Category Archives: Micro

A2 Economics – the need to move to more contestable markets.

The Economist had as its main Leader an article on the lack of competition in the global market place. Too many companies have  monopoly power and earn, what the economics textbooks call,  significant ‘abnormal profits’. In 2016 a survey found that more than half of young Americans no longer support capitalism. In the past governments have made it a more level playing field.

  • US – at the start of the 20th century they broke up monopolies in railways and the energy industry. Ronald Reagan also unleashed the power of the market
  • West Germany – created competitive markets to rebuild their post-war economy
  • Britain – Margaret Thatcher exposed state-owned inefficient domestic industries to the dynamic foreign competition. She also privatised the Commanding Heights of the economy.

There are 3 tests that The Economist use to examine the market structure:

Concentration Ratios
A lot of firms have experienced inertia and become very comfortable whilst the tech firms are building significant amounts of market power. In the US Concentration ratios between 1997 and 2012 have risen in approximately 600 census industries, with the weighted average market share of the top 4 firms growing from 26% to 32%. 10% of the US economy is made up of industries where 4 firms have more than 66% of the market share. The concentration ratio is the percentage of market share taken up by the largest firms. It could be a 3 firm concentration ratio (market share of 3 biggest) or 5 firms concentration ratio.

Abnormal Profits
In a healthy economy you would expect profits to be competed down, but the free cashflow of companies is 76% above its 50-year average, relative to GDP. In Europe the trend is similar, if less extreme. The average market share of the biggest four firms in each industry has risen by three percentage points since 2000. On both continents, dominant firms have become harder to dislodge.

Openness
Of US firms that made very high profits in 1997, 50% still did in 2017. There is a reduction in new firms and with a lowdown in globalisation industries that are less exposed to trade have become more dominant in the market place – the domestic market. The current protectionist policies of the Trump Administration don’t help to breakdown the barriers to entry and as the high stock values of profitable firms show, investors believe their advantages will continue. Powerful firms tend to stay and of the total capital spending and R&D done by America’s leading 500 companies the top 20 firms account of 38% of this spending.

The Contestable Market – A2 Economics – Theory

The degree of contestability of a market is measured by the extent to which the gains from market entry for a firm exceed the cost of entering (i.e. the cost of overcoming barriers to entry), with the risks associated with failure taken into account (the cost associated with any barriers to exit). Accordingly, the levels of barriers to entry and exit are crucial in determining the level of a market’s contestability. Barriers to exit consist of sunk costs, that is to say costs that cannot be recovered when leaving the market. The contestable markets approach suggests that potential entrants consider post‑entry profit levels, rather than the pre-entry levels suggested by neo‑classical theory.

Obviously no market is perfectly contestable, i.e. with zero sunk costs. In modern economies it is the degree of contestability which is relevant, some markets are more contestable than others. Also just because there have been no new entrants to a market over a given period of time does not mean that this market is not contestable. The threat of entry will be enough to make the existing (incumbent) firms behave in such a way as to recognise this, i.e. by setting a price which doesn’t attract entry and which only makes normal profits.

Markets which are highly contestable are likely to be vulnerable to ‘hit and run competition’. Consider a situation where existing firms are pricing at above the entry‑limit level. Even in the event that existing firms react in a predatory style, new entry will be profitable as long as there is a time lag between entry and the implementation of such action. Having made a profit in the intervening period, the new entrant can then leave the market at very little cost.

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms.
Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market.

The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.

Sources:

The Economist – The Next Capitalist Revolution – November 17th 2018

Anforme – A2 Level Economics Revision Booklet

A2 Economics – Marginal Revenue Product Theory

Marginal Revenue Product of Labour

Marginal revenue productivity (MRPL) is a theory of wages where workers are paid the value of their marginal revenue product to the firm.

The MRP theory outlined below is based on the assumption of a perfectly competitive labour market and the theory rests on a number of key assumptions that realistically are unlikely to exist in the real world. Most labour markets are imperfect, one of the reasons for earnings differentials between occupations which we explore a little later on.

  • Workers are homogeneous in terms of their ability and productivity
  • Firms have no buying power when demanding workers (i.e. they have no monopsony power)
  • There are no trade unions (the possible impact on unions on wage determination is considered later)
  • The productivity of each worker can be clearly and objectively measured and the value of output can be calculated
  • The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate

Marginal Revenue Product (MRPL) measures the change in total output revenue for a firm as a result of selling the extra output produced by additional workers employed. A straightforward way of calculating the marginal revenue product of labour is as follows:

MRPL = Marginal Physical Product x Price of Output per unit

Therefore the MRP curve represents the firm’s demand for labour curve and the profit maximising condition is where:

MRPL = MCL (Marginal Cost of Labour) where the revenue generating by employing an additional worker (MRPL) = the cost of employing an additional worker (MCL).

Mind Map below adapted from Susan Grant’s book CIE A Level Revision Guide

A2 Revision: The Perfectly Competitive Firm and the Market

Supernormal, normal, and subnormal profit only identified what happens to the firm. However it is important to be aware of what is happening in the market as a whole. Take for instance a firm making supernormal profits. The price that the firm charges is determined by what is happening in the market (supply and demand). If a firm makes supernormal profits this attracts other firms into the industry to take advantage of these profits. Therefore the supply of firms in the market increases which in turn reduces the price that firms can charge and they now make normal profits and are in the long-run see fig below.

AS Revision – Income Elasticity of Demand graph

Currently taking CIE revision classes this holiday and was working through Unit 2 and income elasticity of demand. Quite a few of the class had never come across this graph which is popular in multiple-choice questions. It is important that you read the axis.

Usefulness of Income Elasticity of Demand

Knowledge of income elasticity of demand for different products helps firms predict the effect of a business cycle on sales. All countries experience a business cycle where actual GDP moves up and down in a regular pattern causing booms and slowdowns or perhaps a recession. The business cycle means incomes rise and fall.

Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the economic cycle

The NZ economy has enjoyed a period of economic growth over the last few years. So average real incomes have increased, but because of differences in income elasticity of demand, consumer demand for products will have varied greatly over this period.

Over time we expect to see our real incomes rise. And as we become better off, we can afford to increase our spending on different goods and services. Clearly what is happening to the relative prices of these products will play a key role in shaping our consumption decisions. But the income elasticity of demand will also affect the pattern of demand over time. For normal luxury goods, whose income elasticity of demand exceeds +1, as incomes rise, the proportion of a consumer’s income spent on that product will go up. For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall. See table below for a summary of values.

A2 Revision – Economies of Scale Mind Map

With the A2 exam not far away here is something on Economies of Scale – also a mind map which I have edited from Susan Grant’s book.

When the average cost curve slopes downwards it means that average costs are decreasing as output increases. Whenever this happens the firm is experiencing economies of scale . If on the other hand the average costs are increasing as output increases the firm is experiencing diseconomies of scale . Why do firms experience economies of scale?

Technical Economies: large firms can take advantage of increased capacity machinery. For example, a double-decker bus can carry twice as many passengers as a single decker bus. But without the purchase costs and the running costs are not doubled.

Managerial Economies: In a small firm the manager may perform the role of cost accountant, foreman, salesman, personnel officer, stock controller etc. However, as a firm increases in size it can take advantage of specialisation of labour.

Commercial Economies: The large firm can buy it raw materials in bulk at favourable rates.

Financial Economies: the larger firm can negotiate loans from banks and related institutions     easily and at favourable rates.

Risk-Bearing Economies: All firms are subject to risk at sometime or other. However, the larger firm has distinct advantages in this area as small changes in supply and demand can often ruin a small company and larger firms can cover itself by producing a variety of products for a variety of markets.

Indifference Curves – Mindmap and Video

Been covering this topic with my A2 class and it is one of the more complex parts of the micro course. The video is particularly useful.


Income and Substitution Effects with Indifference Curves
Any price change can be conveniently analysed into 2 separate effects – the INCOME EFFECT and the SUBSTITUTION EFFECT.

Income effect of a price change: – when there is a fall in the price of a product, the consumer receives a real income effect and is able to buy more of this and other products in spite of the fact that nominal income is unchanged. If the consumer buys more of the good when the price falls it is a Normal good. If the consumer buys less of the good when the price falls it is seen as an Inferior good.

Substitution effect of a price change: – when there is a rise or fall in the price of a product, the consumer receives a decrease or an increase in the utility derived from each unit of money spent on the product and therefore rearranges demand to maximise utility. This is distinct from the income effect of a price change. For all products, the substitution effect is always positive such that a fall in price leads to an increase in demand as consumers realise an increase in the satisfaction they derive from each unit of money spent on the product.

Remember for normal goods, both the income and substitution effects are positive. But the income effect can be negative: if a negative income effect outweighs the positive substitution effect, this means that less is bought at a lower price and vice-versa. This good is therefore known as a Giffen good.

Giffen goods are generally regarded as goods of low quality which are important elements in the expenditure of those on low incomes. A good example is a basic food such as rice, which forms a significant part of the diet of the poor in many countries. The argument, not accepted by all economists, is that when the price of rice falls sufficiently individuals’ real income will rise to an extent that they will be able to afford more attractive substitutes such as fresh fruit or vegetables to makeup their diet and as a result they will actually purchase less rice even though its price has fallen.

New Zealand vegetables prices spike in March with bad weather

Tomato, lettuce, cauliflower, cabbage, and broccoli prices rose sharply in March 2018, boosting vegetable prices 9.5 percent in the month after adjusting for typically seasonal changes.

“Vegetable crops have been affected by a run of storms in recent weeks – lower supply (supply curve to the left) due to bad weather usually means higher prices,” consumer prices manager Matthew Haigh said.

“In February, we saw rising prices for lettuce, broccoli, and cauliflower, due to a combination of humid weather and cyclone Gita. As expected, that wet weather has affected vegetable prices in March too.”

Tomatoes rose more than 60 percent in March to $4.65 a kilo. In March last year, tomatoes were 83 cents cheaper at $3.82 a kilo.

 

The avocado market – prices up by 143%

The current avocado market has seen the wholesale price of a box of 48 avocados increase by 143%.

US$34.45 in September 2016
US$83.75 in September 2017

The reasons can be explained by simple Supply and Demand.

Supply

There have been droughts, storms, wildfires and strikes in various growing areas including California, Chile and Mexico

California – production down 44%
Mexico – production down by 20%

This has a huge impact on supply with the supply curve shifting to the left – S1 – S2 therefore increasing scarcity and putting up the price.

Demand

Annual consumption in the US has increase from about 0.5 kg in 1989 to 3.5 kg in 2016.

In 2016 total consumption was 1.15 billion kg. Demand curve shifts to the right – D1 – D2 therefore increasing the price.

A lot of demand has been driven by trends like avocado toast and the growth of fast-casual Mexican chains like Chipotle. There has also been higher avocado consumption in China and Europe as health-conscious consumers in the world’s most populous nations show an interest in the “heart-healthy” avocados.

Gourmet chocolate the economic lifeline to Venezuela

At the end of the 18th century Venezuela was the world’s leading cocoa producer. But the rise of the oil industry in the 20th century and the emergence of Hugo Chavez saw the decline of the cocoa industry. Chavez boosted state involvement in the economy and promised to create a society of equals. However since the crash in oil prices – up to 90% of government revenue came from oil – society has been divided. Doctors and engineers rarely make as much as US$50 a month whilst other with access to small amounts of hard currency can afford gourmet products.

Recently in Caracas there have been some 20 new businesses launched producing bars of Gourmet chocolate which retails for around US0.80 each in high end grocery stores — well out of the reach of most Venezuelans who earn less than that in a week but catering for the well-off in a two-tier system. Bars can fetch US$10 in a place like New York and Paris but bureaucracy makes this very difficult.

Although aware of these barriers one producer, Nancy Silva, is now focused on getting her chocolate to France, where she once sold a single kilo of her chocolate for the equivalent of 80 euros (US$96), which is today the equivalent of five years of minimum wage salary in Venezuela.

Venezuela cocoa beans

Venezuela produces 16,000 tonnes per year which is less than 1% of the global output and less than 10% of regional output when you take into consideration big producers like Brazil and Ecuador. However the use of Venezuela cocoa is seen as a marketing tool for shops as bars are produced with 100% local cocoa which is deemed high quality.

Many gourmet bars made in the United States now prominently advertise the use of Venezuelan cocoa but generally mix in other less-desirable cocoas. Bars made in Venezuela by contrast are made with 100 percent local cocoa.

This gives the new Venezuelan chocolatiers a leg up as they tap into the global ‘bean-to-bar’ movement, in which chocolate makers oversee the entire process of turning cocoa fruit into sellable treats.

On the second floor of an old mansion in Caracas, economist and chef Giovanni Conversi has been making specialty chocolate for two years under the name Mantuano. Sprinkled with sea salt or aromatic fruits from the Amazon, the chocolate bars are a hit in London, Miami and Panama City in specialty chocolate stores or shops that specialize in Latin American food.

Source: Reuters – Gourmet chocolate becomes economic lifeline in Venezuela crisis – 12th January