# A2 Revision – Oligopoly and the kinked demand curve – download

With the A2 Essay paper tomorrow I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

# New Zealand labour market – unemployment gap around zero.

The unemployment rate gap is the unemployment rate minus the estimate of the natural rate of unemployment. The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).

The natural rate of unemployment will therefore include:

Frictional unemployment – those people in-between jobs. Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

The size of the gap gives us an idea about the amount of capacity in the labour market, and hence pressure (or otherwise) on wages and inflation. ASB estimate that the NAIRU is currently hovering just above 4%, the bottom of the RBNZ’s recently estimated range (4.0-5.5%). With the current HLFS unemployment rate at 4.2%, a NAIRU of 4% suggests the unemployment gap is currently around zero. In other words, the labour market is neither particular tight nor loose. This is of course quite a change from a few decades ago when a 4% unemployment rate would indicate a super tight labour market and strong pressure on wages to rise. Broadly, what we have seen is a fundamental change in the capacity and inflation trade-off, not just in the labour market but economy-wide.It could be that increased globalisation and technological change are facilitating a shift in these trade-offs, which likely explains why inflation both here and abroad has been so low despite historically-low rates of unemployment and elevated measures of resource utilisation. Source: ASB Bank Economic Note

# Market structures and Netflix

Covering this topic with my A2 class and fortuitously came across a very relevant blog post from Michael Cameron’s blog Sex Drugs and Economics. He talks about Netflix increasing its subscription price by 19% (now \$21.99) for the premium plan and how Kiwi subscribers are going to social media to announce their departure from the streaming service.

However although people are voting with their feet it is highly likely that Netflix are not too perturbed by this. With the law of demand a higher price will reduce the demand for the service – simple Law of Demand.

The diagram below from the Cameron Blog shows a horizontal MC=AC curve which means that the cost of producing one more unit of output is the same. Some would suggest that it could be close to zero as the additional cost of providing one more subscriber with the service doesn’t involve significant costs.

Let’s assume that Netflix originally charged a price of P0 and sold a quantity of Q0 before the increase. Note here that they still make a supernormal profit rectangle – P0 C H F.

However they are not producing at the profit maximisation which is where MC=MR. Therefore although Netflix is increasing their price it is unlikely that they are charging a price at profit maximisation output as Netflix has too many subscribers to maximise profits. If they did produce at profit maximisation output Q1 and charge price P1 they would make profits of P1 B E F. So at a price of P1 – they gain profit of P1 B G P0 but lose the area G C H E. However the former area is bigger than the latter.

So with the market power that Netflix has it is not surprising that they are increasing their subscription price. With the video stores like Blockbuster, Video Ezy, United now struggling to survive and in some cases out of the market, they are less alternatives out there for the consumer.

# UK pound under pressure

From the FT – a weaker pound makes imports more expensive raising prices in the shops and eroding the real value of their earnings and savings. If the pound falls against other currencies, it makes those of us whose earnings or savings or investment income is in pounds poorer. However with a weaker exchange rate it should makes UK exports cheaper – but this doesn’t seem to be the case as although the pound depreciated significantly after the GFC it had little or no effect on the trade balance. Companies that rely on imports haven’t been able to reduce their price as the overall production cost has increased.

# Liberalism v GDP per capita

Martin Wolf in the FT wrote an interesting piece entitled ‘Liberalism will endure but must be renewed’. He states that liberalism is not a precise philosophy, it is an attitude. Liberals share a belief and trust in the capacity of human beings to decide things for themselves and express opinions and participate in public life.

Liberals share a belief that agency depends on possession of economic and political rights. As Martin Wolf stated ‘institutions are needed to protect those rights’ but liberalism also depends on markets to co-ordinate independent economic actors, free media to allow the spread of opinions, and political parties to organise politics. The graph below shows that economic growth and political freedom tend to go together as both depend on the rule of law. Liberal societies tend to be rich and rich societies tend to be liberal. Note that :

• New Zealand is one of the most liberal economies – approx 98 on the index – with its GDP per head being just over US\$40,000.
• Singapore has a GDP per head over US\$100,000 in relation to a Liberal Freedom index of approximately 72.
• Eritrea ranks as the lowest

# IGCSE Economics – Division of Labour

Just been doing Division of Labour with my IGCSE class and came across this very good video from Marginal Revolution University.

Division of Labour  is the breakdown of a production process so that each person can specialise in one part of that process and, through skill development and timesaving, workers’ productivity is increased. Adam Smith in The Wealth of Nations pointed out that the making of pins required 18 distinct operations and if one person did them all, approximately 20 pins would be produced each day. However, if ten people carried out some of the operations, then – through a division of labour – upward of 48,00 pins or 4,800 pins per worker would be produced each day.

# US – China trade war. Who has the power?

Another PBS video from Paul Solmon about the trade war between the US and China. The trade war hits China more for two reasons:

1. Trade makes up a much higher proportion of China’s GDP than that of the USA
2. With the Chinese economy slowing there is a big reliance on the export sector as an employer

The Chinese have certain options (see below) open to them which are discussed in the video below.

1. Bond dump
2. Squeezing US firms in China
3. Pull back on the number of Chinese coming to US for education
4. Devalue their currency
5. China might make sweetheart trade deals with other countries leaving out the US

# Brexit and the Common Agricultural Policy (CAP)

With the 29th March deadline approaching UK farmers are particularly opposed to a no-deal Brexit; customs hold-ups at the borders could ruin fresh produce. And there is concern that new trade deals with countries like New Zealand could lead to a flood of cheap imports and therefore making it harder for British farmers.

The EU bloc receives receives about 60% of UK food exports with 70% of the UK food imports come from the EU bloc. Lamb and beef exports could face export tariffs of at least 40% if the UK reverted to World Trade Organization rules under a no-deal exit. The UK produces approximately 60% of what is required to feed its population with the remainder being imported. The UK’s £110bn-a-year agriculture and food sector is deeply integrated with Europe relying on the bloc for agricultural subsidies of £3.1bn (\$4bn) under the CAP – Common Agricultural Policy. The government has promised to pay the equivalent of the CAP subsidies up to 2022, no one is certain what will happen after that.

What is CAP?

At the outset of the EU, one of the main objectives was the system of intervention in agricultural markets and protection of the farming sector has been known as the common agricultural policy – CAP. The CAP was established under Article Thirty Nine of the Treaty of Rome, and its objectives – the justification for the CAP – are as follows:

1. Raise and maintain farm incomes, through the establishment of high prices for food. Such prices are often in excess of the free market equilibrium. This necessarily means support buying of surpluses and raising tariffs on cheaper imported food to give domestic preference.
2. To reduce the wide flutuations that often occur in the price of agriculutural products due to uncertain supplies.
3. To increase the mobility of resources in farming and to increase the efficiency of all units. To reduce the number of farms and farmers especially in monoculturalistic agriculture.
4. To stimulate increased production to achieve European self sufficiency to satisfy the consumption of food from our own resources.
5. To protect consumers from violent price changes and to guarantee a wide choice in the shop, without shortages.

CAP Intervention Price

An intervention price is the price at which the CAP would be ready to come into the market and to buy the surpluses, thus preventing the price from falling below the intervention price. This is illustrated below in Figure 1. Here the European supply of lamb drives the price down to the equilibrium 0Pfm – the free market price, where supply and demand curves intersect and quantity demanded and quantity supplied equal 0Qm. However, the intervention price (0Pint) is located above the equilibrium and it has the following effects:

1. It encourages an increase in European production. Consequently, output is raised to 0Qs1.
2. At intervention price, there is a production surplus equal to the horizontal distance AB which is the excess of supply above demand at the intervention price.
3. In buying the surplus, the intervention agency incurs costs equal to the area ABCD. It will then incur the cost of storing the surplus or of destroying it.
4. There is a contraction in domestic consumption to 0Qd1
Consumers pay a higher price to the extent that the intervention price exceeds the notional free market price.

Figure 1: The effect of an intervention price on the income of EU farmers.

The increase in farmers’ incomes following intervention is shown also: as has been noted, one of the objectives of price support policy is to raise farmers’ incomes. The shaded area EBCFG indicates the increase in the incomes of the suppliers of lamb.

Throughout most of its four decades of existence, the CAP has had a very poor public relations image. It is extremely unpopular among consumers, and on a number of occasions it has all but bankrupted the EU.

# Airline prices: 2014 – 2018 and dynamic pricing

Another great graphic from The Economist showing the change in the price of an economy class ticket for both short-haul and long-haul flights. Routes longer than 5,000km have generally seen price drops of 30% and 50% on some transatlantic routes.

Reasons for the drop in fares:

• Fuel costs have come down – 2014 = US\$0.81 / litre – 2016 = US\$0.22 / litre
• Increasing long-haul competition from low-cost carriers
• More fuel efficient planes = lower costs
• Subsidies to state owned e.g. China
• Major airline deregulation
• Airlines have become much better at making more efficient use of their planes – i.e. having them full

Airlines and dynamic pricing

To the average buyer, airline ticket prices appear to fluctuate without reason. But behind the process is actually the science of dynamic pricing, which has less to do with cost and more to do with artificial intelligence. See video below from Tom Chitty of CNBC

# Is it time to ‘short’ the Aussie dollar

Although I wrote recently on Australia avoiding the ‘resource curse’ this video from the FT suggests otherwise and that the Aussie Dollar in 2019 is going to be volatile. The slowing down of the Chinese economy accompanied by a trade dispute with the US has meant lower demand for the Aussie Dollar. Imports of commodities, especially iron-ore, have slowed as China recorded significant reduction in exports and imports in December last year – see graph below:

A lot will depend in the US Fed and its interest rate stance and whether with weaker inflationary pressure and a slowing economy there could be a drop in rates which would help the Aussie Dollar. The cother concern is the exposure that commercial banks have in the mortgage market. Housing has long been a favoured investment option in Australia and with the housing market slowing banks could be left exposed with defaults on mortgages. So is it time to dump the Aussie Dollar?