Category Archives: Micro

Cobweb Theory and Price Elasticity

I have blogged on this topic before and although not in the NCEA or CIE syllabus’ I find it useful theory to mention when doing supply, demand and elasticity. Agricultural markets are particularly vulnerable to price fluctuations. many agricultural products have inelastic demand and inelastic supply. This means that any change in demand or supply has more of an impact on price than on quantity. Price fluctuations can also arise due to the time lag between planning agricultural production and selling the produce. The cobweb theory (so-called because of the appearance of the diagram) suggests that price can fluctuate around the equilibrium for some time, or even move away from the equilibrium. Dairy farmers base their production decisions on the price prevailing in the previous time period.


The supply of dairy products in New Zealand fits this assumption – farmers make their production decisions today, but the dairy cooperatives (Fonterra, Westland, etc.) don’t make a final decision on the price farmers will receive until close to the end of the season.

Cobweb scenarios:
Convergent
At the equilibrium point, if the demand curve is more elastic than the supply curve, we get the price volatility falling, and the price will converge on the equilibrium. For example:

  • Adverse weather conditions means their is a poor crop – Qt
  • The excess demand causes the price to rise – Pt
  • Because of the higher price famers plant more crops and therefore greater supply – Qt+1
  • With supply so high prices drop to meet demand – Pt+1
  • Lower prices mean that famers supply less to the following year – Qt+2
  • This results in higher prices again – Pt+2
  • Because of the higher price famers plant more crops and therefore greater supply – Qt+3 etc.
  • This process continues until you get to an equilibrium as the PED is greater than the PES – supply curve is steeper than the demand curve.
Source: Policonomics

Continuous
This is occurs where there is a continuous fluctuation between two equilibriums – Pt and Pt+1. The PED and the PES are equal to each other.
Divergent
Prices will diverge from the equilibrium when the PES greater than the PED at the equilibrium point – i.e.the demand curve is steeper than the supply – price changes could increase and the market becomes more changeable.

Even though these three diagrams show very different results they are dependent on the PES and the PED of the market.

Source:
https://policonomics.com/lp-closed-economy-cobweb-model/

A2 Economics – Economic Rent and Transfer Earnings

Economic Rent and Transfer Earnings To most of us “rent” is defined as a periodical payment made for the use of a particular asset – usually a residential or commercial property. However, the concept is not limited to land or buildings because it can also be applied to the other factors of production. When a factor is earning more than its supply price, it is receiving a part of its income in the form of economic rent. This situation arises when demand increases and supply cannot fully respond to the increases in demand. For example, labour already employed will experience an increase in income so that they must be earning more than their supply prices.

Present Wages – Wages when initially employed = Economic Rent

The minimum payment required to prevent a person transferring to another employer or another occupation is know as transfer earnings. It is determined by what the factor could earn in its next best paid employment. Transfer earnings may be regarded as the opportunity cost of keeping an employee in their present job or it may be regarded as the employee’s supply price in their present occupation. For example, if the minimum weekly wage that would persuade someone to work as a shop attendant is $200 but he or she actually receives a wage of $250, then the transfer earnings amount is $200 and he or she is receiving $50 in the form of economic rent. Therefore, economic rent can be defined as any payment to a factor of production that is in excess of transfer earnings.

The graph below shows the demand and supply for labour. The equilibrium wage is $120 with a quantity of 50 units. Total earnings is equal to $120 x 50 units of labour = $6,000 and employees receive the same wage of $120. However, all workers except the last one taken into employment were prepared to offer their services at wages less than $120. Therefore, provided the supply of labour slopes upwards (i.e. it is less than perfectly inelastic) an increase in demand will give rise to rent payments to those factors that were already employed at the original wage of $120. The area of economic rent and transfer earnings is shown in the graph below. Only the last labour unit employed earns no economic rent because the wage of $120 is the supply price to that particular labour unit.

Inelastic and Elastic labour supply

The amount of economic rent and transfer earnings in the return to labour depends upon the elasticity of supply and the level of demand. The greater the occupational mobility of labour, the smaller the element of economic rent. If labour can do a variety of occupations then quite small changes in the wage rate will cause large movements of labour into an industry when wages rise, and out of that industry when wages fall.

Very specialised labour has an inelastic supply curve. This includes surgeons, top CEOs, scientists and jobs that require high skill levels or involve significant danger and skill, eg, deep sea divers. The relatively high rewards to this labour are due to the fact that they are in very scarce supply relative to the demands for their services. Their transfer earnings will be much less than their salary because the market values outside their own specialised professions are probably very low. A frequently quoted example of earnings that contain a large amount of economic rent are those of top sports people. Today these people can earn significant amounts of money in a short period of time. A footballer such as Christiano Ronaldo earns €326 923 per week because of his ability to attract big crowds, merchandise sales and sponsorship deals when he was at Real Madrid Football Club. His skill levels are unique and in very limited supply when considering other players. This reflects a very high marginal productivity leading to a higher wage.

Some other occupations that are held in high regard by society do not command such high salaries because of their low marginal productivity. This includes nurses, firefighters, teachers, etc. Furthermore, the supply of labour for these jobs tends to be elastic because there are many people to choose from, unlike their footballing counterparts who have unique skills.

Quasi rent

Where the supply of labour is less than perfectly elastic an increase in demand will lead to some workers receiving economic rent. This rent may be of a temporary nature, however, because the higher wage may lead to an increase in supply, which in turn, lowers the wage. Increased wages might entice other workers to undertake the necessary training. The economic rent that is earned during the period before supply can be increased is referred to as quasi rent. True economic rent refers to the remuneration of factors that are fixed in supply.

Read more at: elearn Economics – https://www.elearneconomics.com/

A2 Revision – Indifference Curves – Mindmap

With the A2 multiple-choice paper next week here are some notes on indifference curves – there is usually a question on either the income effect or substitution effect. 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 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.

A2 Economics – Differing objectives of firms

With the CIE A2 essay paper on Wednesday here are some notes on the differing objectives of firms. This could be the second part of an essay question with the first part potentially being about market structures – perfect and imperfect competition.

The standard neo-classical assumption is that a business seeks to maximise profits (MC=MR) from producing and selling an output in a market. However, there are other objectives that firms might decide to pursue and this has implications for price, output and economic welfare. Furthermore, it is sometimes difficult for firms to identify their profit maximising output because they cannot accurately calculate marginal revenue and marginal costs. Any company has various interest groups that have stakes in the company. These include employees, managers, shareholders and customers.

Each of these groups is likely to have different objectives or goals. What the managers want to do is not necessarily what the owners want them to do. Managers may have a lot of freedom to pursue their own objectives rather than those of the shareholders and may try to maximise their own utility rather than the profit levels of the company. Shareholders may not keep themselves well informed and therefore rely on the decision making of the managers of the company.

The dominant group at any moment in time can give greater emphasis to their own objectives, for example, the main price and output decisions may be taken at local level by managers, with shareholders taking only a distant view of the company’s performance and strategy. Below are some other objectives:

Satisficing – with all the interest groups in a company all with their own objectives (higher wages for employees, customer satisfaction, marketing, etc) the overall objectives of a company are the result of discussion, negotiation and bargaining with all these groups. The result of this is likely to be a compromise between parties that does not maximise anything, this is satisficing.

Market share – some firms may be motivated by increasing market share. This is prevalent when firms operate in markets with a few large competitors and try to attract new customers from other competitors.

Survival – some firms look at survival, – especially those new to a highly competitive market. Surival is also prevalent when an economy goes through a downturn and consumer spending falls throughout the economy.

Shareholder value – increase shareholder value means to increase the asset value of the business. Shareholder value is defined as the remaining value of the business once all debts have been paid.

Ethical goals – increasingly, firms are introducing ethical goals such as those associated with the environment and carbon emissions, and with fair trade. This may mean more investment into these goals that leads to a higher cost structure. However, advertising ethical goals to consumers could attract more demand.

Limit pricing – firms may adopt predatory pricing policies by lowering prices to a level that forces any new firms entering the industry to operate at a loss. This allows firms to sustain a monopoly position in a market.

Sales volume maximisation – firm might wish to maximise the number of units sold, in turn maximising its share of the market, although this goal would have to be pursued subject to a profit constraint. The firm could expect to sell a large number of units if it dropped its price far enough, but at some point cutting price any further will involve making a loss. The output and price of a firm that wishes to maximise sales is subject to the constraint of making at least normal profit. Therefore output is set at the level where AR = AC. See graph below.

Sales revenue maximisation – total revenue is maximised when Marginal Revenue = zero (MR = 0), shown on the graph below. The shareholders of a business may introduce a constraint on the price and output decisions of managers, this is known as constrained sales revenue maximisation. Shareholders may introduce a minimum profit constraint designed to underpin the market valuation of their shares and maintain a dividend (a share of the company’s profits).

Read more at: elearn Economics – https://www.elearneconomics.com/section/key_notes/84

A2 Economics – Pareto Efficiency

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.

The diagram shows an economy with only two people, John and Karen. The initial allocation at Z gives John QJ goods and Karen QK goods. Provided people assess their own utility by the quantity of what they themselves receive, Y is a better allocation than Z, which in turn is a better allocation than T. But a comparison of Z with points such as U, V or W, requires us to adopt a value judgment about the relative importance to us of John’s and Karen’s utility. It is important to note from the figure the following:

  • If you move from Z to Y or Z to X it is a Pareto gain – Z to Y both Karen and John are better off. Z to X Karen is better off, John no worse off.
  • If point Y or X is feasible, then point Z is Pareto-inefficient – more goods can be consumed
  • A move from Z to V makes John better off and Karen worse off. However, we need to make a judgment about the relative value of John’s and Karen’s utility before we can comprehensively state that John 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 a whole and how many goods it can produce. On the diagram the frontier AD shows the maximum quantity of goods that 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. John can only be made better off by making Karen worse off and vice versa. The distribution of goods between John and Karen 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.
  • Moving from a point E to C is Pareto gain – both John and Karen gain output.
  • Moving from point B to C is Pareto-efficient – John gains more goods but Karen loses goods.

The economy should never choose an inefficient allocation inside the frontier. Which of the efficient points on the frontier (A, B, C or D) is the most desirable will depend on the value judgment about the relative value of John’s and Karen’s utility.

A2 Economics – Contestable Markets

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.

Source:

Anforme – A2 Level Economics Revision Booklet.

AS Economics – Price Elasticity of Demand

Doing some revision courses for AS students and went over Price Elasticity of Demand. Might be useful for those doing AS at the moment.

Price Elasticity of Demand (PED)
This measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. The equation is:

% change in Quantity ÷ Demanded % change in Price

How is PED calculated?

Consider the following demand schedule for buses in a city centre.

Price (average fare)          Quantity of passengers per week
100c                                      1000
60c                                        1300
30c                                        2275

Suppose the current average fare was 100c, what is the PED if fares are cut to 60c?

The percentage change in QD is equal to:
• The change in demand 300 (1300-1000) divided by the original level of demand 1000. To obtain a percentage this must be multiplied by 100. The full calculation is (300 ÷ 1000) x 100 = 30%

The percentage change in price is equal to:
• The change in price 40c (100c – 60c) divided by the original price 100c. To obtain a percentage this must be multiplied by 100. The full calculation is (40 ÷ 100) x 100 = 40%

These two figures can then be inserted into the formula with 30% ÷ 40% = 0.75
Let us now consider the PED when the average fare is cut from 60c to 30c

The percentage change in QD is equal to:
• The change in demand 975 (2275-1300) divided by the original level of demand 1300. To obtain a percentage this must be multiplied by 100. The full calculation is (975 ÷ 1300) x 100 = 75%

The percentage change in price is equal to:
• The change in price 30c (60c – 30c) divided by the original price 60c. To obtain a percentage this must be multiplied by 100. The full calculation is (30 ÷ 60) x 100 = 50%

These two figures can then be inserted into the formula with 75% ÷ 50% = 1.5

Please note that the minus sign is often omitted in PED, as the price elasticity is always negative because demand curves slope downwards. The textbook displays figures as:
PED = (-) 0.2

What price elasticity of demand figures tell us.

Determinants of Elasticity of Demand

The elasticity of a product is influenced by:
• the number of substitutes available
• whether it could be described as a luxury or a basic commodity
• the proportion of the purchaser’s income it represents
• the durability of the product.

Usefulness of Price Elasticity of Demand

The usefulness of price elasticity for producers. Firms can use price elasticity of demand (PED) estimates to predict:

1. The effect of a change in price on the total revenue & expenditure on a product.

The relationship between elasticity and total revenue.

                      Elastic         Inelastic            Unitary
Price ↑           TR↓                TR↑                      No Change
Price ↓           TR↑                TR↓                      No Change

2. The likely price volatility in a market following unexpected changes in supply.

3. The effect of a change in GST (indirect tax) on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.

4. Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination – off-peak and peak travel in major cities. Before 9am – inelastic demand curve – after 9am elastic demand curve.

Adapted from CIE A Level Revision – Susan Grant

AS Economics Revision – Income Elasticity of Demand graph

Here are some revision notes on YED which might useful for the CIE AS Economics exam next month. 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 Economics – Concentration Ratio

Part of the CIE A2 syllabus deals with the concentration ratio and by good fortune a recent edition of The Economist schools brief looked at this area.

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. Concentration ratios are used to determine the market structure and competitiveness of the market. The most commonly used are 4, 5 or 8 firm concentration ratios which measure the proportion of the market’s output provided by the largest 4, 5 or 8 firms.

Example of a hypothetical concentration ratio
The following are the annual sales, in $m, of the six firms in a hypothetical market:

Firm A = 56
Firm B = 43
Firm C = 22
Firm D = 12
Firm E = 3
Firm F = 1

In this hypothetical case, the 3-firm concentration ratio is 88.3%, that is 121/137 x 100.

According to the OECD, member countries between 2000 and 2014 experienced an increase in concentration ratios. The share of sales accounted for by the top eight firms in a given industry in the EU and North American were as follows:

Some policy makers are unconcerned with industrial concentration as it doesn’t tell you how competitive the market is for a particular good. Although others have blamed falling levels of competition, the stagnant labour markets and growing inequality. Add to that low interest rates and weak investment the rising power of companies has been increasing.

However one could argue that those firms which have high concentrations (especially in the technology sector) have also been very productive. The internet has broken down barriers to entry into markets and enabled firms to deliver goods and services in a very convenient manner at lower prices to a vast consumer market. But although this sounds encouraging there are barriers to new firms entering into this medium:

  • a new firm will require masses of data to tailor their services to individual users
  • other firms already in the market can see what preferences consumers have and because they already have a client base they can easily provide similar products/services.
  • established firms already in the market can buy out new entrants – Facebook bought Instagram and WhatsApp. Between 2009-2019 technology firms made over 400 acquisitions with little interference from regulators.

Source: The Economist – Economics brief – Competition. 8th August 2020