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

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Concentration ratio of the Premier League, La Liga, Bundesliga and Serie A

I have blogged on concentration ratios before and currently covering it with my A2 class. This topic can be a multiple-choice question or part of a market structures essay/data response.

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.

HHI and European Football
However, we can apply a similar calculation to measure the concentration of football league championships. The Herfindahl-Hirschman Index (HHI) was originally developed to measure the concentration of firms in an industry, but it has been used in football. To work out the HHI (see equation) you count the number of championships a team won (Ci) within a given time period, dividing by the number of years in the period (N), squaring the fraction, and adding the fractions for all teams.

If the HHI is a maximum 1 this indicates a perfect imbalance and one team has been champion for all years. The minimum HHI value is 0.1 and this means that there has been a different winner each year. Below is the HHI in various European leagues between 2012-13 to 2021-22.

Distribution of championships in European Leagues – 2012-13 to 2021-22 (10 years)

From the above table this to the big football leagues in Europe we see that the distribution of championships is high skewed toward a few dominant teams. In all four leagues one team has won at least 5 championships over the 10 years with Bayern Munich being totally dominant in the Bundesliga winning all 10 – HHI = 1. In a lot of cases the runner-up in these leagues is also featured as a championship winner. La Liga and the EPL had two teams that were 1st or 2nd in most years – Barcelona or Real Madrid, Manchester City or Liverpool. To the extent that teams can ‘buy championships’ because they have more revenue than their competitors, differences in market size and team popularity may be to blame. The EPL is the most balanced of the league with a HHI = 0.32 with La Liga HHI = 0.38. This lack of competitive balance combined with the extraordinary popularity of European football provides additional evidence that fans may be less concerned with the competitive balance that one might think.

Source: The Economics of Sport (2018) – M. Leeds, P. Von Allmen and V. Matheson

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Price elasticity of demand and Premier League replica shirts. Do they pay the players wages?

Listening to the Podcast ‘The Price of Football’ the theory of price elasticity of demand was raised with regard to the sale of Premier League replica shirts. Should clubs actually reduce the price of shirts in order to increase demand and raise revenue revenue for the club? The theory measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. What price elasticity of demand figures tell us:

Over the years shirt prices have increased but clubs have found that there has been little resistance with the consumer is still buying them – very much inelastic demand. So how much do clubs make from selling shirts? There is an assumption that they make a lot of money but in the larger scheme of things it really isn’t that much. Every time you get a big name transfer, whether it be Messi and Neymar to PSG or Haaland to Man City there is a flurry of activity to buy the replica shirt with the players name on it. The reality is that a typical club only gets about a 7.5% commission on each shirt or as is the case of Liverpool 20% which is unique. The table below looks at the number of shirts sold and the revenue from retail in 2022.

Do shirt sales pay for transfer fees?
To put it into context say a Premier League club sells 100,000 shirts in a season at £75 each. That price would generate a total revenue of £7.5 million, of which a club would typically receive a 7.5% fee = £562,500. Liverpool with a 20% commission would make £1.5m. So the myth of shirt sales covering transfer fees doesn’t really stack up. Mo Salah’s earns a weekly income of £1m and for Liverpool to pay his wage from shirt sales they would need to sell to 66,666 per week.

For clubs replica shirts are just a small part of the revenue stream but it is the sponsorship fee from the brand – Adidas, Nike, Puma, Umbro – where the money is. The table above shows the top 7 deals in the Premier League. Notice the big drop off to 6th – Spurs – and especially to 7th – Everton.

Sources:

Sports Journal

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Role of Price Elasticity of Demand – Wall Street Journal

Below is a very good video from the Wall Street Journal on price elasticity of demand (PED). PED is key to understanding how companies price their products. Consumer spending has held up relatively well so far despite inflation, but experts say we’re approaching an inflection point. The WSJ explains the role ‘elasticity’ plays in a company’s decision on whether to raise prices. After the video I’ve included some notes about calculating PED and a mindmap.

Price Elasticity of Demand (PED)
This measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. The equation is:

% change in Quantity ÷ Demanded % change in Price

How is PED calculated?

Consider the following demand schedule for buses in a city centre.

Price (average fare)          Quantity of passengers per week
100c                                      1000
60c                                        1300
30c                                        2275

Suppose the current average fare was 100c, what is the PED if fares are cut to 60c?

The percentage change in QD is equal to:
• The change in demand 300 (1300-1000) divided by the original level of demand 1000. To obtain a percentage this must be multiplied by 100. The full calculation is (300 ÷ 1000) x 100 = 30%

The percentage change in price is equal to:
• The change in price 40c (100c – 60c) divided by the original price 100c. To obtain a percentage this must be multiplied by 100. The full calculation is (40 ÷ 100) x 100 = 40%

These two figures can then be inserted into the formula with 30% ÷ 40% = 0.75
Let us now consider the PED when the average fare is cut from 60c to 30c

The percentage change in QD is equal to:
• The change in demand 975 (2275-1300) divided by the original level of demand 1300. To obtain a percentage this must be multiplied by 100. The full calculation is (975 ÷ 1300) x 100 = 75%

The percentage change in price is equal to:
• The change in price 30c (60c – 30c) divided by the original price 60c. To obtain a percentage this must be multiplied by 100. The full calculation is (30 ÷ 60) x 100 = 50%

These two figures can then be inserted into the formula with 75% ÷ 50% = 1.5

Please note that the minus sign is often omitted in PED, as the price elasticity is always negative because demand curves slope downwards. The textbook displays figures as:
PED = (-) 0.2

What price elasticity of demand figures tell us.

Determinants of Elasticity of Demand

The elasticity of a product is influenced by:
• the number of substitutes available
• whether it could be described as a luxury or a basic commodity
• the proportion of the purchaser’s income it represents
• the durability of the product.

Usefulness of Price Elasticity of Demand

The usefulness of price elasticity for producers. Firms can use price elasticity of demand (PED) estimates to predict:

1. The effect of a change in price on the total revenue & expenditure on a product.

The relationship between elasticity and total revenue.

                      Elastic         Inelastic            Unitary
Price ↑           TR↓                TR↑                      No Change
Price ↓           TR↑                TR↓                      No Change

2. The likely price volatility in a market following unexpected changes in supply.

3. The effect of a change in GST (indirect tax) on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.

4. Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination – off-peak and peak travel in major cities. Before 9am – inelastic demand curve – after 9am elastic demand curve.

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Robusta coffee prices hit 29-year high

The robusta coffee bean is widely used in espresso blends as it is widely accepted that it produces a better creamy layer found on the top of a shot than arabica. However over the last year prices have reached their highest level for 29 years – 186.36 US cents/lb in March 2024. The cause of this increase is basic supply and demand

If we look at actual coffee prices in New Zealand the average price of a takeaway coffee around the country has risen to $4.74. That’s 64% higher than it was back in 2007 (which is the earliest we have nationwide data). As a comparison, consumer prices more generally rose by just over 50% over the same period. The cost of beans (arabica beans) has risen around 67%, milk prices are up 50% and the cost of labour in the hospitality sector has basically doubled. See graph below:

Source: Westpac Weekly Economic Commentary – 8th April

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

With the northern hemisphere getting ready for the external exams in May/June here is a revision post on 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.

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A2 Economics – Differing objectives of firms

Different objectives of firms could be part of an essay question on market structures – perfect and imperfect competition.

The standard neo-classical assumption is that a business seeks to maximise profits (MC=MR) from producing and selling an output in a market. However, there are other objectives that firms might decide to pursue and this has implications for price, output and economic welfare. Furthermore, it is sometimes difficult for firms to identify their profit maximising output because they cannot accurately calculate marginal revenue and marginal costs. Any company has various interest groups that have stakes in the company. These include employees, managers, shareholders and customers.

Each of these groups is likely to have different objectives or goals. What the managers want to do is not necessarily what the owners want them to do. Managers may have a lot of freedom to pursue their own objectives rather than those of the shareholders and may try to maximise their own utility rather than the profit levels of the company. Shareholders may not keep themselves well informed and therefore rely on the decision making of the managers of the company.

The dominant group at any moment in time can give greater emphasis to their own objectives, for example, the main price and output decisions may be taken at local level by managers, with shareholders taking only a distant view of the company’s performance and strategy. Below are some other objectives:

Satisficing – with all the interest groups in a company all with their own objectives (higher wages for employees, customer satisfaction, marketing, etc) the overall objectives of a company are the result of discussion, negotiation and bargaining with all these groups. The result of this is likely to be a compromise between parties that does not maximise anything, this is satisficing.

Market share – some firms may be motivated by increasing market share. This is prevalent when firms operate in markets with a few large competitors and try to attract new customers from other competitors.

Survival – some firms look at survival, – especially those new to a highly competitive market. Surival is also prevalent when an economy goes through a downturn and consumer spending falls throughout the economy.

Shareholder value – increase shareholder value means to increase the asset value of the business. Shareholder value is defined as the remaining value of the business once all debts have been paid.

Ethical goals – increasingly, firms are introducing ethical goals such as those associated with the environment and carbon emissions, and with fair trade. This may mean more investment into these goals that leads to a higher cost structure. However, advertising ethical goals to consumers could attract more demand.

Limit pricing – firms may adopt predatory pricing policies by lowering prices to a level that forces any new firms entering the industry to operate at a loss. This allows firms to sustain a monopoly position in a market.

Sales volume maximisation – firm might wish to maximise the number of units sold, in turn maximising its share of the market, although this goal would have to be pursued subject to a profit constraint. The firm could expect to sell a large number of units if it dropped its price far enough, but at some point cutting price any further will involve making a loss. The output and price of a firm that wishes to maximise sales is subject to the constraint of making at least normal profit. Therefore output is set at the level where AR = AC. See graph below.

Sales revenue maximisation – total revenue is maximised when Marginal Revenue = zero (MR = 0), shown on the graph below. The shareholders of a business may introduce a constraint on the price and output decisions of managers, this is known as constrained sales revenue maximisation. Shareholders may introduce a minimum profit constraint designed to underpin the market valuation of their shares and maintain a dividend (a share of the company’s profits).

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Liverpool v Man City and variable ticket pricing

I blogged on this before but thought it would appropriate to mention it again on the eve of the big game in Premier League today. When Liverpool play Manchester City at Anfield in the English Premier League on 10th March tickets will be very sought after (increase in demand) with both teams in the running for the EPL title. Because of the importance of such a game Liverpool FC can charge a higher price for tickets in order to maximise profits. This is referred to as variable ticket pricing (VTP) as ticket prices are set according to expected demand for a future game. This is widely used in the EPL and this year ticket prices at Anfield vary considerably for newly promoted Burnley and title holder Manchester City – see below. Prices from Live Football Tickets

From Liverpool’s perspective differences in demand create an opportunity for the club to maximise profits. The assumption is that attendances at Anfield will be similar for earlier games against clubs in the EPL – Nottingham Forest – 50,000 and Arsenal 58,000 (capacity). With the soon to be completed Anfield Road Stand the capacity is set to be 61,000.

For the firm 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. Remember that the firm will make profits as long as the extra revenue brought in from selling the last unit of output(MR) is greater than the extra cost which is incurred in producing it(MC).

In the graph it can be assumed that the marginal cost of hosting a game is essentially zero up to the point of the stadium’s capacity (58,000) as costs are about the same no matter how many fans attend. The demand curve for the Burnley game is AR2 and demand for the Manchester City game is AR1. A team using variable ticket pricing sets marginal revenue equal to marginal cost for each game – MC=MR1 and MC=MR2 resulting in prices of £399 and £189 respectively. Marginal analysis is in the syllabus of most introductory economics courses, in particular Cambridge A2 level, IB and NCEA Level 3.

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A2 Economics – Imperfect competition and marginal analysis

For the CAIE A2 Economics course and NCEA AS 3.2, below is a note on Imperfect Competition which tends to be a popular question in the exam. The rule for maximising profit or minimising a loss (the equilibrium) for a monopoly is the same as any other firm. The most profitable output or smallest loss is where marginal revenue (MR) = marginal cost (MC). Any other position will result in a smaller profit or greater loss

Therefore, the equilibrium output (determined from the intersection of the MC and MR curves is at a price of PM ($8) and quantity Qm ($200m). The average revenue (AR) = $8 and the average cost (AC) = $5.

• Total revenue (TR) = $8 x 200m = $1,600m
• Total cost (TC) = $5 x 200m = $1,000m
• Profit = TR – TC = $1,600-$1,000 = $600m – yellow shaded area.

A monopoly charges more and produces less than it would be the case if the firm operated as a perfect competition. Operating at the equilibrium output position creates a deadweight loss = ABE green shaded area. At the equilibrium position the market is not allocatively efficient because consumer surplus and producer surplus are not maximised. The new consumer surplus is the area above the profit maximising price – light blue shaded area.

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Scarcity, opportunity cost and a football club

Let us start with a basic rule of economics! If something is scarce – it will have a market value. If the supply of a good or service is low, the market price will rise, providing there is sufficient demand from consumers. For example, the low levels of water in New Zealand’s South Island dams forced up the market price of electricity for some consumers.

A football player in the English Premier League (EPL) starting wage is between £12-18m, well above £50k a week, nudging nearer to £100k for first team regular players at top half clubs – £1 = NZ$2.04 approx. Top players e.g. Kevin De Bruyne of Manchester City (below) – earns £21m a year which equates to £404,000 (NZ$824,000) per week.

For top clubs the fear of missing out on talent leads to individual player transactions being vastly overvalued in comparison to the alternative uses of that money. In economic terms you would say there is information asymmetry. The transfer market suffers from the lemon problem – this refers to issues that arise regarding the value of an investment or product due to asymmetric information possessed by the buyer and the seller. Put simply the buyer can’t really judge the current value of players. This probably leads to too high a value being put on recent performance and too low a value being put on players who haven’t played recently or don’t have an established reputation

Example: A club has £20m (plus £80k a week wages for 5 years) available to spend. What else could £20m (plus £80k for 5 years) buy? In 5 years’ time, what are the expected payoffs of either purchase?

Alternatives:

• Clear debts: £~10m
• Cover deficit: £5m a year, including cost of a new management team to put a sensible structure in place, then run at break even.
• Build a new stand and ground infrastructure.
• Put the money into the youth development programme

Therefore the definition of opportunity cost in decision-making is the value of the next-best alternative forgone.

Source: Opportunity Cost in football

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A2 Economics – deriving the demand curve from indifference curves.

Some textbooks for the CAIE A2 Economics course don’t cover indifference curve analysis in detail and tend to just focus more on the income and substitution effect. For essays at A2 level it is important to show an understanding / analysis of how you can derive the demand curve of a product against income or price by using the indifference curves in an indifference map.

An indifference map contains information on the quantity of a product a consumer will purchase at different prices and different incomes. So you should be able to see that deriving the demand curves is simply a matter of transferring the price-quantity and income-quantity relationships onto new graphs. By altering the price of the product and the income of the consumer, you can find the price-consumption curve and the income-consumption curve on the indifference map. The two sets of graphs illustrate the price-consumption curve, income-consumption curve and their corresponding individual demand curves.

To find the price-consumption curve (left graph), we alter the price of the product only, causing the change in the budget line as shown in the graph. The budget lines B1, B2, and B3 on the indifference map correspond to the prices P1, P2, and P3 on the individual demand curve. Note that we are dealing with a normal good here. The individual purchases more good X (say, at B3) because it is cheaper (at a price P3). Of course, this is mainly the substitution effect at play. Only three sets of budget lines and indifference curves are shown here. But you can derive more points by shifting the budget lines and finding their corresponding indifference curve.

For the income-consumption curve (right graph), we alter the income or budget of the individual, shifting the budget curve parallel. At any price, say P, the quantity purchased increases as the income increases due to good X being a normal good. It should be clear that each budget line corresponds to one and only one indifference curve as only one indifference curve can intersect the budget line at the tangent. So when you shift the budget line, parallel or not, you need to find its new corresponding indifference curve. The trick is to find out the slope of the new budget line or the price ratio. Note that the slope of the new budget line equals the slope of the indifference curve at the tangent, and the slope of the indifference curve is the marginal rate of substitution (MRS).

Source: Wells Yuan – Yr 13 student (2023)

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Cross price elasticity of demand and airline safety – how much should be invested?

You are no doubt aware of the two catastrophic accidents in 2018 involving Boeing 737 Max aircraft which led to the Federal Aviation Administration (FAA) to ground all 737 Max aircraft and make regulatory changes. The compliance costs incurred by the FFA were significant and can ultimately drive up fares and cause consumers to substitute higher-risk road travel for air travel – cross price elasticity of demand. See table below:

Before the 737 Max crashes the last major fatal US airline disaster was in 2009 when Colgan Air Flight 3407 crashed near Buffalo, NY, killing all 49 passengers aboard and one person on the ground. This contrasts sharply with the 36,560 fatalities on the nation’s roadways in 2018 alone, the most recent year for which data are available. The numbers show that US road fatalities are more than twice the number of lives lost in the two 737 Max crashes. Therefore if the cross price elasticity of demand of road travel with respect to air travel = 0.2, this means that a 10% increase in airfares would result in a 2% increase in the demand for road miles traveled – 2% / 10% = 0.2. Table 1 below estimates that a 10% increase in airfares an estimated 33 billion additional passenger-miles would be driven. This would have an expected increase in road fatalities of 240 – 70% of the 737 Max crashes.

Analysis of Automobile Travel Demand Elasticities with Respect to Travel Costs,” by Jing Dong, Diane Davidson, Frank Southworth, and Tim Reuscher. Prepared for the Federal Highway Administration, August 30, 2012. Table 27.
“Comparing the Fatality Risks in United States Transportation across Modes over Time,” by Ian Savage. Research in Transportation Economics 43: 9–22 (2013). Table 2.

The graph below shows the impact of an increase in airfares due to increased safety regulations. With the price rise the quantity demanded for air travel decreases and given that road and air are substitutes, the increase in the price of air travel shifts the demand curve for road travel.

The FAA’s mission is to provide the safest and most efficient air travel in the world. However the society’s optimal amount occurs when the marginal benefit of airline safety = to the marginal cost of airline safety – MB=MC. This theory does not say that society should invest in airline safety up to a point where the chance of a crash is zero, although an airline might have the resources to do so. As the investment in airline safety is subject to the law of diminishing returns, the cost increases are significant and the airline attempts to recover these through higher fares which, to a rational consumer, reduces demand.
The theoretical relationship between investment in airline safety and net lives saved is shown below.
I1 = more investment in airline safety will save more lives
I2 = less investment in airline safety will save more lives.
I* = the optimal amount of investment to save the most lives.

Of course, there are always opportunities to do better and Boeing and the FAA should avail themselves of all “efficient” opportunities to do so (i.e., those that save lives on net). Still, there is a real risk of reflexive over-regulation that costs more lives than it saves.

Source:

The Risk of Too Much Air Safety Regulation – Regulation Spring 2020

eLearnEconomics – Natural Monopoly

Below are some notes from the eLearnEconomics site. For more information click on the link.

A natural monopoly is when one firm has the ability to supply the entire market at lower prices than two or more firms. A natural monopoly faces downward-sloping average cost (AC) for the entire range for which demand is applicable. The reason for its downward-sloping AC curve is usually that the initial investment in the infrastructure of the firm is large, but once it is in place, the marginal cost (MC) of production is low, for example hydro power. This high establishment cost is a strong barrier to entry and a natural monopoly could undercut any would-be competitor so they could not survive. Natural monopolies often involve some kind of network, for example water, gas,phone, rail.

Equilibrium Output-Natural Monopoly

The rule for maximising profit or minimising a loss (the equlibrium) for a natural monopoly is the same as any other firm. The most profitable output or smallest loss is where marginal revenue (MR) equals marginal cost (MC). Any other position will result in a smaller profit or greater loss. Therefore, the equilibrium output is at a price of Pe and quantity Qe (determined from the intersection of the marginal cost and marginal revenue curves). At the equilibrium output Qe the natural monopoly is making a supernormal profit (of $100m) and produces less than what society or consumers desire. Operating at the equilibrium output position creates a deadweight loss of BFG because consumer surplus and producer surplus are not maximised. The natural monopoly is charging a price in excess of marginal cost (P > MC), this is called mark-up pricing. At the equilibrium output in perfect competition, price and marginal cost are the same. Sellers cannot charge higher prices because they would immediately lose sales to competitors. This is called marginal cost pricing and occurs in perfect competition where at the equilibrium output position price equals marginal cost (P = MC). A natural monopoly charges more and produces less than would be the case if the firm operated as a perfect competitor.

Policies concerning natural monopoly

One way a government can regulate a monopoly is by administering price controls that do not allow a natural monopoly to operate at its preferred equilibrium output position where marginal revenue equals marginal cost. For this monopoly the equilibrium output is at a price of $7 (Pe) and quantity of 50m (Qe). The aim of price controls is to benefit the consumer with lower price and a greater quantity. Average cost pricing is a way that the government can improve resource allocation because it increases total surpluses in the market and reduces the deadweight loss that would be associated with a natural monopoly operating at its equilibrium position (MR = MC). Average cost pricing regulates the firm to charge a price equal to average costs (P = AC). In this instance the price would be $4 (Pn) and the quantity would be 80m units (Qn). The natural monopoly would no longer be maximising profits because the marginal revenue is less than marginal cost, the firm is making marginal losses on the increased output. The firm would make a normal profit instead of a supernormal profit. Normal profit is a return to the entrepreneur sufficient to keep them in their present activity. A natural monopoly regulated to a situation where price equals average cost is able to earn a fair rate of return. The net deadweight loss to society is reduced but not eliminated, the deadweight loss is now the area HKG. The natural monopoly is making a normal profit so they may lack the funds to do R & D and be less innovative, this could be viewed as a negative impact on resource allocation of fixing the price. A price set to equal average cost is more socially desirable than the equilibrium output position because consumers experience a significant increase in consumer surplus due to the lower price and higher quantity consumed. Average cost pricing has the advantage over marginal cost pricing of not having to provide a subsidy to a natural monopoly to keep the firm operating.

Read more at: elearn Economics – https://www.elearneconomics.com/

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Marginal Benefit and Marginal Cost of airline safety regulations.

A recent post by Michael Cameron on his blog ‘Sex, Drugs and Economics’ looked at the writing of Eli Dourado and the marginal analysis of airline safety. The Federal Aviation Administration (FFA) sets the safety standards for international carriers as well as smaller aircraft and it is within the latter that Dourado focuses on. The FAA in its role can either regulate personal aviation too much or too little and the challenge is finding that ‘optimal zone’ where the level of safety regulation is just right.

Too little regulation = higher risk of fatalities due to an inadequate safety program that is commensurate with the risk.

Too much regulation = less innovation in the industry therefore it is possible that the market will not produce the optimal amount of safety improvements therefore regulation continues. The greater the regulation could mean increased costs and wages for workers.

A balanced approach allows the FAA to meet and/or increase safety objectives while imposing the least burden on industry and society. This is shown in the green shaded area in the Figure below:

Marginal Benefit and Marginal Cost analysis

The economic theory of marginal analysis is similar to that above – marginal benefit and marginal cost. Let’s reconsider the nature of the demand and supply curves and what they illustrate on a diagram. Remember that marginal utility is expressed in money terms and would become an individual’s demand curve. When measured in money terms, the marginal benefit to society, or the marginal utility to consumers, becomes the demand curve. Similarly, the marginal cost to society, or the marginal cost to producers, becomes the supply curve.

The consumers at MB1 are paying more than the utility they are getting for the quantity of as P > MB1, so they will decrease their consumption to Q2 at P = MB. The consumers at MB2 are not maximising their utilities as they will get more utility than what they are paying for the quantity of as P < MB2, so they will increase their consumption to Q2 at P = MB. Therefore, at any given price, consumers will consume at a quantity where P = MB. As a result, the marginal benefit curve and the demand curve are identical. Similarly, suppliers will always produce at a level where the price equals marginal cost at any given price. Because at MC1 they are not maximising their profits as P > MC1; at MC2 they are making a loss as P < MC2. So, the marginal cost curve and the supply curve are identical. This can help you understand the concepts of consumer and producer surplus as they can both choose to consume and produce at a level that will maximise their utilities and profits. And this maximum utility or profit is more or ‘in surplus’ compared to the amount they have to pay.

The FAA’s diagram works similarly. At low levels of safety effort, there is too little rigour. The marginal benefit of additional safety effort is greater than the marginal cost. At high levels of safety effort, there is too little safety innovation. The marginal cost of the additional safety effort is greater than the marginal benefit. Michael Cameron

Source: Wells Yuan – CAIE A2 Level Economics notes – Unit 7

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Cobweb Theory and Price Elasticity

I have blogged on this topic before and although not in the NCEA or CIE syllabus’ I find it useful theory to mention when doing supply, demand and elasticity. Agricultural markets are particularly vulnerable to price fluctuations. many agricultural products have inelastic demand and inelastic supply. This means that any change in demand or supply has more of an impact on price than on quantity. Price fluctuations can also arise due to the time lag between planning agricultural production and selling the produce. The cobweb theory (so-called because of the appearance of the diagram) suggests that price can fluctuate around the equilibrium for some time, or even move away from the equilibrium. Dairy farmers base their production decisions on the price prevailing in the previous time period.

The supply of dairy products in New Zealand fits this assumption – farmers make their production decisions today, but the dairy cooperatives (Fonterra, Westland, etc.) don’t make a final decision on the price farmers will receive until close to the end of the season.

Cobweb scenarios:
Convergent
At the equilibrium point, if the demand curve is more elastic than the supply curve, we get the price volatility falling, and the price will converge on the equilibrium. For example:

• Adverse weather conditions means their is a poor crop – Qt
• The excess demand causes the price to rise – Pt
• Because of the higher price farmers plant more crops and therefore greater supply – Qt+1
• With supply so high prices drop to meet demand – Pt+1
• Lower prices mean that farmers supply less to the following year – Qt+2
• This results in higher prices again – Pt+2
• Because of the higher price farmers plant more crops and therefore greater supply – Qt+3 etc.
• This process continues until you get to an equilibrium as the PED is greater than the PES – supply curve is steeper than the demand curve.

Source: Policonomics

Continuous
This is occurs where there is a continuous fluctuation between two equilibriums – Pt and Pt+1. The PED and the PES are equal to each other.
Divergent
Prices will diverge from the equilibrium when the PES greater than the PED at the equilibrium point – i.e.the demand curve is steeper than the supply – price changes could increase and the market becomes more changeable.

Even though these three diagrams show very different results they are dependent on the PES and the PED of the market.

Source:
https://policonomics.com/lp-closed-economy-cobweb-model/

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OPEC+ to extend production cuts as oil prices fall?

The fall in oil prices – $77 / barrel 18th Nov – accompanied by the Israel-Hamas war has led the OPEC+ countries to consider extending their oil production cuts. At present Saudi Arabia produces approximately 9mn b/d compared to a maximum of 12mn b/d. Although the oil price drop is the main cause of the fall in output, the Israel-Hamas war has alarmed the cartel, especially Kuwait, Algeria and Iran.

On the demand side OPEC+ could cut 1mn b/d from production on the anticipation that there will be a reduction in demand for oil with a slowdown in global activity reducing the price. The meeting of the members of the OPEC+ on November 26 will decide whether or to cut supply with concerns of global growth. Some analysts have suggested that as Saudi Arabia has made several voluntary cuts to production in July, that they will demand Kuwait, Iraq and the UAE do the same. However oil supply has continued to grow outside the OPEC+ nations – US, Guyana and Brazil have increased their output. The latter hoping to become the world’s fourth largest producer by 2029.

OPEC’s aim

OPEC’s objective is to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry. Source: opec.org

OPEC and OPEC+ timeline

• 1960 – Organisation of the Petroleum Exporting Countries (OPEC) – formed by Iraq, Iran, Kuwait, Saudi Arabia, and Venezuela.
• 2016 – with the drop in oil prices (shale production from the US) OPEC+ was formed.
• 10 countries added including Russia who produce 13% of the world total – 10.3m b/d. 2022 – OPEC produced 28.7m b/d = 38% of world production
• 2022 – OPEC and OPEC+ produced 48m b/d = 59% of world production

Of the OPEC+ countries Russia’s oil output is much larger than the other 9 countries. Therefore, any policy initiatives are largely discussed between OPEC and Russia.

Source: OPEC+ weighs further oil production cuts as anger mounts over Gaza. FT – 18-11-23

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

Another post geared towards the A2 multiple-choice exam next week. Long-run and short-run average costs curves are a popular question in CAIE Economics Paper 3.

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

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AS Economics – Subsidy Graph – Multiple-Choice questions

The AS multiple-choice paper (P1) is next week and a popular question is either a subsidy or indirect tax question. Below is a typical subsidy graph and the question usually asks students to identify a particular area of the graph. I have put some options below with the corresponding area.

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A2 Economics – Indifference Curves – Mindmap

With the A2 multiple-choice paper not too far away here are some notes on indifference curves – there is usually a question on either the income effect or substitution effect. The video below 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.

A2 Economics – Optimising Consumption Choices

With the A2 Multiple Choice paper coming up here are some notes on Optimising Consumption Choices – this has been a popular question in Paper 3. The theory assumes that the RATIONAL CONSUMER aims to MAXIMISE SATISFACTION (or utility) by equating the MARGINAL UTILITIES yielded by the expenditure of a last money unit (cent or dollar) on each commodity purchased. The consumer is this is EQUILIBRIUM when the following formula is achieved:

MU of A / Price of A   =     MU of B / Price of B   =     MU of C /  Price of C  etc.

This means that the LAST unit of money spent provides the consumer with the same SATISFACTION (or UTILITY) irrespective of the good on which it is spent.

Examples

A consumer has $35 to spend. Price of X = $10 and Price Y = $5. What combination of X and Y maximize total satisfaction?

Quantity Bought	Marginal Utility X	Marginal Utility Y
1	30	15
2	20	12
3	15	10
4	9	8

MU of X / Price of X  =  MU of Y / Price of Y

20 / 10   =   10 / 5   

Here the consumer buys 2X and 3Y

TOTAL UTILITY in this example = 30+20+15+12+10 = 87. (Note that TOTAL UTILITY is otherwise irrelevant to the calculation).

When the PRICE of a good falls, more will be bought (since the M.U. ÷ price formula is disturbed – and a LOWER M.U. {i.e. MORE BOUGHT} will restore equilibrium). Similarly, when the price of a good RISES less will be bought. This emerges from the LAW OF DIMINISHING MARGINAL UTILITY which states that as successful and equal quantities of a good are consumed, total utility increases but at a DIMINISHING RATE (i.e. MARGINAL UTILITY is FALLING – and can eventually become NEGATIVE.

Limitations of marginal utility theory

1. Unit of measurement – difficult to find an appropriate unit of measurement of utility.

2. Habit and impulse – consumer spending on a particular product maybe habit forming or on impulse and therefore does not consider the marginal utility

3. Enjoyment may increase as consumption increases – in some case utility may increase from further purchases of an item. A collector of memorabilia may obtain greater satisfaction from consuming an additional item – collecting a set of stamps etc.

4. Quality and consistency of successive units of a good – there is the assumption that all goods are homogenous but if successive can of soft drink are not the same then the marginal utility may change and be more or less than the previous one

5. Other things remain constant – assumes that all factors affecting individuals’ satisfaction remain the same. However over time there maybe changes in income and the quality of other products as well as development of new products.

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