Economics VG

7/26/2019 Economics VG

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EconomicsHeriot Watt Edinburgh Business School

Last revised: November 1, 2003B: !amela "reightonBac# to to$

Module 1 Economic Concepts, Issues and Tools
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Scarcity and Choice

free goodAnything which satises wantsbut requires no human

eort is a free good, wants that are provided by nature without

human efort, e.g. oating in the sea of Bermudas south coast and

drying of on the silver sand. These are ree goods i you are in

Bermuda.

Any good or service the production o which requires scarce resources

is, by de!nition, not a ree good.

Resourceis de!ned as anything that helps produce the goods and

serices people want.

"ome wants in society can be satis!ed withoutthe need for

choiceThe bounty o nature supplies many goods and services at

#ero cost$ sunshine, resh air, beautiul views are freely available

to many societies throughout the world continuously. To en%oy

some o them e.g. air does not involve choice in most locations

throughout the world. To be available continuously does not imply

that scarce resources are involved in their production.

!references, Resources and Economic E"cienc#

The what, how and for whom problems in economics

concern decisions

To ma&imi#e societys welare, given limited resources, the choice all

nations ace is common'

whichgoods and services to produce,

how to produce them ( alternative uses o resources and

how to allocate(distri$utethem among the population

Engineeringe)ciency *escribes a situation in which a good o give


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produced using fewest resources%

Economice)ciency +equires that the good produced using the s

resources did not have a superioralternati

Marginal &nal#sis and 'pportunit# Cost

The opportunit# costto any society o an activity undertaen is

the $est alternatie foregone- the best, not any other option.

Marginal anal#sis analysing incremental changes in resource

allocationand ealuatingthe marginal $enets and marginal

costs

(ierent Economic )#stems

/ations have the choice among three methods o solving the

scarcity-choice problem$

Tradition *etermined by socialcustom and

habitsesta$lished oer time.

"carcity and choice are resolved

*istribution issue is determ

other social factors

Command *oernmentpurchase o goods and

services 0 1entral +uling body

The state determinesbo

the price of goods and s

Mar+ets Capitalist nationssolve the bul o

the scarcity-choice problem

2t is the orces o demand

factorinputs which determ

interest and dividends, i.einputs and as a consequen

distributions and subseque

services are distributed


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!roduction !ossi$ilities Cure

A curve o numbers that illustrates the production possibilities

o an economy--the alternative combinations o two

goodsthat an econom# can producewith gien resources

and technolog#. A production possi$ilities cure!!C-represents the $oundar# or frontiero the economy3s

production capa$ilities, hence it is also requently termed

aproduction possi$ilities frontier !!.-%

As a rontier, it is the ma&imum production possible given

e&isting 4!&ed5 resources and technology.

The opportunit# costo each good at any pointo the cure. 6roducing on the curemeans resources are full# emplo#ed, while 6roducing inside the curemeans resources are unemplo#ed.

The law o increasing opportunity cost is

what gives the curve its distinctive conve& shape.

The society, operating at

pointx, prepares or growth

allocating all o its resources to

capital goods production. 7hat

is the increase in capital goods

production and what is its

opportunity cost8

2n moving rom pointx49::,9;;5 to all capital goods

production 49


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>or the opportunity cost o capital goods in terms o butter to

be constant, no matter the point o production o the

production possibility curve, the production possibility curve

has to be a straight line. "ince the production possibility curve

passes through the points 9


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Law of Diminishing Marginal Utility

As an individual consumes more o a good total utility increases

but at a decreasing rate, i.e. each additional unit consumed

contributes less utility than the previous unit.

Individual Household Demand

Household equilibriumA household is in equilibrium consuming only goods,xandy, i.e.

ma&imising utility sub%ect to a budget constraint. The price o

goodxalls and simultaneously the budget is increased. Assuming

the household continues to consume onlyxandywhat will happen

to their purchases8

1onsider !rst the impact o price decrease inxin isolation. To re-

establish equilibrium, i.e. equate and necessitates an increase

in the quantity oxconsumed and decrease in the quantityoyconsumed. The efect o the budget increase, taen in isolation,

will be to increase purchases o bothxandy. Taing together the

price and budget changes, the purchases oxwill increase but net

purchases oywill depend upon the relative strengths o the price

efect and budget efect$ i.e. they could increase, remain constant

or decrease.

Substitution effect

The su$stitution eectis always negative Increasesinthe priceo a good always lead to the su$stitution o relatively less

epensie goods

1onsider a household in equilibrium concerning two goods a

and b$ i.e.


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2 the price o A increases'

To re-establish utility ma&imisation some e&penditure should

be switched rom a to b. ow much8 ntil equality rules. The

increase in the price o a leads to the substitution, at the

margin, o the relatively cheaper b.

Real Income

The households real income can increase in two ways$ daily

income can increase and prices o goods and services can remainconstant, or daily income can remain constant and prices o goods

and services can decrease.

"uppose the household were initially allocating its C9:: to the

purchase o melons D C9.:: each. The household buys 9::

melons. 7hen the daily income increases by 9: the household

can now buy 99: melons.

"uppose however the price o melons decreases by 9: each

melon will now cost F:p. 7ith an income o C9:: the household

can purchase 999 melons 4C9::(.F:5 i.e. almost 9 better of.

Demand Curve

The conditions which hold or an individual demand curve hold or

the maret demand curve.

6rice is the independent variable,

quantity demanded the dependent variable with relevantparameters determining the position o both curves.

A linear demand curve, be it individual or maret, which

touches both a&es, price and quantity, will each have price

elasticities varying rom to :.


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Inferior goods

such as cheap cuts o meat and low quality housing are goods

or which the quantities purchased decrease as incomes increase.

Cetris pari$us0 with other things being equal or unchanged.

Market Demand

*emand curb - price is independent variable and quantity

demanded is the dependant variable.

"ensitivity o quantity demanded to price changes, nown as priceelasticity o demand

The price elasticity o demand is, or small changes in price, the

relative change in quantity divided by the relative change in price.

Three possible classi!cations o price elasticity'

2nelastic As price change, the

proportional change in

the quantity demands

is 2than that in price

change

3o matter priceyou must buy

product -mil

Elasticity The proportional

change in the quantity

demanded is4that the


price

7here the good is a want, not a

need so price in5uence

demand 4stea5

0nitar#pric The proportional As price changesso


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e elasticity change in quantity

demanded is 6the


price

doesthe7uantit#, thereby

eeping the e&penditure the

same 4regardless o price, 2m still

going to spend a C9:: on beera

night5

'ther Elasticities of (emand

1ross Elasticity o *emand A change in the price o one good 4b5 can afect

good 4a5

2ncome elasticity = import values

a5 negative 4-5' quantity good demanded de

b5 #ero4:5' quantity does not change as inco

c5 between #ero 4:5 and one 495' good dema

proportion to the increase in income.

d5 nitary' quantity good increases in propo

e5 Greater 4H5 one 495' quantity increases by

increase in income.

The Theor# of Consumer 8ehaior in the real world

95 1haracteristics o people who consume the product 0

characteristic important

?5 Estimate elasticity, price, income and cross

elasticitys

I5 1ompetitor doing


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;5 6redict demand

=5 Government use

J5 Ta&es 02ncome ta&es


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: : : :

9 < < 9N J.P i&ed 1ost 4>15 R Lariable co

Average Total 1ost 4AT15 N Total 1ost 4T15 Kutput (Ou

Average Lariable 1ost 4AL15 N Total Lariable 1ost 4TL15 Kutput (Ou

Average >i&ed 1ost 4A>15 N Total >i& 1ost 4T15 Kutput(Oua

@arginal 1ost 4@15 N 1ost o producing another unit

As output increases average !& cost 4A>15 decreases and small

diference between Average !&ed cost 4A>15 and Average Total 1ost4AT15

@arginal cost @15 is at its minimum, marginal product o labour is at

its ma&imum


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Average Lariable 1ost 4AL15 is minimum Average 6roduction 4A65 is

ma&imum

As long as total revenue e&ceeds total cost, a pro!t is made andthere may be a range o outputs where this is possible. 2t ollows

that there may be a range o outputs where marginal cost is less

than, equal to or greater than marginal revenue and a pro!t is made

given that total revenue 4average revenue5 e&ceeds total cost

4average total cost5 in that range.

9. T6 N : TL1N: T1N >1

?. AT1 @inimum AT1 N @1

I. AL1 @inimum AL1 N @1

;. @1 H AT14AL15 AT1 4AL15 increasing

= @1 Q AT1 4AL15 AT1 4AL15 decreasing

Short Run Supply Curve

>i&ed actor inputs costs do not afect short run supply curves by

de!nition

short run supply curve will shit to the right i.e. a !rm would be

willing to supply more at each and every price i the costs o

production ell$ thus it could occur i either there were a

movement towards the production rontier, i.e. greater e)ciency

or the cost o variable actor inputs decreased

the number o !rms is !&ed and changes in the prices o !&ed

actor inputs do not afect short run supply curves.


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Long Rn !pply "r#e

The !rm in the long run is in the planning stage, deciding on the

optimally si#ed plant$ it estimates long run marginal cost and

equates this with @+. As soon as the plant is built the !rm is bac

in the short run.

A !rms in!nitely elastic long run supply curve has no meaning.

>or the industry supply curve to be innitel# elasticit means

that asnew rms enterthe costo inputs do not change, i.e.

the industry in question is in!nitely small relative to all other

industries taen together which are using the same actor inputs.

2 input prices were to increase as new !rms entered, the average

total cost curves o all !rms would shit upwards, the marginal costcurves 4!rms short run supply curves5 shit let and the industry

long run supply curve would be upwards sloping.

num$er of rmsis !&ed and changes in the prices o !&ed actor

inputs doaect long run suppl# cures.

Return to factor inputs R.- refersto a !rm ar#ing one

factor input holding all others constant and seeing what

happens to output. +> can be positie, constant or negatie.

By holding at least one other actor constant +eturn to actors 4+>5

is a short runphenomenon.

Returns to )cale RC-refersto a !rm altering all factor

inputs4a long runissue5 and observing the change in output.

+eturns to "cale 4+15 can be positie, constant or negatie

Both +eturns to actor inputs 4+>5 and +eturns to "cale 4+15

reer to a !rm not an industry,

+eturn to actor inputs 4+>5 and +eturn to "cale 4+15 are

independent o each other.

Module < The Mar+et


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Market Supply and Demand

*emand curve 4quantity5 =uantit#indiidualsprepared at $u#at diferent prices

"upply curve 4price5 Ouantity suppliers willing to sellat diferent prices

Operation of Markets

E&cess "upply At a gien pricethe quantity o a good !rms are

prepared to suppl# eceedthe 7uantit#

consumersare prepared to $u#.

E&cess *emand At a gien price7uantit# consumersprepared

to $u#eceedsthe quantity !rms are prepared

tosuppl#


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Equilibrium =uantit#goodconsumerswilling to$u#

e7ualsquantity o good !rm will to sellat that

priceneither e&cess demand nor e&cess supply

e&ist

1onsumer

"urplus

*iference betweenprice indiiduals actuall#

pa#andhigher pricethey would be prepared

to pa#.

6roducer "urplus !rice suppliers actual receieor good and

the lower pricesthey would be prepared to

accept.


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6rice 1eiling 6rice o a good

is ed$elowthe e7uili$riumlevel

- E&cess demand e&ists, blac maret good

or prices higher than !&ed level.

6rice >loor !rice of a good is ed a$oe the

e7uili$rium leel

E&cess supply is disposed o i.e. pay

armers not to produce wheat

(emand Increasenot related to

"upply 0 change in actor other than

price

*emand curve shit +ight Equilibr

"upply

(emand (ecreasenot related to

"upply 0 change in actor other than

price

*emand curve would shit Met Equilibr

and r

)uppl# Increase 0 change in price 4sellmore or less5 "upply curve shit

right *own"upply4price5

Equilibrandri

)uppl# (ecrease0 change in than

price 4sell less or more5

"upply curve shit leftp "upply

4price5

Equilibr

and>e


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Change in Mar+et E7uili$rium

(emand Increaseand)uppl#

Increase

(emandEquilibrium

shit Right (Increase

)uppl

thesam

increa

(emand Increaseand)uppl#(ecrease

(emandEquilibriumma# rise, fall,orremain the samedepending on e&tent

o demand relative to supply

)uppl

(emand (ecreaseand)uppl#

Increase

(emandEquilibriumma# rise, fall,

orremain the samedepending on e&tent

o demand relative to supply

)uppl

(emand (ecreaseand)uppl#

(ecrease

(emandEquilibrium >eft ; .all )uppl

thesam

increa

Ta&es +aise the price paid by individuals or good lower price receive

reduces the volume o transactions and thus reduces the gain

Dynamic Adjustments in the Market

1omparative statics

Analysis o demand and(or supply changes a new equilibriu

"hort +un "upply o goods less inelasticthan maret period 0 ad%ust

production, equilibrium price wouldchange, but by as muc

Equilibrium 7uantit#would change.

Mong +un "upply o goods more elasticthan short run0 ad%ust all qu

!rms could enter or leave the industry.

1yclical 6atterns 1obweb model, discrete blocs o time the supply curve con

afect the ne&t periods production.

+eview


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i&, initiall, a $rice bet'een $eand $2'ere announced +he $rice

bet'een $eand $2'ould cause

e-cess su$$l in the mar#et &orcing su$$liers to lo'er $rices, i%e% move along theirsu$$l curves%

+he lo'er $rices 'ould result in a larger uantit being demanded, i%e% buers 'ouldmove along their demand curves%

+here 'ould be no shi&ts in the su$$l and demand curves because none o& the$arameters determining their $ositions had changed,

E-cess Su$$l 'ould e-ist%

The increase in the price o a complementary good would cause the

quantity o it demanded to decrease

and as a consequence cause the demand curve or the good in the

diagram to shit to the let.

The imposition o the ta& would cause the supply curve to shit to

the let.

Thus the equilibrium quantity must decrease but the equilibrium

price could be higher, unaltered or lower.

The winle picers pic winles at low tide, the small crustaceanbeing a delicacy which requires a toothpic to e&tract rom its

shell. They are taen to the local !sh maret each morning and

sold to local !shmongers and restaurants$ around =: ilos in bo&es

o ? ilos are brought in by the !shermen each day. A >rench

restaurateur rom the capital city some 9:: ilometres away

arrived at the maret this morning and outbid all the local


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!shmongers and restaurant owners or every bo& o winles

pushing the price way up. The winle picers were delighted and

stated they would rise much earlier tomorrow when there would be

winles or all.

"ince the quantity o winles is given, i.e. no more can be

collected instantaneously and brought to maret, the supply

will not vary with the price ofered. The supply in the maret

period is completely price inelastic. The increase in todays

price however has apparently motivated the winle picers to

bring more than usual to maret tomorrow - at least that is

their stated intention, i.e. to supply a larger quantity at an

e&pected higher price. Thus the short run 4tomorrow5 supply

curve is less inelastic than todays supply curve.

The >rench restaurateur bid or every baset until he had

outbid everyone else, i.e. in this price range his demand was

price inelastic.

The local buyers were bidding at lower prices and thus their

demand was not completely elastic but they did stop when a

certain price was reached and thereore their demand was

not completely inelastic.

cobweb model

2n the non convergent cobweb model cyclical movements in

price do not converge towards equilibrium but move urther rom

equilibrium over time with increasing gaps developing between

demand and supply.

2n the real world it would be e&pected that some producers

recognising this act would, to ma&imise pro!t, ad%ust their

behaviour counter cyclically and(or speculators observing such

behaviour would buy and store in surplus periods and resell in

tight periods both o which would lead towards convergence.

ow does the price system react to e&cess supply o a good8 2t


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The presence o e&cess supply will cause suppliers to lower

price in an attempt to clear the maret.

. The position o the demand curve is independent o supply

conditions.

!roducer and consumer sur$lus 'ill both increase 'hen euilibrium is

reached%

Module ? Economic E"cienc#

Economic E"cienc# Re7uires@

9. 6roducing a combination o goods and services using theleast amount o resources

?. 6roduce the combination o goods and services that

satis!es comers, wants as ully as possible.

2t is always possible however to mae one individual better of by

transerring goods and services rom other members o society.

(iision of >a$our

7hile the si#e o the labour orce, capital stoc, maret and total

output may be highly correlated it is the si#e o the maret which

sets a limit on the e&tent o division o labour. As Adam "mith

pointed out i the si#e o the maret or pins is large enough people

start to specialise in pin maing, e.g. shaping the point, maing the

head, etc.

Marginal E7uialenc# Conditions

*e!nition

@arginal 1ost 4@15 The change in total cost 4or total variable cost5 resulting rom a

quantity o output produced by a !rm in the short run. @arginal c

much total cost changes or a give change in the quantity o outp


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in total cost are matched by changes in total variable cost in the

total !&ed cost is !&ed5, marginal cost is the change in either tota

variable cost, is ound by dividing the change in total cost 4or tot

the change in output.

1% "onsumer ma-imi.e utilit 'hen

and b a com$etitive &irm ma-imi.e $ro&its b

!/ )"/, !B ! )" 2

+he marginal euivalenc conditions )E" 4 conditions &or economicefficiency are found by substituting MCs for Ps in equation !"#

+hese conditions do not hold in the $resence o& mar#et &ailures i%e% $ublic

goods, e-ternalities and economies o& scale because the )E" are not &ul&illed5

this can occur because the $rices in euation 1 do not re&lect the bene&its

and6or the costs in euation 2 do not re&lect societal costs%

@a&imi#e utility 4@5 when each good and service divided by its

prices 465 is equal

A competitive !rm will ma&imi#e pro!t by producing that level o

output at which price equals marginal cost /o pro!t ma&imising

!rm producing in an engineering e)cient ashion will produce

beyond that point at which marginal revenue equals marginal cost$

it would cost more than the !rm would receive in revenue or any


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production beyond that point$ thus to be e)cient !rms will not

produce the ma&imum amount o output possible.

6AN @1A

The drug addict stated that the Maw o *iminishing @arginal

tility did not apply to him. Sust the reverse The more o the

drug he too the more he en%oyed it. 2 a Maw o 2ncreasing

@arginal tility held or a consumer what would the

implication be8 2t would mean that the consumer would

purchase only one good

2ncreasing marginal utility implies total utility increases at an

increasing rate. Thus A is wrong. A consumers behaviour hasno implications or the production process$ thus 1 and * are

wrong. 2 each additional unit o a good consumed were to

yield greater satisaction than the previous unit a consumer

would gain total utility the more he consumed o any one

good. Thus it would be to his bene!t to consume one good

only - thin o the drug addict.

2 in a I good economy to achieve economic

e)ciency which o the ollowing will have to occur8

@ore o a will have to be produced

>or economic e)ciency to prevail the marginal equivalency

conditions must hold, i.e. . 2 resources were

transerred rom industry c to industry a would decrease

and would increase. 2t is theoretically possible that both

could equal without any resources moving into industry b. 2

all three industries are competitive and average costs are

unafected by marginal movements o resources the prices o

which are determined also in competitive marets marginal

cost need not change.

7hich o the ollowing is correct8


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it ollows that

>or the economy to be in long run equilibrium not only will the

ratios o be equal but !rms will be earning normal

returns producing where price N @1longrun$ this means the

optimally si#ed !rm, i.e. the !rm with the lowest average total

cost. 2t ollows that price must also equal the @1 o this

optimally si#ed !rm which is o course @1shortrun. e.

2n the utility ma&imi#ing equation it is which must equaland not @aN @bor 6aN 6b. Thus B and 1 are wrong.

"imilarly it is @1aN 6aand @1bN 6bwhich must hold or !rms to

be in equilibrium, not @1aN @1b.

Resource &llocation and !rotAMaimi:ing 8ehaior in the

)hort Run

Equilibrium price and equilibrium quantity e&changed between

buyers and sellers will be determined by the intersection o the

demand and supply curve.

>irms will produce both !&ed and variable actor inputs. 0 not able

to alter !&ed actor able to vary variable actor

6ro!t ma&imi#ing short run 0 produce output4O5 until marginal cost

4@15 equal 4N5 price 465

1ompetitive pro!t ma&imi#ing !rms 0 price o a product will equal4N5 short-run marginal cost 4@15 or each !rm

1onsequently price o a product N marginal cost to society

/ot all !rms produce identical amount each !rm produce to

the point at which price 465 N @arginal cost 4@15


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2 equilibrium price and quantities alter, the utility-ma&imi#ing

behaviors o consumers and pro!t ma&imi#ing behaviors o !rms will

establish new equilibrium price and quantities. @arginal

equivalency condition will be re-established and economic e)ciently

will again prevail.

$esource Allocation and Profit%Ma&imi'ing (eha)ior in the *ong $un

*e!nition

Mong +un @arginal 1ost4M@15 there are no !&ed inputs in the long run. As such, the

that long-run marginal cost is the result o changes i

Long-run Average Cost(LAC) The per unit cost o producing a good or service in th

2n other words, long-run total cost divided by the qua

average cost is based on economies o scale 4or incr

diseconomies o scale 4or decreasing returns to scale

2n long run the relevant marginal cost o each commodity is the

long-run marginal cost

Mong-run equilibrium the price o the commodity being produced

must equal long-run marginal cost


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6rice of all commodities produced must equal their long-run

marginal cost.

+atio o marginal utilities to prices or all commodities must be

equal. 0 no consumer could increase total utility 0 each !rm normal

pro!ts by producing output when Mong +un Actual cost4MA15 and

Average Total cost 4AT15 are minimi#ed and price 465 equals N Mong

+ung @arginal cost 4M@15 and @arginal 1ost 4@15. Any reallocation

o resources would reduce utility.

2 long run average cost 4MA15 curve were Uat bottomedV over a

range o output could diferent-si#ed plants e&ist in the long run.

Based on ollowing drawings o Mong +un Equilibrium

"uppose ater an economy had achieved long run e7uili$riumthe

maret demand or the product in the !gure shited to the right. 7hat

would happen in the short run8 The price would rise and the !rm

would move up its @1


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2n the maret diagram the supply curve is the summation o

all the !rms 4in this maret5 short run marginal cost curves.

The rightward shit in demand curve, given ", will cause the

price to rise which in turn will cause the !rms, given pro!t

ma&imising behaviour to move up their @1 curves as they

equate price with @1.

2n the short run the supply curve is given and no !&ed

resources move into the industry.

"uppose ater an economy had achieved long run e7uili$riumthe

maret demand or the product in the !gure shited to the right. 7hat

would happen in the long run8 /ew !rms would enter the maret$ what

would happen to the price o the product is unnown

The shit in demand to the right would cause !rms to move up

their short run marginal cost curves to achieve equilibrium$

this would result in above normal pro!ts which in turn would

attract new !rms into the industry, shiting the short run

supply curve to the right. 2 the entry o new !rms did not

cause actor input prices to increase the long run supply curve

would be a hori#ontal line and the price o the product would

return to its original equilibrium level. 2 however the entry o

new !rms caused actor input prices to increase the long runsupply curve would be positively inclined, i.e. upward sloping

and the new equilibrium price o the product would be higher

than it was beore.

"uppose ater an economy had reached long run e7uili$riumthe

maret demand or the product in the !gure shited to the let. 7hat

would happen in the short run8 >irms would move down their short run

marginal cost curves

To ma&imise pro!t !rms move up(down their marginal costcurves in response to price changes. 2n the short run the

number o !rms in the industry by de!nition, is !&ed thus

"uppose ater an economy had reached long run e7uili$riumthe

maret demand or the product in the !gure shited to the let. 7hat


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would happen in the long run8 The maret supply curve would shit to

the let

To minimise losses !rms in the short run would move down

their marginal cost curves, the price o the product would all

and !rms would earn less than normal returns. This in the long

run would orce some !rms out o the industry causing the

maret supply curve to shit to the let.nless actor input

prices were afected, the long run cost curves would remain

unaltered$ in the long run equilibrium normal pro!ts(returns

would e&ist.

2 the !rms average variable cost curve were to be drawn in the

!gure its minimum point would equal the distance rom the origin

to where the maret supply curve cuts the hori#ontal a&is

7here the maret supply curve begins indicates the price

below which no !rm will supply any output because average

variable costs 4AL15 will not be covered and as a consequence

a !rm would lose less by closing down. Thus where the "

curve touches the vertical a&is indicates the minimum point o

the !rms AL1. The @1 curve must go through the minimum

points o both the AT1 and AL1 and as a consequence the

M@1 curve must intersect the AL1 above its minimum point.

The MA1 curve is an envelope curve indicating the optimally si#ed

plant or any given level o output$ i.e. it traces out the lowest

average total cost or each output level. Given its saucer shape

there will be one plant at which AT1 is a minimum and this will be

the optimally si#ed plant and reect minimum MA1.

The M@1 curve traces out the marginal cost o producing an

additional unit o output when all actor inputs are variable. The @1

curve reects the cost o an additional unit o output in the

presence o !&ed actor inputs. There is no connection thereore

between the M@1 and AL1s.

The Bonderful Borld of &dam )mith ersus the Real Borld


29/204

1annot be stated unequivocally that a completive maret economy

will be e)cient and will produce that combination o commodities

most in accordance with consumers wishes. using as ew resources

as possible.

/ew goods and services constantly appearing

Kld goods and services disappearing

Technology changes

+apid and dramatic changes continue to occur the achievement o

long-run equilibrium is impossible.

1hanges in consumers taste preerences, changes in population

@ove !rms rom one geographic to another geographic area

@ore rapid the change less the change !rms to reach long-run

equilibrium

Eplain the distinction $etween the shortArun and the longA

run in microeconomics%

The )uggested &nswer

The short-run and long-run in economics do not reer to !&ed

time periods but instead reer to the time required to bring

about changes in the inputs o various actors o production.

The short-run e&ists when at least one actor input cannot be

varied.

The long-run reers to that period when all actors inputs are

variable, i.e. the planning period.

Knce a long-run decision has been made and actors

committed, e.g. a plant(actory has been built the !rm is bac

in the short-run.


30/204

7hat constitutes the long-run varies rom industry to industry,

e.g. e&tending a nuclear power plant is liely to tae longer

than e&tending a university dormitory.

E&plain in detail the behaviour o a !rms costs in the shortArun.


>i&ed costs 4>15 are costs o the actors which cannot be

varied in the short-run and which are unrelated to output

levels 4O5, e.g. rent on premises, property ta&es, interest

charges. Even i the !rm produces #ero output, !&ed costs are

incurred.

"ince they do not vary with output levels average !&ed costs

will decline as output increases, asymptotically approaching

#ero as output becomes in!nite

i.e. declines as O increases

Total variable costs increase as output increases and decrease

as output decreases but not normally in a linear ashion

because o increasing(diminishing marginal returns to variable

actor inputs.

Average variable cost is determined by the average

productivity o variable actor inputs and their maret prices

and marginal cost is determined by the marginal productivity

o variable actor inputs and their maret prices.

7hen marginal costs 4@15 is less than average variable cost

4AL15, AL1 must be declining, i.e. the cost o each additional

unit produced is less than the average and must thereorereduce the average. 7hen @1 is greater than AL1, AL1 must

increase.

Thereore, @1 must pass through the minimum point on the

AL1 curve.


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The AL1 curve will approach the AT1 as A>1 approaches #ero

&s a nation we wish to o$tain from our limited resources

the maimum $enet at minimum cost% The mar+et

mechanism guarantees such economic e"cienc#% (o #ou

agree with the statement a$out the e"cienc# of the

mar+et mechanism Bh# or wh# not


nder certain conditions it is possible, theoretically, or a

nation to achieve ma&imum bene!t rom its limited resources$to do so goods and services must be produced at minimum

cost.

Economic e)ciency conditions are captured in the marginal

equivalency conditions 4@E15.

Kne necessary condition is that consumers ma&imise utility

rom the way they allocate their incomes. This occurs when

Another necessary condition is that goods and services are

produced using minimum resources. A !rm will ma&imise

pro!t by producing that level o output where @+ N @1$ under

conditions o perect competition price equals @1 o

production.

Thus

"ubstitution the @1s or 6s yields the @E1.


32/204

2n the dynamic real world many orces are at wor which

prevent @E1 being achieved. They include'

i. introduction o new goods and services

ii. changes in actor supplies(prices

iii. technological change

"econd there are areas where competitive maret orces will

not lead to economic e)ciency$ they are nown as maret

ailures. These areas involve'

i. imperect marets

ii. e&ternalities

iii. public goods

i. An imperect maret e&ists i the characteristics o a

maret are not the same as those or a perect maret'

o @any buyers and sellers

o 6erect inormation

o >reedom o entry and e&it

o omogeneous product

2 all o the above characteristics do not e&ist then a

maret is said to be an imperect maret and as a

consequence the pro!t ma&imising output supplied will

be lower than the output at which price is equal to

marginal costs, i.e. lower than the optimal output level

determined in perect competition. This means it is notpossible to substitute marginal costs or price in the @E1

since 6 H @1.

ii. E&ternalities are those costs(bene!ts that result rom an

act o production or consumption but are not taen into

account by the economic agent maing the decision. 2


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e&ternalities e&ist it implies that either the costs o

production or consumption are understated or that the

bene!ts o either or both are understated.2 e&ternal

bene!ts e&ist in the consumption o good A then the

value o @a in the @E1 will understate the societal@a. "imilarly i the societal costs o producing goods B

e&ceed a !rms private cost then will be higher than

the rates o other goods.

iii. 6ublic goods or services have two characteristics, which

distinguish them rom private goods and services$ they

are

o non-e&cludability and

o non-rivalry

The latter characteristic implies that the consumption o

the good by one consumer does not preclude the

consumption o it by another consumer. This creates a

problem as to how to determine the optimum level o

supply. owever, it is the !rst characteristic, which

implies that consumers can consume a good or service

without paying or it, i.e. they can be ree riders, that

creates the maret ailure$ this is because no !rm would

be prepared to supply a good or service or which it

cannot e&tract a price.

A !sh arm was established and the owner installed the necessary

set o tans and !ltration plants to help eep the sea water in and

around the !sh tans pure. The e&pected lie o the tans and

!ltration plants was 9: years and their purchase price was W=::

:::$ the accountant depreciates the plants 4straight line5 at W=:::: per year. The annual variable costs associated with the !sh

arm were also W=:::: per year. Annual !sh sales o W9?:::: per

annum were anticipated. 2mmediately ater the installation o the

equipment, which once installed cannot be removed, has no

alternative use and no scrap value, the price o !sh dropped

dramatically, because o the availability o oreign !sh. Annual


34/204

revenues rom sales o !sh decreased to WP:::: and it is e&pected

the WP:::: annual revenue !gure will remain or the oreseeable

uture.

The accountant has advised the !sh arm owners to cease

operations immediately. e stated, 7ith annual revenues o WP:

::: and annual costs o W9::::: it does not need an @BA

graduate to tell you that staying in business is throwing good

money ater bad.

)hould the owner of the sh farm follow the accountants

adice Bh# or wh# not


The owner should not ollow the advice o the accountant'

2 the arm is closed down the owner will lose the W=:: :::

start up cost or W=:::: per annum or 9: years. e will

however incur no variable cost.

2 the arm remains in business or 9: years, the e&pected lie

o the equipment, there will be generated each year a surplus

o WI:::: over the variable costs, i.e. WP:::: in total

revenues minus W=: ::: in variable cost, to set against the

!&ed cost o W=::::. Thus the loss will be only W?::::instead o W=::::. Thus in the short run i.e. 9: years the arm

should remain in business.

7hen it comes time to replace the capital equipment, i.e. at

the end o 9: years the marginal bene!t or remaining in

business i.e. WP:::: is less than the annual marginal cost, i.e.

W9:::::$ thus in the long run the arm should close.

Bould #ou hae adised the esta$lishment of a sh farm if

there were no sh imports Bh# or wh# not


The arm was set up on the e&pectation o an annual return o W?:

:::, i.e. revenue o W9?:::: minus total costs o W9:::::, W=:

::: or depreciation and W=:::: o variable cost. The W=: :::

annual depreciation is the W=::::: initial investment spread


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evenly over 9: years. But what was the opportunity cost o the

W=:::::8 An interest rate o ; earns W?:::: in the ban and

thus any rate higher than ; says no !shing assuming any

woring capital aces the same opportunity cost.

Module D 'rgani:ation of Industries

'rgani:ation of Industries

T#pe of

.irms

!roduct T#pe Entr#

8arriers

!rice Control (e

Co

6erect

1ompetition

Lery

@any

2dentical /one /one :

@onopolistic

(2mperect

1ompetition

@any *iferentiated /one(>ew "ome Mow

Kligopoly >ew 2dentical "cale "ubstantial ig

@onopoly Kne nique "cale or Megal 1omplete 9::

Perfect Competition

2n the world o perect competition it is assumed that

2. on the demand side consumers, with perect nowledge,

are utility ma&imi#es

22. on the supply side !rms, with perect inormation, ace

no restrictions on movement in to and out o any

industry.

nderlying Assumptions

(emand )ide Customer- )uppl# )ide .irm;Compan

9. +ational consumers 9. omogeneous 4identical5

?. tility @a&imi#ing ?. 6ro!t ma&imi#ers


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I. Taste and 6reerences nown I. /o entry or e&it barriers

;. >ree 2normation on 6rice and characteristics o goods ;. >ree 2normation o opport

Total +evenue4T+5

2s the price times quantity +7 ! 8 9

Average

+evenue 4A+5

is the revenue received

orm each unit o output

@arginal

+evenue 4@+5

the revenue obtained rom

each additional unit ooutput

Above normal

pro!t45

7hen a !rms price 4average

revenue

e&ceeds4H5 average cost5

45 N 4690 6?AT15O

6erectly

1ompetitiveMong +un

Equilibrium

*emand 4*5 N 6rice

465NAverage +evenue4A+5N@arginal +evenue4@+5

N

6N @1srNM@1NAT1minN MA1min

tility

@a&imi#ing

Behaviour

+equires that the ration

o or all goods

And since

6ro!t @a&imi#ing

behaviour

Ensures that 6 N @1 or all goods

Economic

E)ciency

is achieved when the ration

oor all goods


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1onsumer

Equilibrium

2s when they allocate their

budget to ma&imi#e utility

on a range o goods and

serves

same as

6erectly competitive !rms are price taers in both the short run

and long run. They can sell all they can produce at the going

maret price and would thereore never charge a lower price.

They can sell nothing at a price higher than the equilibrium

price

Monopol#

A @onopolist is a producer that supplies the complete maret

or a good or service.

Barrier o entry ie patents or maret conditions 4small town5

)hort Run maimi:ing

6roduce output 4O5 where @arginal +evenue 4@+5 N @arginal

1ost 4@15 but will be able to

sell at a price 465 equal 4N5maret *emand 4*5 and(or Average

+evenue 4A+5 giving it a higher than normal pro!t since price

465 is above the @arginal 1ost 4@15

>air price would have been 6rice 465 N Average +evenue 4A+5

N@arginal 1ost 4@15 this would have been lower and the

monopolist would have produced more. owever the

@onopolist would not have ma&imi#ed pro!t at that point

>ong Run maimi:ing

@ay e&pand or contract by ad%usting plant si#e

M@1 Q @+ thenO

@1 H @+ then

O

2n both cases the pro!ts will increase in the long run.


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2 @onopolist e&it in the economy Economic e)ciency will not

prevail ands the marginal equivalency condition or all goods

and services will not be reached 6rice 465 will not equal

@arginal 1ost 4@15 thus the ration o are not all equal

6roblem with @onopolist is that what consumer pays does not

reect accurately the marginal cost or society o producing

that good.

Economies of )cale

@ay be in societys interest to have a monopolist i economies

o scale e&ist.

*e!nition o Economies o scale' the average cost o good

declines as output e&pands.

"ources o Economies o "cale

9. labour speciali#ation

?. 2ncreased 1apital equipment si#e Mower cost per unit

4economies o scale5

I. Bul Buying o raw materials

E-$lain in detail 'h economic e&&icienc cannot $revail in the $resence o&

mono$ol5 e-$lain 'hat a government might do to bring about economic

e&&icienc and e-$lain 'h societ might 'ish to $reserve mono$olies%


+he conce$t o& economic e&&icienc is ca$tured in the marginal

euivalenc conditions )E"

and is derived &rom the conditions o& utilit ma-imising b households%


39/204

and $ro&it ma-imising conditions b com$etitive &irms in euilibrium

/ mono$ol &aces the industr demand curve because it is the sole

su$$lier and 'ill ma-imise $ro&it b $roducing that out$ut level at $ricemarginal revenue )7 euals marginal cost )"% +here 'ill be a uniue

$rice ! 'hich clears the mar#et% +his $rice ! must be greater than )"

because o& the do'n'ard slo$e o& the demand curve%

"onsumers 'ill attem$t to ma-imise utilit in their $urchase o& goods and

services no matter the t$e o& &irm $roducing those goods% "onsumers 'ill

ta#e the $rices as given and eual &or all goods%

Ho'ever 'hen 'e attem$t to substitute )" &or ! in the )E" euation the

mono$olists )" 'ill be less than ! and as a conseuence

because )"m; !m

and there&ore o& each $er&ectl com$etitivel $roduced good%

+o attem$t to achieve economic e&&icienc the government must &orce the

mono$ol to $roduce that out$ut level at 'hich $rice euals )"%


40/204

'hether or not it actuall e-ercised that $o'er, i%e% the mono$ol to avoid

anti trust6mono$ol legislation might elect not to ma-imise $ro&it%

+o ta#e advantage there&ore o& the economies o& scale, the government

allo's the mono$ol to continue but tells it to set ! )" long run%

+here are $roblems, ho'ever, not 'ith the solution but in reaching the

solution% >irst the mono$olist ma in&late costs, i%e% cause the average

total cost curve to increase 'ith ?$ro&ligate s$ending thereb shi&ting the

L)7" le&t'ards &rom 'here it 'ould have been had engineering

e&&icienc been a goal% +he mono$olist has little incentive to $ursue

engineering e&&icienc i& he is not re'arded &or doing so% +hus the

government as regulating bod &aces a $rinci$al6agent $roblem% Second

even i& engineering e&&icienc $revailed there is no guarantee that at the !

)" level o& out$ut, /+" 'ould be covered% +he mono$ol might incur

losses at this level o& out$ut and as conseuence 'ould reuire a subsidto remain in business

+mperfect Competition

*e!nition' large number o !rms, each acing a downward sloping

demand curve or its goods or services.

*emand curve is not completely price-elastic.

>ewer !rms e&ist than in perect competition

>irms ave degree o control over price because o several

actors

Mong +un equilibrium the price 465 o its product will be H that

marginal cost 4@15

.

1ompanies will move into the industry as long as above normal

pro!ts are earned and thereore the maret supply curve will shit to

the let.

Mong run equilibrium the Average total cost 4AT15 will N Average

+evenue 4A+5 again, but


41/204

Kne implication o an economy having imperectly competitive !rms is

spare capacity each !rm is not operating at the minimum point on its

average cost curve

Oligopoly

Kligopoly igh degree o concentration, small number o !rms,

homogeneous product, signi!cant control over price, Kne !rms sales

depends upon the price it charges and its competitors prices.

+in+ in the oligopolistic


42/204


43/204

9. The problem an oligopolistic !rm aces is that i it increases

price and no competitor ollows it will lose maret share and

revenue$

?. i it decreases price and all competitors ollow it will not gain

maret share and will lose revenue.

The in in the oligopolistic demand 4A+5 curve produces a

discontinuity in the @+ curve, through which the @1 curve passes. An

alteration in @1 still allows the @1 curve to intersect the @+ curve in

its discontinuous range, the pro!t ma&imising output at the in will

not change

Cartel

2 all !rms got together however to orm a cartel, the cartel could actas a monopolist acing the maret demand curve, equating @arginal

+evenue4@+5 and @arginal 1ost 4@15 and earning monopoly pro!t.

Each !rm will produce an agreed amount o output and share in the

monopoly pro!t. Each could be better of than operating in isolation

!rincipal ; &gent !ro$lem


44/204

2s a conict o interest, An agent is an individual or group o

individual to whom a principal has designated decision-maing

authority. owever, the agent might not act in the best interest o

the principal as he might have other 4conicting5 interests.

Regulation and Economic E"cienc#

A government can regulates a monopoly, in which economies

o scale e&ist, by

>orcing the monopoly to produce that output level at

which price equals long run marginal cost. 2.e.$ set the

output and pricing strategy by government to reali#e 6

N @1 or

ta&ing a monopolist pro!t and subsidi#ing losses,

thereby again aiming to achieve 6N@1

The problem with these suggestions is that they will not

produce any incentive in the monopolist to operate

e)ciently.

An alternative would be to replace the monopolist with

competitive !rms.

A pro!t ma&imising(loss minimising !rm will always produce an

additional unit o output i its contribution to revenue 4marginal

revenue - @+5 e&ceeds its contribution to costs 4marginal cost -

@15. 7hen @+ N @1 a urther increase in the output level will

mae pro!t(return lower than it otherwise would have been. This

condition holds or all types o !rms.

$e)ie,

+o s$read his ris# a &armer 'ith three identical &ields $lants one 'ith 'heat, one

'ith barle and one 'ith oats% He has to 'ait until harvest time to see 'hat

'orld $rices are5 onl then can he assess 'hich i& an o& his cro$s is $ro&itable%

>or each &ield his &i-ed costs are those costs associated 'ith $re$aring the land

&or $lanting and the seeds% /ll other costs are associated 'ith s$raing and


45/204

harvesting the cro$s and dring the grain% @rain merchants, &or a &i-ed

$ercentage o& the 'orld $rices, collect the grain &rom the &arms%

Ho' use&ul is the model o& the $er&ectl com$etitive &irm in e-$laining theactivities o& the &armerA



46/204

Module F !u$lic *oods and Eternalities

? principal reasons why we as a society do not rely on maret

orces completely in determining the allocation o scarce resources.

9. to help achieve economic e)ciency

?. to alter the distribution o goods and services to

households

7hen arguing that a competitive maret economy would tend to

be economically e)cient two underlying assumptions

9. whenever a !rm produces a good or services it would haveto pay all the cost o production

?. 2 a household wanted a good or service it would have to pay

or it

owever

many goods and services produced in economy where

!rms do not bear all the cost o production

@any goods and services en%oyed by households who do

not have to pay or them.

7hen the above happens competitive maret economy will tend

not to allocate resources e)ciently.

Private Goods and Public Goods

6rivate Good Good or service or which each unit is consumed by

? important characteristics 0 e&cludable and rivalry,

@ost types o goods are private goods

6ublic goods Each unit is consumed by everyone and rom which


47/204

7ho pays or 6ublic goods involves consideration o

/ormal government !nanced according to ability to

who bene!ts

o >lat rate or equal sum scheme

>ree +ider 2s someone who consumes a good without having to pay

Economic e)ciency implies nothing about the income

distribution in an economy. The @E1 could be achieved even i a

proportion o the population were starving

-&ternalities. Positi)e and /egati)e

6rivate 1osts 1osts the individual or !rm must bear in taing a course o action

6rivate Bene!t Bene!ts the individual or !rm will receive in taing a course o actio

7orthwhile Economic Activity is i the marginal bene!t 4utility5derived rom the course o action e&ceeds the marginal cost.

E&ternal Bene!ts 6ositive E&ternalities /ot directly involved however rec

puts in a garden

E&ternal costs /egative E&ternalities Activity individual not involved di

power plant smoe

2 societal bene!ts arising rom an economic activity e&ceed the

private bene!ts, economic e)ciency will not prevail


48/204

2 societal cost arising rom an economic activity e&ceed the private

cost, economic e)ciency will not prevail

6rivate 1osts 1osts the individual or !rm must bear in taing a course o action

6rivate Bene!t Bene!ts the individual or !rm will receive in taing a course o action

@arginal "ocietal 1osts

4@"15

1ost to society o producing the last units o goods A and B

@arginal "ocietal Bene!ts

4tility5 4@"B or @"5

Bene!ts to society arising orm the consumption o the last

2 @"B H 6@BEconomic E)ciency

-&ternalities0 Collecti)e Action and -conomic -fficiency

7hen e&ternalities e&ist, maret prices will not lead to an e)cient

allocation o resources because o the divergence between private

costs and social cost and(or private bene!ts and social bene!ts.

To achieve economic e)ciency in the presence o e&ternalities, need

or collective action on part o individuals in a society.

Megitimate reason or government to interere in a maret economy

@ethods to +egulate

9. 6er unit ta& on !rm that do not account or e&ternal cost?. "ubsidy paid to producers who generate e&ternal bene!tsI. 6roperty +ights and /egotiation


49/204

Internali:ed Eternalities is when e&ternal costs or bene!ts are

brought within the scope o a single organi#ation$ chemical co vs.

!sherman

Coases Theorem is a situation o clearly de!ned property rights

and an e&ternal cost could be accounted or by negotiation.

*i)culties o /egotiations

9, Transaction 1ost or all afected parties to get

together

?, Kbtaining inormation on 6reerences

The Problem of Collective Decision a!ing

Loting 6arado& 7hen diferent voting methods can lead to

apparently UundesiredV outcomes, ? choices vs. I or more.

Eamples

The marginal equivalency conditions 4@E15 assume utility

ma&imising households allocating their incomes so that

and pro!t ma&imising !rms producing, in equilibrium, output so

that6aN @1a, 6bN @1band 6nN @1n.

A paper mill situated on the ban o a river dumps its used

chemicals in the river. >or a one mile stretch down river anunpleasant smell e&ists$ as a result this stretch o the river is

not used or !shing much to the annoyance o the local

population.

2n producing paper(paper products the mill will tae into

account only the costs it incurs in producing paper, i.e. private


50/204

costs. By ignoring the pollution costs - the gap between

societal and private costs - the mill is not taing all costs into

account in its operations.

The @E1 are made up o two parts utility ma&imising behaviour o

households and pro!t ma&imising behaviour o !rms. >or the latter

in equilibrium, price N societal marginal cost. 2n the paper mill case

the !rm is using private marginal cost which is less than societal

marginal cost.

Because the paper mills marginal cost o producing paper(paper

products is lower than societal cost a ta& imposed on the paper mill

equivalent to the diference in costs would orce the !rm to utilisesocietal marginal cost the only action o the our noted to re-

establish @E1.

The imposition o a ta& on the paper mill could lead to the

@E1 being re-established because

2. output would be reduced and price would increase

22. ewer resources would be employed in the paper

industry

Because the paper mill considers only private costs the prices o

paper(paper products understate their societal costs and as a

result too much paper and too many paper products are being

produced at too low prices and too many resources are being

employed in the paper industry. The imposition o the

appropriate ta& is equivalent to the !rm paying societal costs.

Average costs will increase, the supply curve shit to the let,

prices will rise, less paper will be produced and ewer resources

deployed in the paper industry.


51/204

2 the paper mill were to purchase the !shing rights on the mile o

river downstream the paper mill would tae into account the cost o

polluting the river which previously it had ignored. 7hy8 Because

the pollution afects the !sh catch which is now owned by the paper

mill. The costs o pollution are now borne by the mill$ the e&ternalityhas been internalised. The paper mill may stop polluting the river

and cause more !sh to be caught but that is not guaranteed$ it

would depend on marginal bene!ts and marginal costs as would the

incentive to stop polluting

2 the !shermen owned the property(!shing rights on the river

and enorced these rights legally this could solve the paper

mill pollution problem because the !shermen could sue the

paper mill

2. or an amount equivalent to the value o the !sh

oregone and(or pleasure o !shing and

A negative e&ternality e&ists because the paper mill ignores the

societal cost o producing paper by concerning itsel only with

private costs, i.e. it ignores the value o the !shing oregone

because o the pollution. This value should equal the amount beingsued or and will be the diference between societal and private

costs

>rom an economic e&&icienc vie'$oint, ho' should $ublic sector

s$ending be allocated and 'hat di&&iculties are li#el to be encountered in

&ollo'ing an e&&icienc criteriaA

The )uggested &nswer+he marginal euivalenc conditions )E" are derived &rom the

euilibrium conditions &or utilit ma-imising households

and euilibrium conditions &or $ro&it ma-imising com$etition &rom


52/204

ielding


53/204

+he marginal euivalenc conditions )E" = conditions &or economic

e&&icienc = are &ound b substituting )"s &or !s in euation 1%

+hese conditions do not hold in the $resence o& mar#et &ailures i%e% $ublic

goods, e-ternalities and economies o& scale because the )E" are not

&ul&illed5 this can occur because the $rices in euation 1 do not re&lect

the bene&its and6or the costs in euation 2 do not re&lect societal costs%

E-ternalities are an costs or bene&its 'hich are generated as a result o&

an economic decision but are not included in the decision ma#ing

$rocess% E-ternalities can be either negative or $ositive and can be

associated 'ith both the act o& $roduction and consum$tion% +heir

e-istence im$lies that either the $rivate costs do not re&lect the &ull costs

o& $roduction or consum$tion or that $rices do not re&lect the &ull bene&it o&

consum$tion or $roduction%

)an acts o& consum$tion generate e-ternalities 'hich are not ta#en into

account b the decision o& the $erson 'ho enos the act o& consum$tion%

+he act o& smo#ing $roduces a negative consum$tion e-ternalit = $assive

smo#ing, 'hile the 'earing o& a beauti&ul $er&ume $roduces a $ositive

consum$tion e-ternalit% Whether an e-ternalit is $ositive or negative

sometimes de$ends on ho' it is $erceived b the other $eo$le 'ho are

a&&ected b the e-ternalit% +he loud $laing o& the latest &avourite $o$

record ma be considered a $ositive e-ternalit b the oung and a

negative e-ternalit b the not so oungC

)ost o& the $roblems associated 'ith e-ternalities reside 'ith negative

$roduction e-ternalities% +he e-ternal costs im$osed on members o&

societ b $roduction can ta#e various &orms, &or e-am$le, harmless but

obno-ious smells, to-ic e&&luent in rivers, &ilth smo#e, and high levels o&

noise /s the are e-ternalities, the generate costs 'hich are not ta#en

on board b the $roducers and there&ore are not included in their decision

in the attem$t to ma-imise $ro&its% Dn occasions, their im$act ma be

trivial, but on other occasions the can be o& great signi&icance% +he e&&ecto& the burning o& &orests in South East /sia ma have long term health

conseuences &or ears &or neighbouring countries%

+he im$lication o& the e-istence o& e-ternalities is that even in a $er&ectl

com$etitive mar#et the social o$timal uantit o& a good or service 'ill not

be su$$lied because the &irms costs 'ill not re&lect all the costs incurred


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in the $roduction $rocess% Since the &irm 'ill $roduce the out$ut level at

'hich marginal revenue is eual to $rivate marginal costs the ratio o& the

marginal utilit over the $rivate marginal costs o& $roduction 'ill be greater

than the ratio o& marginal utilit over societal marginal cost and 'ill lead to

an over $roduction o& the good%

The =uestion &s+ed

What are the $olic o$tions available to government, and 'hat mar#et

&orces e-ist, to resolve the $roblems that e-ternalities createA


+he solution to the $roblem o& $roduction e-ternalities ma be &ound

either b direct government legislation or b indirect legislation through

the establishment o& $ro$ert rights%

+he government can im$ose regulations to control the e-ternalit and&orce the $roducer to internalise the costs% +his can be achieved b

setting regulations to eliminate the e-ternalit com$letel or b allo'ing

e-ternalit $ollution $ermits 'hich the $roducers have to $urchase i&

the 'ish to continue $roducing 'hile still creating the e-ternalit% Both

a$$roaches lead to an increase an internalisation in the costs o&

$roduction o& the good or service and there&ore a reduction in out$ut%


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an economy in a year.

6urchase 6ower 6arity 46665 E&change rate compares the purchasing power o

representative baset o goods and services

Marginal !roductiit#@arginal Bene!t o a

+esource

2s the contribution to revenue which could result

additional unit

@arginal 1ost o a +esource The price o an additional unit

Lalue o @arginal 6roduct

4L@65

"how the increase in value o the output or each

input. The maret demand curve or a actor inpu

summation o all the L@6 curves o the !rms in th

ma&imi#ing !rm will pay the equivalent o the valmarginal product as the wage rate.

2s how much the value o output will increase or e

unit hired

GM!Aopportunit# cost 6 Economic


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Economic RentThe diference between the value o marginal pro

actor o product and the opportunity cost 4the ne

alternative5 or that actor.

Monopson#

The opposite o monopoly means only one buyer

occurs when there is only one employee o acto maret

By de!nition amonopsonistis the sole emplo#

wage rate in a monopsony maret will be determ

and supply o labour. owever once that rate is de

monopsonist wishes to have more labour the mon

ofer a wage higher than the going rate to attract

labour maret but the higher rate will then have t

worers. Thus the marginal cost o labour will e&c

the monopsonist will not ace an elastic labour su

Knly a monopsonist aces a supply curve o labou

cost e&ceeds the wage rate$ 4MC 4 wage rate5 i

labour the monopsonist has not only to increase t

new labour but also ofer the same new rate to e&

union by negotiating a higher then equilibrium wa

marginal cost o hiring labour constant. Thus * is

labour marets !rms can hire as much labour as t

wage rate$ unions, or those !rms, mae wage ratotherwise would have been.

E&ploitation o Mabour 7age +ate less than value o the marginal produ

4L@65 4L@6 H 7age rate5

Trade 0nionThat it represents a group o, or all resource owne

or actors o production

Below the poverty line Theirs insu)cient income to support lie adequate

Income (istri$ution, Collectie &ction and Economic E7uit#

Ta& Transer 6olicy 2s individuals with high incomes are ta&ed and ind

income receive transer payments


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6rogressive Ta&

"tructure

2s as income levels increase a large proportion o

income is removed in the orm o income ta&.

Economic Analysis 1an be used or access to impact o any ta&(trans

cannotbe used to determine the correct incom

Lalue Sudgements Are ones own opinion on something

7eaness o a @aret

Economy

2s it produces a socially unacceptable income dist

/egative 2ncome Ta& 2s avoured by many economists and wors as ol

A impoverished person cannot !nd a %ob rec

payment orm the government. That perso

time %ob and receives the transer paymento income ta& he owes on the income earne

eventually maes more and owes ta&es equ

transer payment, hell receive all income. 7

ta&es more that the transer payment, he w

surplus in ta&,

Ta owed H transfer pa#men


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goods

parity dollar

e#change rate $S%

parit# pound

sterling echange

rate

2SA Dollar 344 !#5

+taly *ira 644 444 7444 3444

Portugal -scudo 64 444 744 344

28Pound

Sterling744

#69

the ollowing contains the purchasing power parity dollar e&change

rates


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B de&inition the di&&erence bet'een the value o& the marginal $roduct o& a

&actor in$ut in its most $roductive use i%e% 2 million as a soccer $laer

and its best alternative F0 000 as an advertising agent is 1 IF0 000 2

million = F0 000%


60/204

marginal euivalenc conditions 'ill not $revail% Jour ans'er should s$ell

out 'h mar#et &ailures cause economic ine&&icienc and analse 'hat

governments can do to hel$ restore economic e&&icienc%

/ third role &or the government, elected b the $eo$le remember, is to use

ta-es6trans&ers to $roduce an acce$table distribution o& income sincemar#et &orces in &actor mar#ets do not guarantee that ever individual or

household can earn su&&icient income to survive

Module !4 +nternational Sector

Theory of $bsolte $d#antage

The same commodity can oten be produced in one country using

less labour and capitol than in a second country trying to produce

the same good.

Trade between similar countries can occur so long as thetastes

and incomes o individuals within each countrydier and so long

as there are absolute cost diferences in producing various goods.

Theory of "omparati#e $d#antage

Assumes that resources are ully mobile within a country so that

returns to equivalent labour and capital are equali#ed on a nationalbasis.


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Tariffs and &uotas

@ain argument or restricting internal trade is the protection o

domestic industries.

Tari

Ta& imposed be importing country when a good or service enter the

country

+estriction th

speci!c time

Everyone on average sufers eventually by paying more or both imported

and domestically produced good and services, total world production is

reduced$ resources are not employed in most e)cient way globally

"hort run, worers protected, society is subsidi#ing worers.

The imposition o the tarif, however, could protect a domestic industry to

the bene!t o domestic employees. Thus while all consumers o the good

will be worse of because o the higher price not every person will be

worse of

/o ta& advan

Kn average c

The impact o a tarif is to shit the supply curve upwards by the amount

o the tarif. Given normally sloped demand and supply curves this will

cause the equilibrium price to rise and equilibrium quantity e&changed todecrease

*iference between quota and tarif situation is who gets the CC -

tarif case it is government, quota case depends entirely on how

quota is allocated

Loluntary e&port restraints "igned agreement with e&porting nations to restrain t

Argument for =rade $estrictions

1. As industries start to develop must be a period o protection to allow to reacha si#e and scale economically viable in international competitive world.

?. U*umpingV practice o selling a good in a oreign maret at lower price thanprevails in the maret o the country- drive domestic producer out o


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business. Then e&porting nation raise prices in the absence o domesticcompetition

I. Tarifs imposed on imported goods, !rms that receive production subsidiesrom government. 0 1ountervailing duties designed to cancel the efect othe government subsidy on the price o the imported goods

'#change Rate(

@aret in which people buy and sell diferent national currencies

nown asforeign e%change market.

Ouantity demand and supply are equal is &e%ible e%change rate.

Government agree to buy or sell su)cient quantities '%ed

e%change rate.

8alance of !a#ment

+ecord countrys international trade, its international borrowing and

its international lending.

Three ma%or accounts in a countrys balance o payment account

a5 The current account or

trade account

2mports o goods and services and e&ports

b5 1apital account All international borrowing and lending - a

afect the amount o claims country

oreign countries have in your coun

c5 K)cial settlement account "how the change in a countrys holdings o

A country has been e&porting considerably more than it has been

importing or several years and yet its currency has been

depreciating steadily against most capitalist countries currencies.

A countrys e&change rate is determined by its balance o

payments, a surplus leading to an appreciation a de!cit to


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depreciation. The balance o payments is the sum o the trade

balance and net capital ows. 2 the currency depreciated in

spite o a trade surplus it means that the net capital outow

e&ceeds the trade surplus.

'quilibrium Pricing

Salmon )*+ ,oaves )*+

+sland# >74 O$ !>4

+sland y 744 O$ !44

Ater trade the equilibrium price must lie between the e&tremes

Both islands start to trade and an equilibrium price is

reached or salmon in terms o loaves. K the prices given

which o the ollowing is the only possible equilibrium price o

a salmon8

6rior to trade 9 salmon e&changed or 9(I loa inx. 6rior to

trade 9 salmon e&changed or X loa iny. Ater trade the

equilibrium price must lie between the e&tremes o 9(I 4.II5

and X 4.=5.

International trade

2nternational trade by permitting a more e)cient allocation o

resources globally

Meads to higher world income and higher average living standards. A

signi!cant decrease in world trade would lead to lower average livingstandards.

The decrease in trade however would lead to an increase in demand ordomestic goods in some sectors and as a result could lead to an increase inthe returns to some actor inputs.

Module !! Macroeconomics O)er)ie,


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@icroeconomics About individual parts that mae up the big picture

*escribes and e&plains the woring o the units that mae u

ousehold, business !rm and government

E&plain +elative prices

2ndividual units income and output

iring !ring practices o individual !rms

@acroeconomics Behaviour o the level o prices o all goods and services ta

1hange price level rom one period to another 0 2nation rat

*eation 0 price level alls

6rice o one good compared with another relative price

Total income and total output or whole economy

Employment and unemployment rates or economy as a wh

Potential and -ctual .utput

6urchase 6ower 6arity 46665 "imilar baset o goods in diferent countries is comp

common currency such as the dollar

6otential Kutput Kutput that economy would produce i both the labou

ully employed.

>ull Employment A percentage o people in the labour orce being emp

hours per wee - does not mean no unemployment

Actual Kutput ( Gross national

product 4G/65

Lalue o all !nal goods and services produced in the e

1alculated by multiplying each good and service prodtogether

Lalue o the !nal goods and services produced

G/6 N 1 R2

Gross /ational 6roduct N 1onsumer Goods 6roduced


65/204

Gross /ational E&penditure 4G/E5 Lalue o total spending by the household

Gross /ational 2ncome 4G/25 Lalue o the services o the actors o production hire

G/2 N 1 R "

Gross /ational 2ncome N 1onsumer goods purchased

Economic activity 1an be measured by G/6 0 G/E 0 G/2

All measure same thing rom diferent views

The Demand for Gross /ational Product

Gross /ational 6roduct purchased by ; groups

a5 consumers 4households5

b5 !rms

c5 government

d5 international 4households, !rms and government5

"up o e&penditure o all ; groups is nown as aggregate demand

E&penditure can be afected by governmental policies, that efect

unemployment rate and interest rate 0 act with a lag

Assumed in the short run 6otential Kutput is !&ed.

urther complicated by ? actors

95 ousehold and !rms have minds o their own

a. ousehold e&penditure more predictable than !rms

b. Government under or overestimate household

e&penditure out o additional income

?5 E&ogenous shoc 0 outside world events


66/204

@acroeconomics relationships

G/6 G/E G/2 Y4G/65

>or a *omestic economy, aggregate demand N consumption

e&penditure 415 R 2nvestment e&penditure 425 R Government

E&penditure 4G5

G/6 Y4G/651R2RG

2nternational "etting includes E&ports 4Z5 02mports 4[5 nown

as (ational )ncome identity.

G/6 Y4G/651R2RGRZ-[

Policy Tools

Two 1ategories

>iscal 6olicy 1ontrol o government e&penditure and ta& rates

@onetary 6olicy 1ontrol supply o moneyN directly afects interest rates

Three ways to 1lose 2nationary gap by Government

2ncrease government e&penditure 4G5 2ncrease G 4i.e. road building5 2ncrea

+educe ta&es rate 4r5 +educe r 4marginal ta&es5 Yd4dispos

2ncrease money supply 4@s5 2ncrease @s+educe + 4interest rate5

Government E&penditure @ultiplier is the ratio o the total change

in Y to the initial change in G


67/204

@acroeconomic goals are'

95 Mow ination rate

?5 Mow unemployment rate

I5 Balanced government budget

;5 Trade balance

=5 "table currency in international e&change marets

Module 1 !otential 'utput

Introduction

"imple model classiy resources as'

1apitol Goods Mand

1apital

Mabour >orce Mabour

Enterprise

2n the short run 4a year5 supply o actors o production and state o

technical nowledge are given or !&ed. +esult in !&ed upper limit o

total output nown as the production potential

6roducing a !&ed quantity o inputs means orgoing alternative

compilations, dilemma encounter' how to allocate scarce resources.

Potential .utput in the ,ong Run

"hort run the most important question is whether a society attains

its given production possibility rontier, thus maing ull use o the


68/204

e&isting supply o the actors o production and the given stoc o

technical nowledge.

Monger periods o time production possibility rontier is not !&ed

/et investment N Gross investment - +eplacement 2nvestment


69/204

"tructural 2ndustrial 1hange 0 mismatch between unemployed and ch

%ob vacancies

"easonal *ependent on weather or the calendar

*emand *e!cient Actual Kutput 4Y5 Q 6otential Kutput 4O5 2nsu)cient *ema

@ost important actors determine the amount o rictional,

structural, and seasonal unemployment are'

a5 Mevel o economic activity

b5 Transmission o inormation

c5 +ate o structural change

d5 Ease o changing occupation and home

e5 2nstitutional restrictions and barriers$

5 *ependence on seasonal industries

nemployment afected by general level o economic activity.

Actual Kutput 1lose 6otential Kutput

Employment "trong com

employers

Actual Kutput Below 6otential Kutput

Employment Mess comp

employersrictional \

unemploy

nemployment

afected by quality o transmission o %ob inormation


70/204

"tructural 1hange 0 tastes change, new products emerge

"easonal industries

2n a perectly competitive labour maret wages would all i the

supply o labour e&ceeded the demand or labour. >or a variety o

reasons in many labour marets this does not occur, e.g. collective

bargaining agreements, employers wishing to retain employee

goodwill and it is said wages are sticy downwards, i.e. downward

wage rigidity

The Relation etween the nemployment Rate -U.,

*otential +tpt -/. and $ctal +tpt -0.6olicy maers are more con!dent about eradicating demand-

de!cient unemployment than they are about rictional, structural,

and seasonal unemployment

Main categor# of unemplo#ment

*emand *e!cient Actual Kutput 4Y5 Q 6otential Kutput 4O5 2nsu)cient *

Mabour

+tpt and )n&ation

In5ation Rate

increase per year in the average price level rom one time period

to another.

6rice level is the Consumer !rice Inde. This measures the

average level o prices o the goods and services consumed by the

typical household. 1alculated monthly. "everal hundreds goods and

services regularly purchased each month by average households are

selected, initially to establish a base period,


71/204

2nde& that includes all goods and services produced in the economy

is nown as the G/6 deator.

Aggregate demand 4*5 nemployment 45 2nation +ate 42/>5

Aggregate demand 4*5 nemployment 45 2nation +ate 42/>5

!hilips Cure

6hilips 1urve is a short-run relationship. 2t simply shows the

consequence or ination and unemployment would be in any given

short-run period or various levels o aggregate demand.

95 "lopes downward rom let to right- any short-run period, lower

unemployment will be associated with higher ination, depend on

the level o aggregate demand,

2nverse relationship between unemployment and inations reerred

to as thetrade1o2between unemployment and ination

Mower unemployment can only be achieved at the e&pense o higher

ination

?5 istorically it has usually been in a position such that the ination

rate that occurs at ull employment is positive. )n&ationarybiaso the economy.


72/204

>ull employment does not mean #ero unemployment it means that

there are enough %obs available or all those who are in the labour

orce, but there is still an imperect match between %obs and

worers, 2n other words, even though there is ull employment, there

is rictional and structural unemployment

nemployment and ination depends on where the economy is onthe curve. At high rates o unemployment, the curve is relatively

at.

The 6hilips 1urve shits up or down over time

"hits p >ull employment ination rate nemployment rate where

The rate o ination that results in any period depends not only

where the economy is along the 6hilips curve, but also the position

o the 6hillips 1urve itsel.


73/204

igh aggregate demand means a low unemployment rate$ the high

in aggregate demand reers to actual G/6 being close to, equal to or

greater than potential output which by de!nition means almost ull

employment, ull employment or e&cess demand or labour.

6olicy @aers must decide where along the ination-unemployment

trade-of the economy should be.

ow decided depends in part on the position o the 6hillips 1urve.

7hen relatively low and to the let tend to choose target close to ull

employment

7hen high and to the right choose low ination even though this willmean higher unemployment.

The 6hillips 1urve shows a relationship between unemployment

rates and ination rates or a given level o aggregate demand. The

inverse relationship observed between ination and unemployment

rates 4the trade of5 is in one sense lie the inverse relationship

between prices and quantities$ or a given income, on a demand

curve, i.e. i income were to increase dramatically a large quantity

might be purchased at a high price, i.e. large compared to what waspurchased previously at a low income. Thus i aggregate demand

were to change dramatically 4a shiting 6hillips 1urve5 relationship

between low unemployment and high ination may not be observed

empirically.

'+uns >aw

A relationship between an economy3s G*6 gap and the actual

unemployment rate.

The relationship is represented by a ratio o 9 to I.


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Thus, or every 9 e&cess o the natural unemployment rate, a I

G*6 gap is predicted.

Based on empirical data, associated a 9 unemployment rate

4above the ull employment unemployment rate5 with a Ireduction in real output.

Reiew

)carcit# and choice

2t is the dual e&istence o insatiable wants and limited

resources that produces, what economists call, the

undamental act o scarcity. Economics is the study o how

individuals and nations use resources under their command

to satisy their wants as ully as possible$ economics is

concerned with scarcity and choice$ scarcity because there

are insu)cient resources to produce the goods and services

to satisy all wants ully, choice because resources used to

produce one set o goods and services are, by de!nition,

not available to produce a diferent set o goods andservices.

There are three diferent methods o solving the scarcity-

choice problem in the world today$ by tradition by

command and by maret. All nations today utilise each o

the methods albeit in difering degrees. The traditional

method relies upon social custom and habit$ the command

method relies upon the decision o a central ruling body$

the maret method relies upon the interactions o willing

buyers and willing sellers negotiating prices and quantities

e&changed.


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Economic e"cienc#

Technological e)ciency means producing goods and

services using a minimum amount o resources. Economic

e)ciency subsumes technological e)ciency but alsorequires that the collection o goods and services produced,

compared to all other possible collections o goods and

services, is that collection which satis!es societys wants as

ully as possible.

Economic e7uit#

Economic eq

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