Marginal Revenue Product refers to the amount of revenue generated by an additional worker. This is a theory of wages where workers are paid the value of their marginal revenue product to the firm and is based on the assumption of a perfectly competitive labour market. Therefore an employer will hire workers up to the point where the value of the marginal product of labour equals the wage that is being paid. The demand curve for labour can therefore be represented by the value of the marginal product curve – see graph below and a revision mindmap.
The primary sector is seen as integral to assisting developing countries grow and raise their standard of living. For the Mozambican economy the cashew industry is an example of this – more than 40% of Mozambican farmers grow and sell cashew, and the processing sector provides formal employment to more than 8,000 individuals. Mozambique is currently the second largest producer in East and Southern Africa and has links with premium export markets, including the United States and Europe.
In the 1960’s the cashew nut industry in Mozambique was in good shape supplying over 50% of global supply and processed most of these domestically and thereby adding employment. However, with a civil war and the instruction from the World Bank in the 1990’s to remove controls and cut taxes on the exports of raw nuts, trading firms shipped out cashews and processed them overseas with significant job losses. But an about turn by the government in 2001 has seen:
an export tax of 18-22% for raw nuts
a 0% tax for processed kernels.
a ban on exports during the first few months of the harvest
16 factories employing 17,000 people, which process about half the cashews sold.
However by having less competition amongst processors – a little like a monopsony market – farmers selling raw cashew nuts are finding that the price of their crop is being reduced by the smaller number of processors. Most cashew nut farmers are smallholders and the government seems to be oblivious to the 1.3m families for the sake of protecting processing jobs.
Monopsony – one buyer many sellers – other examples include: – large supermarkets, who can dictate terms to smaller suppliers. – buyers of labour in the labour market.
There is a dilemma for developing countries as when a primary industry starts to expand into the secondary stage of processing, government protection can hurt nut-growers. Just like the coffee industry farmers are at the mercy of a small number of middlemen in this case the processors monopsony power.
Source: Mozambique’s nut factories have made a cracking comeback – The Economist 12th September 2019
The AS multiple-choice paper is coming up and here is this graphic to explain indirect taxes – a popular question. An indirect tax will have the following effects on the market:
• The supply curve shifts vertically upwards(effectively a shift to the left) by the amount of the tax(gf) per unit. The price increases but not by the full amount of the tax. This is because of the slopes of the demand and supply curves. • The consumer surplus is reduced from acp to agb. The portion gbhp of the old consumer surplus is transferred to government in the form of tax. • The producer surplus is reduced from pce to fde. The portion phdf of the old producer surplus is transferred to the government in the form of tax. • The market is no longer able to reach equilibrium, and there is a loss of allocative efficiency resulting in the deadweight lost shown by the area bcd. This represents a loss of both consumer surplus bhc and the producer surplus hcd that is removed from the market. The deadweight loss also represents a loss of welfare to an individual or group where that loss is not offset by a welfare gain to some other individual or group.
With the CIE A2 multiple-choice paper coming, up a popular question concerns the point on the Total Cost curve when MC, AVC, and ATC are at their lowest point. In the graph note the corresponding points on the Total Cost. They usually ask you where on the Total Cost line is the lowest point on the MC curve/AVC curve etc.
MC cuts ATC and AVC at their lowest points. The firm will supply where
the price is greater than or equal to MC. Thus the individual firm’s
supply curve consists of the firm’s MC curve, but only the portion above
AVC . The reason for this is that where P=AVC the firm will shut down
operations because they are barely covering avoidable costs.
Here is a quick revision note on monopolistic competition. This is a market structure in which there are a large number of firms selling commodities which are very close substitutes. There are weak barriers to entry and firms may enter the industry with ease. Notice on the diagram that the firm initially makes supernormal profit at Q0 – at MC=MR Price = P0 and Cost = AC0. However with weak barriers to entry these profits are competed away and they now produce at Q1 where at MC=MR and the Price and Cost = AC1
Modern capitalism is characterised by a large number of ‘limited’ monopolies. They are sole suppliers of branded goods, but other firms compete with them by selling similar goods with different brand names. This is the market structure described as monopolistic competition. Thus the commodities produced by any one industry are not homogeneous; the goods are differentiated by branding and the use of trade marks. The individual firm has a monopoly position, but it faces keen competition from firms supplying very similar goods. It has, therefore, only a limited degree of monopoly power – how much depends upon the extent to which firms are free to enter the industry. Product differentiation is emphasised (some would say, created) by the practice of competitive advertising which is, perhaps, the most striking feature of monopolistic competition.
Advertising is employed to heighten in the consumer’s mind the differences between Brand X and Brand Y. It is important to realise that we are concerned with the differentiation of goods in the economic sense and not in the technical sense. Two branded products may be almost identical in their technical features or chemical composition, but if advertising and other selling practices have created different images in the consumer’s mind, then these products are different from our point of view because the consumer will be prepared to pay different prices for them.
With the A2 exam on Wednesday next week here are some notes on indifference curves – it is a good essay to do if you know the theory. The video below 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 Normalgood. If the consumer buys less of the good when the price falls it is seen as an Inferiorgood.
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.
I covered this topic today at the Cambridge A2 Economics revision course. 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.
Entry limit pricing
The fear on the part of existing firms of rendering the market contestable (stimulating new entry) by making high levels of profit is likely to lead to the adoption of entry limit pricing, a concept introduced in the previous unit. This is essentially a defensive strategy, with existing firms setting prices as high as possible but not so high as to enable new corners to enter the industry. If the existing firms set price at P2 and output at Q2 (see diagram below), it would be possible for a new firm to enter the industry and supply Q1. Total market supply would then be Q3 (Q1 + Q2), the price would be P3 and the new firm would be covering its costs. If, instead, the existing firms chose to produce at Q3 (with price level P3), the new firm producing Q1 (total market supply would now be Q4 at price P4) would not be covering its costs and would have to exit the industry in the long run.
The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.
Price leadership (dominant firm model) was part of a question in last week’s A2 Economics exam and was not well answered. This example of collusive pricing sees one firm act as the leader in the market, setting the price which the other firms then adopt. The price leader is usually the ‘dominant firm’ in the market, this position being achieved through some factor such as size or cost advantage. The graph illustrates the dominant firm model. The dominant firm sets the price where MC = MR (profit maximisation) and then allows the other firms to supply as much as they wish at this price 0-Q1. The dominant firm supplies the remaining, or residual, market demand Q1-Q2. This behaviour offers all firms the advantage of certainty; the dominant firm is able to set the price, while the remaining firms know that they will be able to supply as much as they wish at the price set.
In the A2 exam there is usually one multiple-choice question on
Pareto Efficiency and part of an essay. The idea of Pareto Efficiency
is named after the Italian Economist Vilfredo Pareto. For a given set of
consumer tastes, resources, and technology, an allocation is
Pareto-efficient, if there is no other feasible allocation that makes
some people better off and nobody worse off. See also a previous post – Pareto Optimality and the perfect wave.
The figure above shows an economy with only two people, Susie and
David. The initial allocation at A gives David QD goods and Susie QS
goods. Provided people assess their own utility by the quantity of that
they themselves receive, B is a better allocation than A which in turn
is a better allocation than C. But a comparison of A with points such as
F, D or E, requires us to adopt a value judgment about the relative
importance to us of David’s and Susie’s utility. It is important to note
from the figure the following:
If you move from A to B or A to G it is a Pareto gain – A to B both Karen and John are better off. A to G Susie is better off, David no worse off.
If point B or G is feasible then point A is Pareto-inefficient – more goods can be consumed
A move from A to D makes David better off and Susie worse off.
However we need to make a judgment about the relative value of
David’s and Susie’s utility before we can comprehensively state that
David is better off. Therefore the Pareto principle is limited in
comparing allocations on efficiency – it only allows us to evaluate
moves to the north-east and south-west
Therefore, we need look at the economy as whole and how many goods it
can produce. In the Figure above the frontier AB shows the maximum
quantity of goods which the economy can produce for one person given the
quantity of goods being produced for the other person. All points on the frontier are pareto-efficient.
David can only be made better off by making Susie worse off and vice
versa. The distribution of goods between David and Susie is much more
equal at point C than at points A or B. Note that:
Anywhere inside the frontier is Pareto-inefficient – some can be made better off without making the other worse off.
The economy should never choose an inefficient allocation inside the frontier. Which of the efficient points on the frontier (A, B, C) is the most desirable will depend on the value judgment about the relative value of David and Susie utility.
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