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.
With the exam season just about to start in New Zealand I thought it appropriate to do some revision blog posts. In the CIE A2 paper there is always a macro policy question and it usually focuses on the conflicts between the different objectives. Below is a mindmap on fiscal policy that might be useful. Fiscal Policy involves the use of Government Spending and Taxation in order to influence the level of economic activity. The Government receives money through Taxation (T) and spends money through Government spending (G).
- A budget deficit occurs when G > T
- A budget surplus occurs when T > G
There is an old saying among economists: “throughout history there have been only four kinds of economies in the world: advanced, developing, Japan, and Argentina”.
The set of once-poor countries that are now rich include Japan, where the transition began more than 100 years ago, and some other East Asian countries such as Korea and Taiwan, whose transition started only 50 years ago and is now almost complete. But going the other way there is only one notable case of a country that started life relatively rich and ended up comparatively poor: this is the great puzzle or paradox of Argentina. In the late nineteenth century, it was among the top five countries in income per capita, richer than all European countries except Britain and on a par with other rich settler societies such as the United States, Canada, and Australia.
Japan and Argentina continue to confound macroeconomics. Below is a table comparing the Argentina and Japan at the moment. How different they are. It doesn’t look as if they will play each other in the Rugby World Cup as they are in different Pools. However if their macroeconomic conditions are anything to go by they should end up in the final
The Economist – Argentina v Japan – March 30th March 2019
Video from CNBC looking at why central banks became independent and if it still should be the case – very informative and they use the Phillips Curve in their explanation. WIth the ongoing inflation problems in the 1970’s and 80’s it was thought that giving central banks independence of government control should be implemented. It was argued that policy makers would struggle to convince the public they were serious about containing inflation if politicians retained a say on setting interest rates. In 1989 New Zealand become the first country to introduce an independent bank with the 1989 – Reserve Bank Act. The mandate was to keep inflation between 0-2% but later changed to 1-3%.
With the GFC in 2008 it was central banks who slashed interest rates and implemented several rounds of quantitative easing to stimulate demand. However the GFC could have been prevented if central banks intervened to stop the biggest asset-bubble in history instead of focusing purely on keeping inflation low. Furthermore the European Central Bank were slow to act and the recovery was stymied. The fact that Germany is under the threat of deflation means that the ECB have cut interest into negative territory and are relaunch another round of quantitative easing – they are running out of options. Economists are focusing on fiscal stimulus – tax cuts and government spending. Therefore monetary and fiscal policy should be working together. According to Larry Elliott of The Guardian. central bank independence is a product of the neoliberal Chicago school of economics and aims to advance neoliberal interests. More specifically, workers like high employment because in those circumstances it is easier to bid up pay.
Last week Argentina imposed currency controls on business to prevent money leaving the economy after the Argentinian Peso lost over 25% of its value since elections last month – see graphic. The central bank now require that:
- exporters to repatriate earnings within 5 to 15 days
- businesses will need permission to repatriate profits abroad or buy US dollars
- residents are restricted to foreign exchange purchase of US$10,000 and non-residents US$1,000
With a track record of hyperinflation and financial crises, Argentinians are quick to sell their Pesos for US$ to maintain store value – with inflation and turmoil in an economy the local currency has less purchasing power. It is important for the Argentina government to restrict the demand for US$ and improve its ability to pay its significant debt – US$101bn. Capital controls have the aim of protecting the stability of the Peso and savers.
Will it work?
Although capital controls do stabilise the currency in a panic situation, they will only work in the long-term if they are used to confront the underlying macroeconomic problems in the economy itself. However, with Argentina’s inflationary issues coupled with fiscal deficits, capital controls are a band aid solution to the macroeconomic problems. Below is a very good video from the FT giving a background to the problems in Argentina.
Once shunned by leading economists like Robert Solow, society’s beliefs and values are just as significant for economic progress as is capital accumulation. Joel Mokyr in his book ‘A Culture of Growth The Origins of the Modern Economy’ describes culture as:
‘A set of beliefs, values, and preferences, capable of affecting behaviour, that are socially (not genetically) transmitted and that are shared by some subset of society’.
Economics has traditionally been focused on rational self-interest as the guiding light of human behaviour. The true catalyst for kick-starting the industrial revolution was not cheap labour and capital accumulation but the continent-wide evolution in beliefs. Mokyr believes that the drivers of technological progress and eventually economic performance are attitude and aptitude.
Attitude – the willingness and energy with which people try to understand the natural world around them.
Aptitude – this determines their success in turning such knowledge into higher productivity and living standards.
Mokyr’s ideas gave rise to how economists can make better use of culture with an evidence-based humanistic approach to scientific inquiry which led to a shift in behaviour that enabled industrialisation. Cultural barriers create a gap between classes and can hinder the flow of ideas and work environments – the modern economic experience cannot be explained without it. The cultural changes in the political economy over the past century cannot be explained solely on the basis of rational self-interest e.g. the fortunes of racial minorities and the increased presence of women in aspects of society. Cultural change can act as a catalyst to the economic potential of people and ideas, and matter for reasons other than their effect on GDP.
Evolving norms that allow women, ethnic minorities, immigrants, and gay and transgender people to play full roles in society not only boost growth but reduce human suffering. But because these shifts matter economically, the dismal science needs a better understanding of when and how cultures change—especially now. These norms shaped behaviour, which enabled progress. But cultures change.
Source: The Economist July27th 2019 – The uncultured science
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.
Source: Economics by Begg
Although there have been arguments that democracy and capitalism are incompatible no advanced capitalist democracy has been relegated out of high-income countries or reverted into a totalitarian state. It seems that in advanced economies democracy and capitalism seem to promote each other. However the next few years will test this theory as inequality starts to threatens the foundations of democracy.
Economist have given their views as to why capitalist democracies might fail. The oldest worry is that the masses will vote to take possession of the wealthy and without secure property rights there can be no capitalism. Here are the thoughts of some economists:
However what explains why democracy and capitalism have co-existed for so long? Iversen and Soskice in their book “Democracy and Prosperity’ see capitalism and democracy as potentially mutually supporting, with three stabilising pillars.
- Strong government – constraining the power of large firms and labour unions, and ensures competitive markets. Weaker countries find it harder to resist the short-term expediency of securing power by protecting monopolies.
a sizeable middle class, forming a political bloc that shares in the prosperity created by a capitalist economy.
- large firms that are not mobile – they cannot break their connections with local skilled networks where business plans and frontier technologies require the know-how developed and dispersed.
- Immobile companies give governments a degree of sovereignty which they use to boost the middle class. The middle classes dictate to feeling confident about the economy but a sharp slowdown in growth in real median incomes, could strengthen the appeal of movements that threaten to disturb the status quo. Governments, too, are becoming less responsive to middle-class priorities. America’s is too dysfunctional, and Britain’s too distracted by Brexit, to focus on improving education, infrastructure and the competitiveness of markets.
Demographic change might also take a toll: older and whiter generations may not much care whether a would-be middle class that does not look like them has opportunities to advance or not. Then, too, the authors may have underestimated the corrosive effect of inequality. Threatening to leave is not the only way the rich can wield power. They control mass media, fund think-tanks and spend on or become political candidates. Proud democracies may well survive this period of turmoil. But it would be a mistake to assume survival is foreordained.
Source: The Economist – Economic stress and demographic change are weakening a symbiotic relationship. Jun 13th 2019
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
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.