Category Archives: Micro

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

Equity / Efficiency trade-off

Covered this online with my A2 class this week – Unit 3 of the CIE course. The efficiency losses when the government raises taxes  and pays transfers means that interventions to improve equity have a cost. Income can only be taken away from the rich and given to the poor in a leaky bucket. The ‘leaks’ are efficiency costs represented by the lost incentive to work and produce caused by the taxes taken and the transfers given. The lost output means that there is less to share out.

The size of the leaky bucket effect is one about which there is considerable disagreement. The New Right for instance, argue that the efficiency losses associated with redistributive policies are very large indeed. Government, too, has considered the problem and tax changes made in New Zealand in the eighties have been designed to minimise the efficiency cost of taxes. The marginal rate of tax on income had been brought down from 66 per cent to 33 per cent because it is believed that high rates on high incomes have very bad side-effects. Not only do they discourage work effort, but they also encourage speculative activity and tax evasion.

The equity and efficiency trade-off may be shown in a very abstract way by a frontier such as the above. At a point such as A, the economy is highly efficient but there is a very unequal distribution of income so that equity is low. To improve equity and achieve a point like B. income must be transferred and in the process some efficiency is lost. Equity gains are at the expense of efficiency. As more and more equity is pursued, the steepness of the efficiency/equity frontier increases as the efficiency costs become higher and higher.

As in production possibility analysis, if the economy is not on the equity/efficiency frontier but inside it at a point such as C, then it should be possible to have more of both equity and efficiency. If jobs can be found for the unemployed, the use of the additional scarce resources should improve efficiency and the distribution of income.

The New Right not only argue that the trade-off is a poor one as the efficiency losses from redistribution are very large, but also feel that the goal of more equality is not very desirable in any case.  Those who put the case for equity- i.e., the Social Left take the view that concern about the ‘leaky bucket’ or the efficiency costs is not justified. They argue that people work for a whole host of reasons including pride in doing a good job and are not much affected by high marginal tax rates. For them, the goal of more equality is highly desirable.

Oligopoly – Game Theory and Dominant Strategy

Been covering this topic with my A2 class and found Jason Welker’s video very good at explaining Prisoner’s Dilemma and the dominant strategy.

In recent years game theory has become a popular way of examining the strategies that oligopolists may adopt in a market. Game theory involves studying the alternative strategies oligopolists may choose to adopt depending on their assumptions about their rivals’ behaviour. Put at its simplest, if a firm is considering reducing its price, in making its decision it will need to take into account how its rival oligopolists might react and how it will affect them. Firms can choose high risk or low risk strategies in what is very similar to a game of poker between four or five players.

Although game theory strategy involves some extremely difficult maths the A2 Economics course concentrates on relatively straightforward two-player zero-sum games where one player’s gain must equal the other player’s loss.

Teaching MC=MR with M&M’s. Winner of the best M&M’s graph – 2020

Today we had our annual Yr 13 M&M’s graph competition. Having just completed Perfect and Imperfect Competition with my Year 13 class I used a couple of packets of M&M’s to drum home the concept of marginal analysis MC=MR. It has always been something that students have struggled with but I am hoping this experience of creating graphs with M&M’s might help their understanding and when to use the concept. There is a three way process for learning about this theory:

  • Students complete worksheets / multiple-choice questions that test their knowledge of the curves that make up the graphs.
  • Students draw the graphs on A3 size whiteboards
  • Students construct graphs using M&M’s

Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest. Using marginal analysis, the firm will produce at a rate of output where marginal revenue equals marginal cost. Below are a few of the graphs done today using M&M’s. The winner this year is Year 13 student Luke Davis – his graphs are the first and second below.

Student worksheet

Student graph on A3 whiteboard

Student graphs using M&M’s

Income Elasticity of Demand and Consumer Purchases Post-Covid

I came across this material on the blog ‘Sex, Drugs and Economics’ which discusses Bruce Wydick’s post on his blog ‘Across Two Worlds’. This is very useful for NCEA Level 3 and CIE AS Level Unit 2 both of which look at Income Elasticity of Demand.

Wydick looks at who is most likely to do well and who is likely to suffer in a post-covid environment. A typical recession is generally caused by supply-side factors (oil crisis years of 1973 – prices up by 400% – 1979 – prices up by 200%) or demand-side impact (loss of business confidence and consumer confidence). Covid-19 is very different as it is a complete shut-down of certain businesses and it forced people to stop buying things that they normal do. Wydick puts goods and services into two categories:

Snap-Back goods and services – things we couldn’t buy during the Level 4 lock-down period but were purchased when we went to Level 3. Pent up demand meant that purchases of these goods and service might have been higher than normal – buying less now means buying more later.

Gone Forever – as it states. Invariably this generally refers to services like air travel, tourism, haircuts, public transport and entertainment. When it becomes safe to have a haircut you still only get one haircut as the rest of your haircuts have disappeared and there is no catch-up spending like with snap-back goods.

These are the differences between goods with low versus high income elasticity. Income elasticity of demand measures the responsiveness of quantity demanded to changes in income. We can have different types of normal goods. If a 10% increase in income brought about a 10% increase in quantity demanded, we can say the income elasticity of demand is unitary. If EY>1 we classify the good as a luxury, and if EY<1, a necessity.

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. Wydick puts the different types of purchases in a simple 2 x 2 matrix“Snap-Back” vs. “Gone Forever” and High vs. Low income elasticity. 

It then becomes easy to see which industries are in the most trouble in 2020.  So, when goods and services are both “gone forever” and have a high income elasticity, we can expect the impact of the coronavirus pandemic to be most severe. Wydick identifies air travel, tourism, sporting events, hospitality, and transport (but not public transport). Everything else either snaps back and experiences some catch-up spending, or isn’t as affected by lower incomes. Goods that have a high income elasticity means that when you lose your job during the recession, you and others like you are even less likely to buy these things. For New Zealand the decline of the tourism industry is a significant hit to GDP and employment in this sector.

A2 Eco – Indifference curves and GIN

Teaching my A2 class the most complex theory in the A2 CIE Economics course – indifference curves. This year one student has come up with a novel way of remembering the position of the indifference curve when the price of one good falls. The three types of goods that eventuate from a price fall are: Giffen, Inferior and Normal – GIN.

G – Giffen – price falls negative income effect outweighs the positive substitution effect – point L would then be to the left of point J on the graph below.
I – Inferior – price falls positive substitution effect outweighs negative income effect – point L would then be between points J and K
N – Normal good – price falls both income and substitution effect are positive – point L will be to the right of point K – as shown below.

Below is a mindmap on indifference curves explaining all the effects of increasing and decreasing prices on different types of goods.

Monopoly power – Luxottica and sunglasses

With summer approaching in the northern hemisphere and the days getting brighter you will be looking to don sunglasses on a more regular basis. Sunglasses come in various styles and brands, eg. Rayban, Oakley, Gucci, Prada, Versace to name but a few,  but can be quite expensive when you consider the so-called competition that is in the market which in theory should driving down the price. Sunglasses these days are reasonably homogeneous in that the frames and materials are very similar and it surprised me that 80% of the major sunglass brands are controlled by Luxottica, in a market that is worth US$28 billion.

Luxottica produced the following brands of sunglasses under their name:

Prada, Chanel, Dolce & Gabbana, Versace, Burberry, Ralph Lauren, Tiffany, Bulgari, Vogue, Persol, Coach, DKNY, Rayban, Oakley, Sunglasses Hut, LensCrafters, Oliver Peoples, Pearle Vision, Target Optical and Sears Optical.

This list of brands is fairly comprehensive and by controlling 80% of the market you have a monopoly and dictate the price consumers have to pay for each specific brand since the industry isn’t competitive. Therefore they are Price Makers. But Luxottica also dictate what goes in the shops as they own Sunglass hut, Oliver peoples and Pearle Vision where consumers shop for sunglasses. This makes it very difficult for a brand outside one that is produced by Luxottica to compete as you can’t get your product into those shops. So not only do they have a monopoly in the production but they also control the distribution of sunglasses. See monopoly graph below.

Although a few years old now, in the clip below from ’60 Minutes’ they mention Oakley’s dilemma when their sunglasses became more popular than those produced by Luxottica. When this happen Luxottica proceeded to hold fewer Oakely sunglasses in their Sunglass Hut shops causing Oakley’s stock to plunge. Then in 2007 Oakley was left with no choice but to merge with Luxottica.

A2 Eco: Micro – Long-Run Average Cost – Envelope Curve

Having covered the macro part of the course with my A2. I’ve made a start on productive and allocative efficiency. One concept that the course covers is the Long-Run Average Cost (LAC).

In the short run at least one factor of production is fixed but In the long run the firm can alter all of its inputs, using greater quantities of any of the factors of production. It is now operating on a larger scale. So all of the factors of production are variable in the long run. In the very long run, technological change can alter the way the entire production process is organised, including the nature of the products themselves. In a society with rapid technological progress this will shrink the time period between the short run and the long run.

The long-run average cost (LAC) curve shows the least costly combination of producing any particular quantity. The graph below shows short-run average costs (SATC) and the LAC. The LAC forms a tangent with the SATC and it is therefore the lowest possible average cost for each level of output where the factors of production are all variable – it is formed from a series of SATC curves. The diagram shows:

From the diagram A is the least-cost way to make output Q1 in the short run. B is the least-cost way to make an output Q2. It must be more costly to make Q2 using the wrong combination of factors of production, for example the quantity corresponding to point E. For the combination of factors of production at A, SATC1 shows the cost of producing each output, including Q2. Hence SATC1 must lie above LAC at every point except A, the output level for which the combination of factors of production is best

The LAC is a flatter U-shape than the SATC curves and can be explained by economies of scale and diseconomies of scale. However it is really important to note that the firm does not necessarily produce at the minimum point on each of its SATC curves. Thus the LAC curve shows the minimum average cost way to produce a given output when all factors can be varied, not the minimum average cost at which a given plant can produce.
Note:

The Long-Run Average Cost is sometimes abbreviated to LRAC
The Short-Run Average Cost is sometimes abbreviated to SRAC

This LAC is also know as the envelope curve (looks similar to the back of an old style envelope) – see image.

Source: Economics by Begg 7th Edition

Moral hazard and Covid-19

Nobel Prize winning economist Paul Krugman defined moral hazard as:

Any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.

Companies exploiting moral hazard privatise the reward (they keep the profit) but socialise the risk (government bails them out if everything goes wrong)

Moral Hazard and the GFC
During the Great Depression more than 6000 American banks went bankrupt between 1930-33 and caused significant levels of unemployment. Learning from this event authorities believe that in future banks should be bailed out and this eventuated after the GFC in 2008. The main cause of the GFC was the sub-prime mortgage market where lenders faced a situation of moral hazard. Because the banks were taking on the risk the mortgage brokers, who sold the mortgages to the banks, didn’t really check whether the person taking on the mortgage could actually pay it back. Brokers were encourages to lie on the mortgage contracts about the income etc of their clients.

Moral Hazard and Covid-19
With corporate stimulus packages rolling out in most countries one wonders if there have been thorough enough checks on corporate behaviour. Issues like firing employees and bonuses to the top executives of companies have been prevalent in the past especially during the GFC. Then large businesses were favoured over small businesses. Today some of the wealthiest people made their money by borrowing from the banks to buy their own company shares in order to inflate its price. Following this they then sold their shares for a profit on the market. Now some of them are asking for bailouts as their company starts to struggle to survive. As well as government bailouts the central banks around the world have also engaged in the purchase of bonds and risky high-yielding debt. This is to ensure liquidity in the market but this intervention could shape how people perceive risk in the future and reward those institutions that behaved recklessly before the pandemic. Also more generous unemployment by the government might encourage people to be laid off and not seek work. However the time taken to minimise the moral hazard could have meant greater economic harm to the economy as a whole.