-maximizing level of output for the firm.
Step 2. The monopolistic competitor decides what price to charge. When the firm has determined its profit-maximizing quantity of output, it can then look to its perceived demand curve to find out what it can charge for that quantity of output. On the graph, we show this process as a vertical line reaching up through the profit-maximizing quantity until it hits the firm’s perceived demand curve. For Authentic Chinese Pizza, it should charge a price of \$16 per pizza for a quantity of 40.
Once the firm has chosen price and quantity, it’s in a position to calculate total revenue, total cost, and profit. At a quantity of 40, the price of \$16 lies above the average cost curve, so the firm is making economic profits. From Table 10.1 we can see that, at an output of 40, the firm’s total revenue is \$640 and its total cost is \$580, so profits are \$60. In Figure 10.3, the firm’s total revenues are the rectangle with the quantity of 40 on the horizontal axis and the price of \$16 on the vertical axis. The firm’s total costs are the light shaded rectangle with the same quantity of 40 on the horizontal axis but the average cost of \$14.50 on the vertical axis. Profits are total revenues minus total costs, which is the shaded area above the average cost curve.
Although the process by which a monopolistic competitor makes decisions about quantity and price is similar to the way in which a monopolist makes such decisions, two differences are worth remembering. First, although both a monopolist and a monopolistic competitor face downward-sloping demand curves, the monopolist’s perceived demand curve is the market demand curve, while the perceived demand curve for a monopolistic competitor is based on the extent of its product differentiation and how many competitors it faces. Second, a monopolist is surrounded by barriers to entry and need not fear entry, but a monopolistic competitor who earns profits must expect the entry of firms with similar, but differentiated, products.
Monopolistic Competitors and Entry
If one monopolistic competitor earns positive economic profits, other firms will be tempted to enter the market. A gas station with a great location must worry that other gas stations might open across the street or down the road—and perhaps the new gas stations will sell coffee or have a carwash or some other attraction to lure customers. A successful restaurant with a unique barbecue sauce must be concerned that other restaurants will try to copy the sauce or offer their own unique recipes. A laundry detergent with a great reputation for quality must take note that other competitors may seek to build their own reputations.
The entry of other firms into the same general market (like gas, restaurants, or detergent) shifts the demand curve that a monopolistically competitive firm faces. As more firms enter the market, the quantity demanded at a given price for any particular firm will decline, and the firm’s perceived demand curve will shift to the left. As a firm’s perceived demand curve shifts to the left, its marginal revenue curve will shift to the left, too. The shift in marginal revenue will change the profit-maximizing quantity that the firm chooses to produce, since marginal revenue will then equal marginal cost at a lower quantity.
Figure 10.4 (a) shows a situation in which a monopolistic competitor was earning a profit with its original perceived demand curve (D0). The intersection of the marginal revenue curve (MR0) and marginal cost curve (MC) occurs at point S, corresponding to quantity Q0, which is associated on the demand curve at point T with price P0. The combination of price P0 and quantity Q0 lies above the average cost curve, which shows that the firm is earning positive economic profits.
Figure 10.4 Monopolistic Competition, Entry, and Exit (a) At P0 and Q0, the monopolistically competitive firm in this figure is making a positive economic profit. This is clear because if you follow the dotted line above Q0, you can see that price is above average cost. Positive economic profits attract competing firms to the industry, driving the original firm’s demand down to D1. At the new equilibrium quantity (P1, Q1), the original firm is earning zero economic profits, and entry into the industry ceases. In (b) the opposite occurs. At P0 and Q0, the firm is losing money. If you follow the dotted line above Q0, you can see that average cost is above price. Losses induce firms to leave the industry. When they do, demand for the original firm rises to D1, where once again the firm is earning zero economic profit.
Unlike a monopoly, with its high barriers to entry, a monopolistically competitive firm with positive economic profits will attract competition. When another competitor enters the market, the original firm’s perceived demand curve shifts to the left, from D0 to D1, and the associated marginal revenue curve shifts from MR0 to MR1. The new profit-maximizing output is Q1, because the intersection of the MR1 and MC now occurs at point U. Moving vertically up from that quantity on the new demand curve, the optimal price is at P1.
As long as the firm is earning positive economic profits, new competitors will continue to enter the market, reducing the original firm’s demand and marginal revenue curves. The long-run equilibrium is in the figure at point Y, where the firm’s perceived demand curve touches the average cost curve. When price is equal to average cost, economic profits are zero. Thus, although a monopolistically competitive firm may earn positive economic profits in the short term, the process of new entry will drive down economic profits to zero in the long run. Remember that zero economic profit is not equivalent to zero accounting profit. A zero economic profit means the firm’s accounting profit is equal to what its resources could earn in their next best use. Figure 10.4 (b) shows the reverse situation, where a monopolistically competitive firm is originally losing money. The adjustment to long-run equilibrium is analogous to the previous example. The economic losses lead to firms exiting, which will result in increased demand for this particular firm, and consequently lower losses. Firms exit up to the point where there are no more losses in this market, for example when the demand curve touches the average cost curve, as in point Z.
Monopolistic competitors can make an economic profit or loss in the short run, but in the long run, entry and exit will drive these firms toward a zero economic profit outcome. However, the zero economic profit outcome in monopolistic competition looks different from the zero economic profit outcome in perfect competition in several ways relating both to efficiency and to variety in the market.
Monopolistic Competition and Efficiency
The long-term result of entry and exit in a perfectly competitive market is that all firms end up selling at the price level determined by the lowest point on the average cost curve. This outcome is why perfect competition displays productive efficiency: goods are produced at the lowest possible average cost. However, in monopolistic competition, the end result of entry and exit is that firms end up with a price that lies on the downward-sloping portion of the average cost curve, not at the very bottom of the AC curve. Thus, monopolistic competition will not be productively efficient.
In a perfectly competitive market, each firm produces at a quantity where price is set equal to marginal cost, both in the short and long run. This outcome is why perfect competition displays allocative efficiency: the social benefits of additional production, as measured by the marginal benefit, which is the same as the price, equal the marginal costs to society of that production. In a monopolistically competitive market, the rule for maximizing profit is to set MR = MC—and price is higher than marginal revenue, not equal to it because the demand curve is downward sloping. When P > MC, which is the outcome in a monopolistically competitive market, the benefits to society of providing additional quantity, as measured by the price that people are willing to pay, exceed the marginal costs to society of producing those units. A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units. This is the same argument we made about monopoly, but in this case the allocative inefficiency will be smaller. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry. See the following Clear It Up feature for more detail on the impact of demand shifts.
Clear It Up
Why does a shift in perceived demand cause a shift in marginal revenue?
We use the combinations of price and quantity at each point on a firm’s perceived demand curve to calculate total revenue for each combination of price and quantity. We then use this information on total revenue to calculate marginal revenue, which is the change in total revenue divided by the change in quantity. A change in perceived demand will change total revenue at every quantity of output and in turn, the change in total revenue will shift marginal revenue at each quantity of output. Thus, when entry occurs in a monopolistically competitive industry, the perceived demand curve for each firm will shift to the left, because a smaller quantity will be demanded at any given price. Another way of interpreting this shift in demand is to notice that, for each quantity sold, the firm will charge a lower price. Consequently, the marginal revenue will be lower for each quantity sold—and the marginal revenue curve will shift to the left as well. Conversely, exit causes the perceived demand curve for a monopolistically competitive firm to shift to the right and the corresponding marginal revenue curve to shift right, too.
A monopolistically competitive industry does not display productive or allocative efficiency in either the short run, when firms are making economic profits and losses, nor in the long run, when firms are earning zero profits.
The Benefits of Variety and Product Differentiation
Even though monopolistic competition does not provide productive efficiency or allocative efficiency, it does have benefits of its own. Product differentiation is based on variety and innovation. Most people would prefer to live in an economy with many kinds of clothes, foods, and car styles; not in a world of perfect competition where everyone will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and drive an identical model of car. Most people would prefer to live in an economy where firms are struggling to figure out ways of attracting customers by methods like friendlier service, free delivery, guarantees of quality, variations on existing products, and a better shopping experience.
Economists have struggled, with only partial success, to address the question of whether a market-oriented economy produces the optimal amount of variety. Critics of market-oriented economies argue that society does not really need dozens of different athletic shoes or breakfast cereals or automobiles. They argue that much of the cost of creating such a high degree of product differentiation, and then of advertising and marketing this differentiation, is socially wasteful—that is, most people would be just as happy with a smaller range of differentiated products produced and sold at a lower price. Defenders of a market-oriented economy respond that if people do not want to buy differentiated products or highly advertised brand names, no one is forcing them to do so. Moreover, they argue that consumers benefit substantially when firms seek short-term profits by providing differentiated products. This controversy may never be fully resolved, in part because deciding on the optimal amount of variety is very difficult, and in part because the two sides often place different values on what variety means for consumers. Read the following Clear It Up feature for a discussion on the role that advertising plays in monopolistic competition.
Clear It Up
How does advertising impact monopolistic competition?
The U.S. economy spent about \$180.12 billion on advertising in 2014, according to eMarketer.com. Roughly one third of this was television advertising, and another third was divided roughly equally between internet, newspapers, and radio. The remaining third was divided between direct mail, magazines, telephone directory yellow pages, and billboards. Mobile devices are increasing the opportunities for advertisers.
Advertising is all about explaining to people, or making people believe, that the products of one firm are differentiated from another firm's products. In the framework of monopolistic competition, there are two ways to conceive of how advertising works: either advertising causes a firm’s perceived demand curve to become more inelastic (that is, it causes the perceived demand curve to become steeper); or advertising causes demand for the firm’s product to increase (that is, it causes the firm’s perceived demand curve to shift to the right). In either case, a successful advertising campaign may allow a firm to sell either a greater quantity or to charge a higher price, or both, and thus increase its profits.
However, economists and business owners have also long suspected that much of the advertising may only offset other advertising. Economist A. C. Pigou wrote the following back in 1920 in his book, The Economics of Welfare:
It may happen that expenditures on advertisement made by competing monopolists [that is, what we now call monopolistic competitors] will simply neutralise one another, and leave the industrial position exactly as it would have been if neither had expended anything. For, clearly, if each of two rivals makes equal efforts to attract the favour of the public away from the other, the total result is the same as it would have been if neither had made any effort at all. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/10%3A_Monopolistic_Competition_and_Oligopoly/10.02%3A_Monopolistic_Competition.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain why and how oligopolies exist
• Contrast collusion and competition
• Interpret and analyze the prisoner’s dilemma diagram
• Evaluate the tradeoffs of imperfect competition
Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other firm(s)' decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.
Why Do Oligopolies Exist?
A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.
Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.
Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.
The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.
Collusion or Competition?
When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion. A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel. See the following Clear It Up feature for a more in-depth analysis of the difference between the two.
Clear It Up
Collusion versus cartels: How to differentiate
In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.
The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.
Economists have understood for a long time the desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits. Adam Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. A small handful of oligopoly firms may end up competing so fiercely that they all find themselves earning zero economic profits—as if they were perfect competitors.
The Prisoner’s Dilemma
Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory, a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.
The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. (Note that the term "prisoner" is not typically an accurate term for someone who has recently been arrested, but we will use the term here, since this scenario is widely used and referenced in economic, business, and social contexts.) The story behind the prisoner’s dilemma goes like this:
Two co-conspirators are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. Your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.
The game theory situation facing the two prisoners is in Table 10.2. To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A should confess, too, so as to not get stuck with the eight years in prison. However, if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. To confess is called the dominant strategy. It is the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up being sentenced to a total of 10 years of jail time between them.
Prisoner B
Remain Silent (cooperate with other prisoner) Confess (do not cooperate with other prisoner)
Prisoner A Remain Silent (cooperate with other prisoner) A gets 2 years, B gets 2 years A gets 8 years, B gets 1 year
Confess (do not cooperate with other prisoner) A gets 1 year, B gets 8 years A gets 5 years B gets 5 years
Table 10.2 The Prisoner’s Dilemma Problem
The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have been incarcerated for two years each, for a total of four years between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer terms.
The Oligopoly Version of the Prisoner’s Dilemma
The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits. Table 10.3 shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly. If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn \$1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn \$400 in profits.
Firm B
Hold Down Output (cooperate with other firm) Increase Output (do not cooperate with other firm)
Firm A Hold Down Output (cooperate with other firm) A gets \$1,000, B gets \$1,000 A gets \$200, B gets \$1,500
Increase Output (do not cooperate with other firm) A gets \$1,500, B gets \$200 A gets \$400, B gets \$400
Table 10.3 A Prisoner’s Dilemma for Oligopolists
Can the two firms trust each other? Consider the situation of Firm A:
• If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of \$400 when both firms increase output (the bottom right-hand choice in Table 10.3) is better than a profit of only \$200 if A keeps output low and B raises output (the upper right-hand choice in the table).
• If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn \$1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only \$1,000 by holding down output as well (the upper left-hand choice in the table).
Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions that will lead B also to expand output.
The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only \$400 each in profits. The following Clear It Up feature discusses one cartel scandal in particular.
Clear It Up
What is the Lysine cartel?
Lysine, a \$600 million-a-year industry, is an amino acid that farmers use as a feed additive to ensure the proper growth of swine and poultry. The primary U.S. producer of lysine is Archer Daniels Midland (ADM), but several other large European and Japanese firms are also in this market. For a time in the first half of the 1990s, the world’s major lysine producers met together in hotel conference rooms and decided exactly how much each firm would sell and what it would charge. The U.S. Federal Bureau of Investigation (FBI), however, had learned of the cartel and placed wire taps on a number of their phone calls and meetings.
From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:
I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ‘em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us ... money. ... And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.
The price of lysine doubled while the cartel was in effect. Confronted by the FBI tapes, Archer Daniels Midland pled guilty in 1996 and paid a fine of \$100 million. A number of top executives, both at ADM and other firms, later paid fines of up to \$350,000 and were sentenced to 24–30 months in prison.
In another one of the FBI recordings, the president of Archer Daniels Midland told an executive from another competing firm that ADM had a slogan that, in his words, had “penetrated the whole company.” The company president stated the slogan this way: “Our competitors are our friends. Our customers are the enemy.” That slogan could stand as the motto of cartels everywhere.
How to Enforce Cooperation
How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.
Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC), have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.
Link It Up
Visit the Organization of the Petroleum Exporting Countries website and learn more about its history and how it defines itself.
Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.
One example of the pressure these firms can exert on one another is the kinked demand curve, in which competing oligopoly firms commit to match price cuts, but not price increases. Figure 10.5 shows this situation. Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of \$500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.
If one firm cuts its price to \$300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to \$550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price, and share a monopoly level of profits even without any legally enforceable agreement.
Figure 10.5 A Kinked Demand Curve Consider a member firm in an oligopoly cartel that is supposed to produce a quantity of 10,000 and sell at a price of \$500. The other members of the cartel can encourage this firm to honor its commitments by acting so that the firm faces a kinked demand curve. If the oligopolist attempts to expand output and reduce price slightly, other firms also cut prices immediately—so if the firm expands output to 11,000, the price per unit falls dramatically, to \$300. On the other side, if the oligopoly attempts to raise its price, other firms will not do so, so if the firm raises its price to \$550, its sales decline sharply to 5,000. Thus, the members of a cartel can discipline each other to stick to the pre-agreed levels of quantity and price through a strategy of matching all price cuts but not matching any price increases.
Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.
Tradeoffs of Imperfect Competition
Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.
Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffered by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.
The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers. Monopoly and Antitrust Policy discusses the delicate judgments that go into this task.
Bring It Home
The Temptation to Defy the Law
Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, sometimes lasting more than four hours, the companies established complex pricing structures. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.
How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million (\$484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region. There were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about \$600,000—a steep fine considering a bag of ice sells for under \$3 in most parts of the United States.
Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/10%3A_Monopolistic_Competition_and_Oligopoly/10.03%3A_Oligopoly.txt |
cartel
a group of firms that collude to produce the monopoly output and sell at the monopoly price
collusion
when firms act together to reduce output and keep prices high
differentiated product
a product that consumers perceive as distinctive in some way
duopoly
an oligopoly with only two firms
game theory
a branch of mathematics that economists use to analyze situations in which players must make decisions and then receive payoffs based on what decisions the other players make
imperfectly competitive
firms and organizations that fall between the extremes of monopoly and perfect competition
kinked demand curve
a perceived demand curve that arises when competing oligopoly firms commit to match price cuts, but not price increases
monopolistic competition
many firms competing to sell similar but differentiated products
oligopoly
when a few large firms have all or most of the sales in an industry
prisoner’s dilemma
a game in which the gains from cooperation are larger than the rewards from pursuing self-interest
product differentiation
any action that firms do to make consumers think their products are different from their competitors'
10.05: Key Concepts and Summary
10.1 Monopolistic Competition
Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the firm sells the product, intangible aspects of the product, and perceptions of the product.
The perceived demand curve for a monopolistically competitive firm is downward-sloping, which shows that it is a price maker and chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist, because the monopolistic competitor has direct competition, unlike the pure monopolist. A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost. The monopolistic competitor will produce that level of output and charge the price that the firm’s demand curve indicates.
If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will experience exit of firms until economic losses are driven up to zero in the long run.
A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient because it does not produce where P = MC, but instead produces where P > MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive firm.
Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.
10.2 Oligopoly
An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.
The prisoner’s dilemma is an example of the application of game theory to analysis of oligopoly. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/10%3A_Monopolistic_Competition_and_Oligopoly/10.04%3A_Key_Terms.txt |
1.
Suppose that, due to a successful advertising campaign, a monopolistic competitor experiences an increase in demand for its product. How will that affect the price it charges and the quantity it supplies?
2.
Continuing with the scenario in question 1, in the long run, the positive economic profits that the monopolistic competitor earns will attract a response either from existing firms in the industry or firms outside. As those firms capture the original firm’s profit, what will happen to the original firm’s profit-maximizing price and output levels?
3.
Consider the curve in the figure below, which shows the market demand, marginal cost, and marginal revenue curve for firms in an oligopolistic industry. In this example, we assume firms have zero fixed costs.
Figure 10.6
1. Suppose the firms collude to form a cartel. What price will the cartel charge? What quantity will the cartel supply? How much profit will the cartel earn?
2. Suppose now that the cartel breaks up and the oligopolistic firms compete as vigorously as possible by cutting the price and increasing sales. What will be the industry quantity and price? What will be the collective profits of all firms in the industry?
3. Compare the equilibrium price, quantity, and profit for the cartel and cutthroat competition outcomes.
4.
Sometimes oligopolies in the same industry are very different in size. Suppose we have a duopoly where one firm (Firm A) is large and the other firm (Firm B) is small, as the prisoner’s dilemma box in Table 10.4 shows.
Firm B colludes with Firm A Firm B cheats by selling more output
Firm A colludes with Firm B A gets \$1,000, B gets \$100 A gets \$800, B gets \$200
Firm A cheats by selling more output A gets \$1,050, B gets \$50 A gets \$500, B gets \$20
Table 10.4
Assuming that both firms know the payoffs, what is the likely outcome in this case?
10.07: Review Questions
5.
What is the relationship between product differentiation and monopolistic competition?
6.
How is the perceived demand curve for a monopolistically competitive firm different from the perceived demand curve for a monopoly or a perfectly competitive firm?
7.
How does a monopolistic competitor choose its profit-maximizing quantity of output and price?
8.
How can a monopolistic competitor tell whether the price it is charging will cause the firm to earn profits or experience losses?
9.
If the firms in a monopolistically competitive market are earning economic profits or losses in the short run, would you expect them to continue doing so in the long run? Why?
10.
Is a monopolistically competitive firm productively efficient? Is it allocatively efficient? Why or why not?
11.
Will the firms in an oligopoly act more like a monopoly or more like competitors? Briefly explain.
12.
Does each individual in a prisoner’s dilemma benefit more from cooperation or from pursuing self-interest? Explain briefly.
13.
What stops oligopolists from acting together as a monopolist and earning the highest possible level of profits?
10.08: Critical Thinking Questions
14.
Aside from advertising, how can monopolistically competitive firms increase demand for their products?
15.
Make a case for why monopolistically competitive industries never reach long-run equilibrium.
16.
Would you rather have efficiency or variety? That is, one opportunity cost of the variety of products we have is that each product costs more per unit than if there were only one kind of product of a given type, like shoes. Perhaps a better question is, “What is the right amount of variety? Can there be too many varieties of shoes, for example?”
17.
Would you expect the kinked demand curve to be more extreme (like a right angle) or less extreme (like a normal demand curve) if each firm in the cartel produces a near-identical product like OPEC and petroleum? What if each firm produces a somewhat different product? Explain your reasoning.
18.
When OPEC raised the price of oil dramatically in the mid-1970s, experts said it was unlikely that the cartel could stay together over the long term—that the incentives for individual members to cheat would become too strong. More than forty years later, OPEC still exists. Why do you think OPEC has been able to beat the odds and continue to collude? Hint: You may wish to consider non-economic reasons.
10.09: Problems
19.
Andrea’s Day Spa began to offer a relaxing aromatherapy treatment. The firm asks you how much to charge to maximize profits. The first two columns in Table 10.5 provide the price and quantity for the demand curve for treatments. The third column shows its total costs. For each level of output, calculate total revenue, marginal revenue, average cost, and marginal cost. What is the profit-maximizing level of output for the treatments and how much will the firm earn in profits?
Price Quantity TC
\$25.00 0 \$130
\$24.00 10 \$275
\$23.00 20 \$435
\$22.50 30 \$610
\$22.00 40 \$800
\$21.60 50 \$1,005
\$21.20 60 \$1,225
Table 10.5
20.
Mary and Raj are the only two growers who provide organically grown corn to a local grocery store. They know that if they cooperated and produced less corn, they could raise the price of the corn. If they work independently, they will each earn \$100. If they decide to work together and both lower their output, they can each earn \$150. If one person lowers output and the other does not, the person who lowers output will earn \$0 and the other person will capture the entire market and will earn \$200. Table 10.6 represents the choices available to Mary and Raj. What is the best choice for Raj if he is sure that Mary will cooperate? If Mary thinks Raj will cheat, what should Mary do and why? What is the prisoner’s dilemma result? What is the preferred choice if they could ensure cooperation? A = Work independently; B = Cooperate and Lower Output. (Each results entry lists Raj’s earnings first, and Mary's earnings second.)
Mary
A B
Raj A (\$100, \$100) (\$200, \$0)
B (\$0, \$200) (\$150, \$150)
Table 10.6
21.
Jane and Bill are apprehended for a bank robbery. They are taken into separate rooms and questioned by the police about their involvement in the crime. The police tell them each that if they confess and turn the other person in, they will receive a lighter sentence. If they both confess, they will be each be sentenced to 30 years. If neither confesses, they will each receive a 20-year sentence. If only one confesses, the confessor will receive 15 years and the one who stayed silent will receive 35 years. Table 10.7 below represents the choices available to Jane and Bill. If Jane trusts Bill to stay silent, what should she do? If Jane thinks that Bill will confess, what should she do? Does Jane have a dominant strategy? Does Bill have a dominant strategy? A = Confess; B = Stay Silent. (Each results entry lists Jane’s sentence first (in years), and Bill's sentence second.)
Jane
A B
Bill A (30, 30) (15, 35)
B (35, 15) (20, 20)
Table 10.7 | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/10%3A_Monopolistic_Competition_and_Oligopoly/10.06%3A_Self-Check_Questions.txt |
Figure 11.1 Oligopoly versus Competitors in the Marketplace Large corporations, such as the natural gas producer Kinder Morgan, can bring economies of scale to the marketplace. Will that benefit consumers, or is more competition better? (Credit: modification of “Aerial view of Kinder Morgan Brisbane Terminal” by Chiara Coetzee/Flickr Creative Commons, Public Domain)
Chapter Objectives
In this chapter, you will learn about:
• Corporate Mergers
• Regulating Anticompetitive Behavior
• Regulating Natural Monopolies
• The Great Deregulation Experiment
Bring It Home
More than Cooking, Heating, and Cooling
If you live in the United States, there is a slightly better than 50–50 chance your home is heated and cooled using natural gas. You may even use natural gas for cooking. However, those uses are not the primary uses of natural gas in the U.S. In late 2021, according to the U.S. Energy Information Administration, home heating, cooling, and cooking accounted for nearly 20% of natural gas usage. What accounts for the rest? The greatest uses for natural gas are the generation of electric power (almost 37%) and in industry (30%). Together these three uses for natural gas touch many areas of our lives, so why would there be any opposition to a merger of two natural gas firms? After all, a merger could mean increased efficiencies and reduced costs to people like you and me.
In October 2011, Kinder Morgan and El Paso Corporation, two natural gas firms, announced they were merging. The announcement stated the combined firm would link “nearly every major production region with markets,” cut costs by “eliminating duplication in pipelines and other assets,” and that “the savings could be passed on to consumers.”
The objection? The \$21.1 billion deal would give Kinder Morgan control of more than 80,000 miles of pipeline, making the new firm the third largest energy producer in North America. Policymakers and the public wondered whether the new conglomerate really would pass on cost savings to consumers, or would the merger give Kinder Morgan a strong oligopoly position in the natural gas marketplace?
That brings us to the central questions this chapter poses: What should the balance be between corporate size and a larger number of competitors in a marketplace, and what role should the government play in this balancing act?
The previous chapters on the theory of the firm identified three important lessons: First, that competition, by providing consumers with lower prices and a variety of innovative products, is a good thing; second, that large-scale production can dramatically lower average costs; and third, that markets in the real world are rarely perfectly competitive. As a consequence, government policymakers must determine how much to intervene to balance the potential benefits of large-scale production against the potential loss of competition that can occur when businesses grow in size, especially through mergers.
For example, in 2006, AT&T and BellSouth proposed a merger. At the time, there were very few mobile phone service providers. Both the Justice Department and the FCC blocked the proposal.
The two companies argued that the merger would benefit consumers, who would be able to purchase better telecommunications services at a cheaper price because the newly created firm would take advantage of economies of scale and eliminate duplicate investments. However, a number of activist groups like the Consumer Federation of America and Public Knowledge expressed fears that the merger would reduce competition and lead to higher prices for consumers for decades to come. In December 2006, the federal government allowed the merger to proceed. By 2009, the new post-merger AT&T was the eighth largest company by revenues in the United States, and by that measure the largest telecommunications company in the world. Economists have spent – and will still spend – years trying to determine whether the merger of AT&T and BellSouth, as well as other smaller mergers of telecommunications companies at about this same time, helped consumers, hurt them, or did not make much difference.
This chapter discusses public policy issues about competition. How can economists and governments determine when mergers of large companies like AT&T and BellSouth should be allowed and when they should be blocked? The government also plays a role in policing anticompetitive behavior other than mergers, like prohibiting certain kinds of contracts that might restrict competition. In the case of natural monopoly, however, trying to preserve competition probably will not work very well, and so government will often resort to regulation of price and/or quantity of output. In recent decades, there has been a global trend toward less government intervention in the price and output decisions of businesses. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/11%3A_Monopoly_and_Antitrust_Policy/11.01%3A_Introduction.txt |
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