Category Archives: Micro

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.

A2 Economics – Dominant Firm Model

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.

A2 Revision – Pareto Efficiency

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.

fig15-01

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
fig15-02

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.

Source: Economics by Begg

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

AS & A2 Revision – How PED varies along a demand curve

Been doing some more revision sessions on CIE AS economics and went through how the elasticity of demand varies along a demand curve. Notice in Case A that the fall in price from Pa to Pb causes the the total revenue to increase therefore it is elastic – the blue area (-) is less than the orange area (+). In Case B the opposite applies – as the price decreases from Pa to Pb the total revenue decreases therefore it is inelastic – the blue area (-) is greater than the orange area (+). In Case C the drop in price causes the same proportionate change in quantity demanded, therefore there is no change in total revenue – it is unitary elasticity.

Remember where MR = 0 – PED = 1 on the demand curve (AR curve). A particularly popular question at A2 level is ‘where on the demand curve will a profit maximising firm produce at?’. As MC = MR above zero the imperfect firm always produces on the elastic part of the demand curve.

Ethics and Profits – what about the coffee growers?

No business, however great or strong or wealthy it may be at present, can exist on unethical means, or in total disregards to its social concern, for very long. Resorting to unethical behaviour or disregarding social welfare is like calling for its own doom. Thus business needs, in its own interest, to remain ethical and socially responsible. As V.B. Dys in “The Social Relevance of Business ” had stated-

“As a Statement of purpose, maximising of profit is not only unsatisfying, it is not even accurate. A more realistic statement has to be more complicated. The corporation is a creation of society whose purpose is the production and distribution of needed if the whole is to be accurate: you cannot drop one element without doing violence to facts.”

Business needs to remain ethical for its own good. Unethical actions and decisions may yield results only in the very short run. For the long existence and sustained profitability of the firm, business is required to conduct itself ethically and to run activities on ethical lines. Doing so would lay a strong foundation for the business for continued and sustained existence. All over the world, again and again, it has been demonstrated that it is only ethical organisations that have continued to survive and grow, whereas unethical ones have shown results only as flash in the pan, quickly growing and even more quickly dying and forgotten.

Business needs to function as responsible corporate citizens of the country. It is that organ of the society that creates wealth for the country. Hence, business can play a very significant role in the modernisation and development of the country, if it chooses to do so. But this will first require it to come out from its narrow mentality and even narrower goals and motives. However behavioural economists have found that many business people don’t behave in this type of profit-maximising manner in times of crisis – e.g a water shortage means businesses could charge more. If they do, consumers remember and retaliate down the road.

Ethical Consumers

As consumers start to develop a preference for ethical brands, e.g.. Fair Trade Coffee, create a market for such coffee. Firms are therefore pressured to shift toward supplying what consumers want. This is even the case if the firm’s management don’t care how or where the coffee is sourced. Changing consumer preferences force firms to change their ways. Even at higher prices consumers are often willing to pay a premium for ‘ethical’ products or the products of socially responsible firms. Being more expensive doesn’t necessarily mean the company will go out of business if consumers have a preference for ethical products. Higher-priced ethical firms remain highly successful under these circumstances. Instead of being protected by tariffs or subsidies, they’re protected by the preference of consumers.

Coffee supply chain.
However a recent article in the FT outlined the desperate state for coffee growers. The price of high quality arabica beans is trading just above $1 in the New York Commodity Exchange – this is half the value it was 5 years ago. This was due to Brazilian producers flooding the market. Although coffee prices in the cafes have increased the farmers are not the ones to benefit. The image below shows that the grower only gets 1p from the $2.50 and the coffee itself only accounts 10p.

There is a supply chain that takes ‘clips the ticket’ on the way through (see image) but the majority of the cost is associated with rent, wages and tax. The video Black Gold (a bit old now but has some good economics) looks at the growing industry in Ethiopia where they have some of the finest coffee beans in the world. Farmers there have been ripping up coffee plants and replacing it with ‘chat’ – a drug which is banned in the West – which fetches a much higher price.

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.

English Premier League – where competition means more revenue and better football

As the season drew to a close with the Europa League and Champions League Finals last week one couldn’t help noticing the dominance of the EPL sides. To have 4 clubs from the EPL in the finals is unprecedented and testament to the strength on the EPL. A lot of the other European leagues have a dominance of one or maybe two teams – EG

  • Spain – La Liga – Barcelona won the championship easily this year. Real Madrid its closest rivals in previous years finished 3rd.
  • Germany – Bundesliga – Bayern Munich won the league for the last 7 years although Borussia Dortmund have been close on a few occasions.
  • France – Ligue 1 – Paris St German won the league by 16 points and have won Ligue 1 6 out of the last 7 seasons
  • Italy – Serie A – Juventus won the league by 11 points and it was their 8th consecutive title.
  • Netherlands – Eredivisie – Ajax won the league by 3 points from PSV Eindhoven. Third place was a further 18 points behind

US Economist Walter Neale said that a pure monopoly in sport is not good. If some team is totally dominant in a league the interest in the competition wanes and fewer fans turn up to games and also television rights become less attractive. Therefore if a club is dominant in a league it will have to look to other alternatives to generate more revenue – creating a super league amongst other teams at the expense of national leagues like the Premier League, La Liga in Spain and Germany’s Bundesliga. This would be like major sports in the USA where the same teams compete without the threat of relegation. It would also be to the detriment of local leagues in which clubs traditionally have huge followings and also generate a lot of income.

However the EPL has done well to have a very competitive competition with 6 clubs being serious contenders for the title – Manchester City, Liverpool, Tottenham, Chelsea, Arsenal and Manchester Utd. With such competition there is interest from the fan base and TV rights which makes for a profitable league. So revenue in the sports arena is generated by competition not monopoly power. The EPL title went down to the last game whilst PSG won the Ligue 1 with 5 games left.

Source: Financial Times – 15th May 2019 – ‘Premier League wins by creating room at the top for football clubs’  by John Gapper.

Veblen Good – £42,000 a night at the Mandarin Oriental Hotel, London

Lucy Kellaway wrote an interesting piece in the FT about the cost of a nights stay at the most expensive hotel in London – a suite in the Mandarin Oriental will cost you £42,000 a night which is £10,000 to £20,000 more than London’s other most expensive suites.

You could say that the Mandarin hotel is a good example of conspicuous consumption which was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status. So-called Veblen goods reverse the normal logic of economics in that the higher the price the more demand for the product.

Over the last three decades conspicuous consumption has accelerated at a phenomenal level in the industrial world. Self-gratification could no longer be delayed and an ever-increasing variety of branded products became firmly ingrained within our individuality. The myth that the more we have the happier we become is self-perpetuating: the more we consume, the less able we are to tackle the myth.

The Economics of Uber

Another video from Paul Solman of PBS in his series ‘Making Sense’. With Uber’s initial public offering expected to be one of the largest ever he  visited their headquarters to better understand what happens when a San Francisco company puts economists in the driver’s seat. Useful for those looking at majoring in Economics.

HT – Sex, Drugs and Economics