Download Quantity of Labour

Microeconomics 1000
Lecture 20
Revision
Copyright © 2004 South-Western
Gains from trade
• If trade is voluntary and the parties are rational,
both parties must gain from trade (or at least not
lose)
• How to measure gains from trade?
Copyright © 2004 South-Western
Willingness to pay
• The willingness to pay is the maximum amount
of money the buyer is willing to pay
• Note: in general, w.t.p. ≠ price, which is what
the buyer actually pays (if he purchases the
good)
• For a rational buyer who purchases the good,
w.t.p. ≥ price
• The difference is consumer surplus
Copyright © 2004 South-Western
Demand
• Rational consumers will buy the good if price is
lower than wtp
• As the price increases, fewer consumers will
want to buy the good
• This creates a decreasing relationship between
price and quantity demanded
• Ranking consumers according to their wtp, each
point (step) of the demand curve will
correspond to a different consumer
Copyright © 2004 South-Western
Elasticity of demand
• Price elasticity of demand is a measure of how
much the quantity demanded of a good
responds to a change in the price of that good.
• Price elasticity of demand is the percentage
change in quantity demanded given a percent
change in the price.
Copyright © 2004 South-Western
Costs
• The goal of firms is to maximize profit, which
equals total revenue minus total cost.
• A firm’s total costs can be divided between
fixed and variable costs.
• Fixed costs do not change when the firm alters
the quantity of output produced; variable costs
do change as the firm alters quantity of output
produced.
Copyright © 2004 South-Western
Average and marginal costs
• Average total cost is total cost divided by the
quantity of output.
• Marginal cost is the amount by which total cost
would rise if output were increased by one unit.
• The marginal-cost curve always crosses the
average-total-cost curve at the minimum of
ATC.
Copyright © 2004 South-Western
Perfect competition
• In a perfectly competitive market, all agents are
price taker
• This requires that each agent is so small,
relative to the size of the market, that it can
have no substantial impact on price
Copyright © 2004 South-Western
Market equilibrium
• Market equilibrium is determined by the
intersection of the supply and demand curves.
• At the equilibrium price, the quantity demanded
equals the quantity supplied.
• An auctioneer, or the behavior of buyers and
sellers, naturally drives markets toward their
equilibrium.
Copyright © 2004 South-Western
Price controls
• Price controls include price ceilings and price
floors.
• A price ceiling is a legal maximum on the price
of a good or service. An example is the cap on
university fees.
• A price floor is a legal minimum on the price of
a good or a service. An example is the
minimum wage.
Copyright © 2004 South-Western
Taxation
• Taxes are used to raise revenue for public
purposes and for other purposes (such as
internalising externalities or reducing
consumption of demerit goods).
• When the government levies a tax on a good,
the equilibrium quantity of the good falls.
• A tax on a good places a wedge between the
price paid by buyers and the price received by
sellers.
Copyright © 2004 South-Western
Taxation
• The incidence of a tax refers to who bears the
burden of a tax.
• The incidence of a tax does not depend on
whether the tax is levied on buyers or sellers.
• The incidence of the tax depends on the price
elasticities of supply and demand.
• The burden tends to fall on the side of the
market that is less elastic.
Copyright © 2004 South-Western
Supply curve
• To maximize profit, a perfectly competitive
firm chooses the quantity of output such that
marginal revenue equals marginal cost.
• For a price taking firm, marginal revenue
equals price
• Thus, at the optimum price equals marginal
cost.
• Therefore, the firm’s marginal cost curve is its
supply curve.
Copyright © 2004 South-Western
Market efficiency
• An allocation of resources that maximizes the
sum of consumer and producer surplus is said
to be efficient.
• Under certain conditions, the equilibrium of a
perfectly competitive market is efficient.
• This result is also known as the First
Fundamental Theorem of Welfare Economics
Copyright © 2004 South-Western
Market failures
• A market economy delivers the efficient
allocation of resources
• However, efficiency is not guaranteed in the
presence of
•
•
•
•
Market power
Externalities
Public goods
Asymmetric information
Copyright © 2004 South-Western
Externalities
• When a transaction between a buyer and a
seller directly affects a third party, the effect is
called an externality.
• Negative externalities cause the socially
optimal quantity in a market to be less than the
equilibrium quantity.
• Positive externalities cause the socially optimal
quantity in a market to be greater than the
equilibrium quantity.
Copyright © 2004 South-Western
Externalities
• The Coase theorem states that if people can
bargain without a cost, then they can always
reach an agreement in which resources are
allocated efficiently.
• When private parties cannot adequately deal
with externalities, then the government steps in.
• The government can either regulate behavior or
internalize the externality by using Pigovian
taxes or by issuing pollution permits.
Copyright © 2004 South-Western
Public goods
• Goods differ in whether they are excludable and
whether they are rival.
• A good is excludable if it is possible to prevent
someone from using it.
• A good is rival if one person’s enjoyment of the
good prevents other people from enjoying the same
unit of the good.
Copyright © 2004 South-Western
Public goods
• Public goods are neither rival nor excludable.
• Because people are not charged for their use of
public goods, they have an incentive to free ride
when the good is provided privately.
• Governments may provide public goods,
making quantity decisions based upon costbenefit analysis.
Copyright © 2004 South-Western
Asymmetric information
• This term refers to situation where there is
uncertainty, and different agents are differently
informed
• Three types of phenomena
• Adverse selection
• Moral hazard
• Signalling
Copyright © 2004 South-Western
Adverse selection
• In general, the term Adverse Selection refers to
any situation where some information is hidden
• To be more precise, it describes the tendency
for the mix of unobserved attributes to become
undesirable from the standpoint of an
uniformed party
• With adverse selection, trades which should
occur do not take place, and the market can
completely vanish
Copyright © 2004 South-Western
Four Types of Market Structure
Number of Firms?
Many
firms
Type of Products?
One
firm
Few
firms
Differentiated
products
Monopoly
(Chapter 15)
Oligopoly
(Chapter 16)
Monopolistic
Competition
(Chapter 17)
• Tap water
• Cable TV
• Tennis balls
• Crude oil
• Novels
• Movies
Identical
products
Perfect
Competition
(Chapter 14)
• Wheat
• Milk
Copyright
© 2004
South-Western
Copyright
© 2004
South-Western
Monopoly
• A monopoly is a firm that is the sole seller in its
market.
• It faces a downward-sloping demand curve for
its product.
• A monopoly’s marginal revenue is always
below the price of its good.
Copyright © 2004 South-Western
Monopoly
• A monopoly maximizes profit by producing the
quantity at which marginal cost and marginal
revenue are equal.
• The price exceeds the monopoly’s marginal
revenue, so its price exceeds marginal cost.
• A monopoly causes deadweight losses.
Copyright © 2004 South-Western
Monopoly power
• Monopoly power is the monopoly’s ability to
profitably charge price above unit cost
• This determines both the profitability of the
monopoly and the magnitude of the deadweight
loss that it imposes on society
• The assessment of monopoly power is also a
preliminary, key step in the implementation of
antitrust policy
Copyright © 2004 South-Western
Lerner index
𝑝−𝑐 1
=
𝑝
𝑒
• The left-hand side is a measure of monopoly
power (Note: the price in the formula is the
optimal monopoly price, i.e. the most profitable
price)
• The right-hand side tells you that the only
determinant of monopoly power is the elasticity
of demand!
Copyright © 2004 South-Western
Causes of monopoly
• Monopoly is due to barriers to entry
• Barriers to entry in turn have various sources:
• Ownership of a key resource.
• The government gives a single firm the exclusive
right to produce some good.
• A producer may be much more efficient than any
other firm
• Costs of production make a single producer more
efficient than a large number of producers.
Copyright © 2004 South-Western
Prisoners’ dilemma
• The prisoners’ dilemma shows that self-interest
can prevent people from maintaining
cooperation, even when cooperation is in their
mutual self-interest.
• The logic of the prisoners’ dilemma applies in
many situations, including oligopolies.
Copyright © 2004 South-Western
Oligopoly
• Oligopolists would maximise their total profits
by forming a cartel and acting like a
monopolist.
• However, if oligopolists make decisions about
production levels individually, the result is a
greater quantity and a lower price than under
the monopoly outcome.
• Policymakers use the antitrust laws to prevent
oligopolies from engaging in behavior that
reduces competition.
Copyright © 2004 South-Western
Monopolistic competition
• A monopolistically competitive market is
characterized by three attributes: many firms,
differentiated products, and free entry.
• The equilibrium in a monopolistically
competitive market differs from perfect
competition in that each firm has excess
capacity and each firm charges a price above
marginal cost.
Copyright © 2004 South-Western
Monopolistic competition
• There is a standard deadweight loss of
monopoly caused by the markup of price over
marginal cost.
• The number of firms can be too large or too
small.
Copyright © 2004 South-Western
Consumer theory
• A consumer’s budget constraint shows the
possible combinations of different goods he can
buy given his income and the prices of the
goods.
• The slope of the budget constraint equals the
relative price of the goods.
• The consumer’s indifference curves represent
his preferences.
Copyright © 2004 South-Western
Consumer theory
• Points on higher indifference curves are
preferred to points on lower indifference
curves.
• The slope of an indifference curve at any point
is the consumer’s marginal rate of substitution.
• The consumer optimizes by choosing the point
on his budget constraint that lies on the highest
indifference curve.
Copyright © 2004 South-Western
The Consumer’s Optimum
Quantity
of Pepsi
Optimum
B
A
I3
I2
I1
Budget constraint
0
Quantity
of Pizza
Copyright©2004
South-Western
Copyright © 2004
South-Western
Consumer theory
• A price change has two effect on the optimal
consumption bundle
• The income effect is the change in consumption that
results when a price change moves the consumer to
a higher or lower indifference curve.
• The substitution effect is the change in consumption
that results when a price change moves the
consumer along an indifference curve to a point
with a different marginal rate of substitution.
Copyright © 2004 South-Western
The Work-Leisure Decision
Consumption
$5,000
Optimum
I3
2,000
I2
I1
0
60
100
Hours of Leisure
Copyright©2004
South-Western
Copyright © 2004
South-Western
An increasing labour supply curve
(a) For a person with these preferences. . .
Consumption
. . . the labor supply curve slopes upward.
Wage
Labor
supply
1. When the wage rises . . .
BC1
BC2 I2
I1
0
2. . . . hours of leisure decrease . . .
Hours of
Leisure
0
Hours of Labor
Supplied
3. . . . and hours of labor increase.
Copyright©2004
South-Western
Copyright © 2004
South-Western
A decreasing labour supply curve
(b) For a person with these preferences. . .
Consumption
. . . the labor supply curve slopes backward.
Wage
BC2
1. When the wage rises . . .
Labor
supply
BC1
I2
I1
0
2. . . . hours of leisure increase . . .
Hours of
Leisure
0
Hours of Labor
Supplied
3. . . . and hours of labor decrease.
Copyright©2004
South-Western
Copyright © 2004
South-Western
Demand for labour
• Firms produce output using factors of
production.
• The three most important factors of production
are labour, land, and capital.
• The demand for a factor, such as labour, is a
derived demand that comes from firms that use
the factors to produce goods and services.
Copyright © 2004 South-Western
Demand for labour
• Competitive, profit-maximizing firms hire each
factor up to the point at which the value of the
marginal product of the factor equals its price.
Copyright © 2004 South-Western
Labour demand
Quantity of
Corn
3000
Supply of
corn
E
0
Demand for
labour
1000
Quantity of
Labour
Copyright
© 2004 South-Western
Copyright©2003
Southwestern/Thomson Learning
General equilibrium
• Partial equilibrium analysis focuses on a single market
• It is based on the ceteris paribus (i.e. all else equal)
assumption
• But changes in one market may also affect several
other markets
• Hence the need for general equilibrium analysis
Copyright © 2004 South-Western
The Circular Flow
Revenue
Goods
and services
sold
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
•Households buy
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
Copyright
© 2004
Copyright
© 2004South-Western
South-Western
General equilibrium
•
•
•
•
Only relative prices matter
With two goods, only one relative price
With n goods, only n – 1 relative prices
By Walras law, if n – 1 markets clear, the nth
market also clear
• Thus, n – 1 prices can clear n markets
Copyright © 2004 South-Western
Efficiency of the General equilibrium
Quantity of
Corn
3,000
E
2,200
0
600
1,000
Quantity of
Leisure
Copyright © 2004 South-Western
Copyright©2003 Southwestern/Thomson Learning
Comparative advantages
• Each person consumes goods and services
produced by many other people both in our
country and around the world.
• Interdependence and trade are desirable because
they allow everyone to enjoy a greater quantity
and variety of goods and services.
Copyright © 2004 South-Western
Comparative advantages
• There are two ways to compare the ability of
two people, or two countries, producing a
good.
• The person who can produce a good with a smaller
quantity of inputs has an absolute advantage.
• The person with a smaller opportunity cost has a
comparative advantage.
Copyright © 2004 South-Western
Comparative advantages
• The gains from trade are based on comparative
advantage, not absolute advantage.
• Trade makes everyone better off because it
allows people to specialize in those activities in
which they have a comparative advantage.
• The principle of comparative advantage applies
to countries as well as people.
Copyright © 2004 South-Western