Economics: Best possible use of available resources

0 1 2 3

English 0 40 60 70

Economics 0 30 50 60

I have 3 hours at my disposal Marginal rule

Instead

1 2 3

English 20 50 85

Economics 10 25 45

Should we specialize or notEndowment 2hrs

Hours 1 2

Food 2 3

clothing 2 3

Hours 1 2

Food 2 3

clothing 2 3

Hours 1 2

Food 2 5

clothing 2 5

Hours 1 2

Food 2 5

clothing 2 5

A

A

B

B

How are prices determined?

Answer: By Demand and Supply

Demand for a product comes from households

Supply for a product comes form producers

Simple Model

1.Two goods food and clothing

2.Two individuals A & B

3.Suppliers of food and clothing

Given Incomes of A& B

To determine, the demand of food and clothing and the price of food and clothing

Food

Market Demand

Pf

Afx

Demand by A

A

Pf

Bfx Food

Demand by B

B

Food

Pf

Bf

Af xx

Pf

Let price of clothing fall

People can buy the same amount of clothing before for less money.

Some of the extra income released can be used to buy more food

Pf

0 Food

APf

0 Food

B

Pf

0 Food

Let the income of A rise and that of B fall, what impact will it have on the demand for food?

Food

Pf

Food

Pf

Food

Pf

Market Demand may either shift to the right or to the left:

Supply of food

Pf

Qfx

Producer Q

Food0

Pf

Pfx

Producer P

Food0

Market SupplyPf

Qf

Pf xx Food

0

What happens to the demand and supply of food if fertilizer prices fall

• Demand for food unaffected

• Supply of food is more at any given price

Pf

Food

Pf

Food Food

Pf

Equilibrium Quantity and price of food

Pf

Pf*

x*

S

D

Food

• Similarly we can determine the equilibrium price of clothing

Markets are interlinked. A shock in one market spreads in other markets too

Example:- Drought:-

• Food supply is less

•Farmers incomes are less

•Farmers demand for clothing falls

•Equilibrium quantity and clothing for price drops too.

Policy options

• If it is a closed economy, any shock in the domestic market affects all other sectors.

• If suppliers of clothing, export a large chunk of their product, they are not affected much by the domestic drought.

Another policy

• Impact of price ceilings.• Shortages created

Pf

Pf*

S

D

Food

P Shortage

Sfq

*fq

Dfq

What is the impact on demand of a change in price?

Elasticity:- Percentage change in demand from a one percent change in price

If there is no change in demand with a change in price, the demand curve is completely inelastic.

Pf

0

D

Food

E

Pf

0Food

D1

D2

The flatter is the demand curve, the more elastic it is.

•Demand for essentials like rice and dal is inelastic. Even if prices rise sharply, the demand does not fall all that much, if prices drop sharply, demand does not rise much.

•In contrast demand for luxury items is elastic

Policy Prescription

If the government wants to raise tax revenues, it should tax goods for which demand is inelastic. People cannot avoid buying these items and tax revenues will rise.

PROBLEMS OF INFORMATION

• Adverse selection

• Moral Hazard

ADVERSE SELECTIONThe worst of the lot are finally chosenExample: A uniform VRS offer is given to employees. The best people would leave, and search for jobs in the open market.

MORAL HAZARDIn the presence of wrong incentives, you might end up inducing wrong behavior.

Example: After buying insurance you might prefer to be careless rather than being careful, since you will be reimbursed the money if the accident happens, if you get full coverage.

Solution: Never offer full coverage. Cover only a part of the loss incurred.

Is it fair that traditional money lenders charge a much higher rate of interest, than normal banks?In the absence of proper information about the lender, the chances of a person defaulting on a loan is very high.

Possibilities:• Tough screening, very little loan disbursed• Easy screening, but charge very high rates so that you can break even

How do you ensure that people repay the loan in the absence of a collateral, if punishment is not that much.

Solution:

GRAMEEN BANK, Muhammad Yonus

Give loans to a group of people and make them collectively responsible. If one person defaults, the whole group has to pay on his behalf. This will result in “peer monitoring”, each person will monitor each other and ensure that the whole group behaves well.

ADAM SMITH

If every individual works for his own selfish interest, he not only serves himself, but indirectly serves society.

Shopkeeper and two types of buyers, one a tourist and the other a neighborhood guy. Whom should he cheat?

TAXES

•Lump-sum Taxes: A fixed amount of money has to be paid by each person, irrespective of his level of income

•Income Taxes: A proportion of your income is paid as taxes, in progressive income taxes, this proportion rises with income.

Lump-sum taxes do not change an individuals behavior, so is desirable. However, such a tax is regressive in the sense that poorer people pay a larger fraction of their income as taxes than poorer people.

Income taxes may be distortionary in the sense it may lead to a misallocation of resources.

Example: An electrician can do his own work in 12 hours and a carpenters work in 20 hours. A carpenter can do his own work in 12 hours and an electrician’s work in 20 hours. The wage rate is Rs. 10 per hour for both. If each needs each other’s services, they would have to work for 12 hours to raise the money. Now let a 50% income tax be imposed. If they were to hire the other, each would have to work for 24 hours, whereas if they did it themselves they would need 20 hours. So the electrician might end up doing the work of a carpenter, and a carpenter of an electrician.

Prices reveal relative scarcity or abundance of a commodity, if markets are not allowed to operate freely, society may end up using resources in not the best way.

Example: Fixed exchange rates

•The rupee was overvalued vis a vis the dollar, so that importers had to pay less to import machinery to help in the country’s industrialization. However, we ended up choosing capital intensive techniques of production instead of labor intensive ones, and so ended up with a lot of unemployment.

•In India we use domestic labor to wash and clean homes rather than washing machines and dish washers since domestic help is so much cheaper to buying or renting these machines.

•A lot of water and electricity subsidies to farmers result in them choosing crops which require lots of water, and not suited to the climatic condition of that place. Example: sugarcane in Maharashtra and rice in Punjab

How do savings behave with a change in interest rate:

•Let interest rates rise

•People can get the same interest income by saving less. This is the income effect which induces people to save less

•However, it is more costly to consume today now. With a rise in the interest rate my forgone consumption tomorrow is much higher. This would induce people to save more. This is the substitution effect.

•At low levels of interest, the substitution effect is larger than the income effect and savings rise with a rise in the rate of interest.

When do women decide to join the workforce?

If outside wages be too low, and domestic help and cost of daycare and for a cook is very high, women may decide to stay at home and do housework.

•However, if outside wages by relatively very high, and cost of daycare and cook low, women might decide to employ domestic help to get housework done.

What is the role of government in an economy?

To provide public goods and services like street lighting. If one person were to provide for the same, others can enjoy the benefit without having to pay for it, that is “free-ride”. Very few people would volunteer to spend money and enjoy such a good, expecting others to spend, and enjoy the benefits without incurring costs. Very little of such services would be provided if left to individuals to provide for the same.

The government therefore collects taxes, decides how much of public services to provide and whom to charge how much for such services.

Economics is all about having the right incentive package to elicit appropriate behavior.

How should wage packages be designed such that workers put their best effort?

Final output is dependent on workers effort and uncertain market conditions.

•Fixed wage contract: workers given a fixed wage. They would choose to shirk, one would have to spend on monitoring, the employer bears all the risk.

•Wages based on performance: Workers need not be monitored, and there is risk sharing.

COSTS, MARKET STRUCTURE AND STRATEGICBEHAVIOR

Is it possible that that some resources in the economy lie wasted:

Yes. If there is no appropriate technology to use up all our resources.

Example: Let the country be endowed with 3 units of labor and 3 units of land. To produce one unit of output may require 2 units of labor and one unit of land. In this situation 1 unit of labor 2 units of land will lie waste. If we have a second technology that can use up 1 unit of labor and 2 units of land to produce 1 unit of output, then all our resources will be utilized.

Before call centers came to India, we had a lot of educated unemployed graduates. However, when appropriate technology came, where we could service the west sitting in India, it became possible to use up our idle manpower resources.

If producers do not have any inputs with themselves but have to buy from the market, they should use the input mix which minimizes their cost given the technology available?

COSTS:

Fixed costs: Costs which do not change for any given level of output produced, example rent for a factory premises.

Variable costs: Costs which are dependent on the amount of output produced, example fuel costs.

Suppose output is the number of kilometers covered on a road by a car. Should you buy a petrol car, where cost of the car is cheap, but fuel costs are high, or a diesel car where costs of the car is high, but where fuel costs are low, assuming mileage is the same for both types of cars?

If you only have to cover a very short distance, go for a petrol car, if you have to cover large distances go for a diesel car.

Example: Let a petrol car cost 50 units and a diesel car cost 100 units. Let petrol cost 2 units a litre and diesel cost 1 unit a litre. Assuming diesel and petrol cars have the same mileage, if we are to drive less than 50 km buy a petrol car, if more buy a diesel car.

SOME CONCEPTS:

Marginal Revenue: Increase in total revenue when an extra unit of the output is produced and sold.

Marginal Costs: Increase in total costs when an extra unit of the output is produced.

Entrepreneurs maximize profits at an output level at which marginal revenue is equal to marginal costs.

Output Price Revenue Costs ProfitMarginal Revenue

Marginal Cost

1 4 4 2 2 4 3

2 4 8 5 3 4 4

3 4 12 9 3 4 5

4 4 16 14 2    

PERFECTLY COMPETITIVE MARKETS

•Large number of buyers and sellers

•Each seller sells a product which is identical to the product of the other sellers

•There is perfect information with both buyers and sellers. No seller can afford to sell at a higher price than what other sellers sell. There are no cost differences amongst in buying from one seller than another.

•Both the buyer and the seller can take prices as given. Any buyer or seller is too small to affect market prices in any significant manner.

•In equilibrium price in any competitive market will come down to a level that any firm will just earn normal profit. Normal profit is that level of profit which will just induce him to continue in this market than moving somewhere else.

•In equilibrium price is equal to the marginal cost.

PERFECT COMPETITION AND EFFICIENCY

•Productive Efficiency

•Allocative Efficiency

PRODUCTIVE EFFICIENCY:

Given the inputs available in the economy two products X and Y are produced. If X and Y are being produced efficiently, it is not possible to increase the production of X, without sacrificing the production of Y.

ALLOCATIVE EFFICIENCY:

Outputs X and Y will finally be consumed by different households. If it is not possible to redistribute X and Y amongst households, such that a household can be made better off only by making some household worse off, then we have achieved allocative efficiency.

If all markets are perfectly competitive, we would achieve efficient allocation of resources. We arrive at a set of equilibrium prices at which

•All producers maximize their profits.

•All consumers maximize their welfare subject to a budget constraint.

•Demand equals supply in all markets.

Is it desirable to have competition in all markets?

No. If there are economies of scale, that it is relatively costless to service an extra consumer, then it is desirable to have to have few or one supplier supplying the entire market. Example, telephone or electricity connections.

Although perfect competition is efficient from the static point of view, it is not when seen on a longer horizon. Given that there is free flow of information amongst different agents, any innovation done by a producer to reduce costs will be quickly known to other producers.

Therefore on producer has the incentive to invest time and effort in research and development.

In order to stimulate research and development, it may be necessary to grant patents. If any producer gets a patent, it may be possible that it is only him that operates in the market.

We then come to a situation of monopoly, that is there is only one producer in the market, who yields substantial market power.

A monopolist can sell more in the market only if he lowers his price. Equilibrium is again where marginal revenue is equal to marginal cost, but he charges a price higher than the marginal cost which denotes his market power.

Example:

Output Price Revenue Costs ProfitMarginal Revenue

Marginal Cost

1 5 5 2 3 3 3

2 4 8 5 3 1 4

3 3 9 9 0    

Prices are higher under a monopoly and output sold is less than what would have prevailed under perfect competition.

A monopolist may be able to increase his profits further by “price discrimination”.

Some instances of price discrimination are:

Charging different prices to different customers for the same service. Example: A doctor charging different rates to different customers. Such a thing is possible, when there does not exist a possibility of resale.

Charging different prices for different quantities bought: example bulk discounts given on big purchases.

Charging different products for the same product sold in two geographically distant regions. Example: Books printed and sold in India are much cheaper than their corresponding editions in US or Europe.

Two part tariffs: Some amusement parks charge an entry fee, and an extra charge for every ride. It has been shown that this pricing scheme yields much more profit than if a higher fee was charged for every ride.

Commodity Bundling: Combo meals in McDonalds: The seller knows that 50% customers are thirsty and 50% customers are hungry. Thirsty customers are willing to pay 2 units for a burger and 2 units for a coke. Hungry customers are willing to pay 1 unit for a coke and 3 units for a burger. If the manager wants to sell burger to all, he cannot sell it for more than 2 units. The manager can sell coke either for 2 units or for 1 unit both of which yield him the same revenue. With such a pricing scheme the maximum he can earn is 3 units. However if both goods are offered as a combo of 4 units, earnings increase from 3 to 4 units.

Oligopoly:

Situation where there are two or more players in the market

Strategic issues in such a market:

•Should producers collude amongst themselves or compete?

•Do producers have any strategies that will deter entry.

•How will rivals react to whatever he does?

ADAM SMITH: People of the same trade seldom meet together, even for merriment and diversion, but a conversation ends against the public, or in some contrivance to raise prices.

A group of companies that formally operate in collusion is called a cartel. A cartel may operate in collusion to restrict output, raise prices to increase profits. Example: OPEC Countries agreed to limit their oil production to maintain prices.

USING GAME THEORY TO MODEL COLLUSION

PRISONER’S DILEMMA

A/B Confess Not Confess

Confess A gets 3 years, B gets 3 years A gets 3 months, B gets 5 years

Not ConfessA gets 5 years, B gets 3 months

A gets 1 year, B gets 1 year

THE PROBLEM OF COLLUSION AS A PRISONER’S DILEMMA

A/BDo not restrict output

Restrict Output

Do not restrict output

0.5bn, 0.5 bn 1.3 bn, 0.4 bn

Restrict Output

0.4 bn, 1.3 bn

1 bn, 1 bn

Both producers end up producing more output although both would Have been better off restricting output

ENTRY DETERRENCE

Oligopolists use restrictive practices to reduce competition and thereby increase profits. Another way to reduce competition is to prevent firms from entering the market. This is called entry deterrence.

BARRIERS TO ENTRY:

•Government permits•Single ownership of an essential input•Information•Market Strategies for entry deterrence 1. Predatory Pricing: Threaten to reduce prices drastically if entry were to occur 2. Build excess capacity so that one can flood the market and reduce prices.

DRAWBACKS OF MONOPOLIES AND RESTRICTED COMPETITION

•Restricted Output

•Managerial Slack

•Rent Seeking: using resources in unproductive ways to maintain monopoly. Example: Bribing politicians to maintain regulations to maintain competition.

In products where there are economies of scale, there are natural monopolies, either there is public ownership or there is regulation of prices to ensure that high monopoly prices are not charged.

WHICH ASSETS DO WE CHOOSE TO INVEST IN?

Assets are judged by

•Their mean returns

•The standard deviation in their returns

We can have a diversified portfolio to reduce the standard deviation in our returns.

weather Umbrellas Ice cream Probability

Good -1 10 0.5

Bad 10 -1 0.5

AUCTIONS

Auctions are a widely used alternative mechanism for transferring goods from the seller to buyers.

Types of Auctions:

•English Auction•First Price Sealed Bid Auction•Second Price Sealed Bid Auction

ENGLISH AUCTIONAuctioneer starts with a very low bid, bidders make increasingly higher bids. The person with the highest bid wins. The optimal strategy is to stay in the auction till the bidding reaches your valuation.

FIRST PRICE SEALED BID AUCTION

Bids are submitted secretly and simultaneously. The person with the highest bid wins. The optimal strategy is to bid below your valuation.

SECOND PRICE SEALED BID AUCTION

Bids are submitted secretly and simultaneously. The person with the highest bid wins but pays the second highest bid. In this case the optimal strategy is to bid your true valuation.