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/

Milk prices on the up – supply and demand

With the start of the academic year in New Zealand the first week of teaching usually looks at the price mechanism and scarcity. A good example in the NZ economy is the reasoning behind the payout that Fonterra pays its farmers that supply them with milk. Fonterra is a monopsony (they have approximately 81% share of the NZ dairy market) in that it is one buyer and many sellers (the farmers) – the farmers look to Fonterra to get them the best price in the Global Dairy market. Fonterra has indicated that the price for the current 2021/2022 season is going to be between $8.90 to $9.50/kgMS.

The mid-point is $9.20/kg and at that level it will be paying out New Zealand suppliers $13.8 bln – see graph below. Ultimately the price of the Fonterra payout is determined by supply and demand on the Global Dairy Trade auction – see below.

Why have prices increased?

Supply – there has been weak production in New Zealand and overseas with poor weather with challenging growing conditions and higher feed costs. Fonterra lowered its forecast on the amount of milk collected by 1.6% – 1,525 million kgMS in 2020/21 to 1,500 million kgMS in 2021/22. A lower production outlook for Europe and North America has increased the forecast milk price.

Demand – demand globally remains strong with North Asian buyers securing over 50% of the total volume sold in the recent Global Dairy Auction. According to the OECD the world per capita consumption of fresh dairy products is projected to increase by 1.0% p.a. over the coming decade, slightly faster than over the past ten years, driven by higher per-capita income growth. Today total dairy consumption in Africa, South East Asian countries, and the Middle East and North Africa is expected to grow faster than production, leading to an increase in dairy imports. As liquid milk is more expensive to trade, this additional demand growth is expected to be met with milk powders, where water is added for final consumption or further processing.

How does the GDT work?

GlobalDairyTrade trading events are conducted as ascending-price clock auctions run over several bidding rounds.  In each auction a specified maximum quantity of each product is offered for sale at a pre-announced starting price. Bidders bid the quantity of each product that they wish to purchase at the announced price. If the price of a product increases between rounds, to ensure their desired quantity a bidder must bid their desired quantity at the new, higher price. Generally, as the price of a product increases, the quantity of bids received for that product decreases. The trading event runs over several rounds with the prices increasing round to round until the quantity of bids received for each product on offer matches the quantity on offer for the product (as shown in the diagram below). Each trading event typically lasts approximately 2 hours.

Quota and Allocative Efficiency

Below are notes on Quota and Allocative Efficiency from elearneconomics.

When the government imposes a quota (a restriction on the quantity that can be produced, exported or imported) it forces the market price up and decreases the quantity sold or produced. Because the market is not allowed to clear (restore or reach the equilibrium) there is a loss of allocative efficiency (termed a deadweight loss). Part of the original consumer surplus and producer surplus is not picked up as part of the quota. Consumer surplus and producer surplus are no longer maximised.

Source: elearneconomics.com

At the original equilibrium (P1, Q1) the value of consumer surplus for butter is $80m (0.5 x 40m x $40, area P3CP1) and the value of producer surplus for butter is $160m (0.5 x 40m x $8, area P1CP0), the market is allocatively efficient because consumer surplus and producer surplus are maximised. When the government imposes a quota and restricts the quantity to 30m (Qs) there is a change in consumer surplus, producer surplus and allocative efficiency.

The total value of consumer surplus decreases by $35m because consumer surplus before the quota was $80m and is now $45m (0.5 x 30m x $3, area P3BP2). The higher price means that the difference between what consumers are willing to pay and what they actually pay will decrease. The lower quantity demanded (30m units rather than 40m units) means there are fewer units from which wool buyers can gain a surplus. Therefore, consumer surplus will decrease.

The total value of producer surplus increases by $20m because producer surplus before the quota was $160m and is now $180m ($9 plus $3 divided by 2 multiplied by 30m area P2BFP0). Producer surplus will increase despite some loss of producer surplus due to the lower quantity sold, 30m (Qs) rather than 40m (Q1). The increase in producer surplus is a result of the higher price from the quota that is more than sufficient to offset the loss of producer surplus due to lower sales. Overall producer surplus increases.

There will be a loss of allocative efficiency because the loss in consumer surplus (CS) of $35m outweighs the gain in producer surplus (PS) of $20m, which results in a net welfare loss (deadweight loss) of $15m (0.5 x 10m x $3, area BCF). This is because producer surplus and consumer surplus are no longer maximised following the imposition of the quota on butter.

More at: elearneconomics.com

A2 – Natural Monopoly – Multiple-Choice questions

With the A2 multiple choice paper (P3) next week here are some thoughts on the types of questions they could ask on natural monopoly graphs. Remember that the natural monopoly achieves economies of scale at all levels of output therefore the MC curve cuts the AC curve above the AR curve. The following are areas/points on the natural monopoly graph that you should know about. Loss of allocative efficiency is a popular question.

A2 Revision – Long-Run Monopolistic Competition

Monopolistic LR

Here is a quick revision note on monopolistic competition. This is a market structure in which there are a large number of firms selling commodities which are very close substitutes. There are weak barriers to entry and firms may enter the industry with ease. Notice on the diagram that the firm initially makes supernormal profit at Q0 – at MC=MR Price = P0 and Cost = AC0. However with weak barriers to entry these profits are competed away and they now produce at Q1 where at MC=MR and the Price and Cost = AC1

Modern capitalism is characterised by a large number of ‘limited’ monopolies. They are sole suppliers of branded goods, but other firms compete with them by selling similar goods with different brand names. This is the market structure described as monopolistic competition. Thus the commodities produced by any one industry are not homogeneous; the goods are differentiated by branding and the use of trade marks. The individual firm has a monopoly position, but it faces keen competition from firms supplying very similar goods. It has, therefore, only a limited degree of monopoly power – how much depends upon the extent to which firms are free to enter the industry. Product differentiation is emphasised (some would say, created) by the practice of competitive advertising which is, perhaps, the most striking feature of monopolistic competition.

Advertising is employed to heighten in the consumer’s mind the differences between Brand X and Brand Y. It is important to realise that we are concerned with the differentiation of goods in the economic sense and not in the technical sense. Two branded products may be almost identical in their technical features or chemical composition, but if advertising and other selling practices have created different images in the consumer’s mind, then these products are different from our point of view because the consumer will be prepared to pay different prices for them.

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

Another post geared towards the A2 exam next week. Long-run and short-run average costs curves are part of economies of scale and market structures essays.

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

A2 Economics – Indifference curves and GIN

With the A2 essay paper next week here is a note on indifference curves – if you know the theory it is a good essay to do. Remember that most indifference curve questions will have a discussion section that asks for the limitations of such theory.

Last year one student has come up with a novel way of remembering the position of the indifference curve when the price of one good falls. The three types of goods that eventuate from a price fall are: Giffen, Inferior and Normal – GIN.

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

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

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

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.

A2 Revision: Multiple-Choice question on shape of Total Cost curve

Web

With the CIE A2 Economics papers next month, a popular question concerns the point on the Total Cost curve when MC, AVC, and ATC are at their lowest point. In the graph note the corresponding points on the Total Cost. They usually ask you where on the Total Cost line is the lowest point on the MC curve/AVC curve etc.

Remember:
MC cuts ATC and AVC at their lowest points. The firm will supply where the price is greater than or equal to MC. Thus the individual firm’s supply curve consists of the firm’s MC curve, but only the portion above AVC . The reason for this is that where P=AVC the firm will shut down operations because they are barely covering avoidable costs.

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 – Pareto Efficiency

Another revision post for my A2 class with the exams approaching in October here in NZ. 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.

The diagram shows an economy with only two people, John and Karen. The initial allocation at Z gives John QJ goods and Karen QK goods. Provided people assess their own utility by the quantity of what they themselves receive, Y is a better allocation than Z, which in turn is a better allocation than T. But a comparison of Z with points such as U, V or W, requires us to adopt a value judgment about the relative importance to us of John’s and Karen’s utility. It is important to note from the figure the following:

  • If you move from Z to Y or Z to X it is a Pareto gain – Z to Y both Karen and John are better off. Z to X Karen is better off, John no worse off.
  • If point Y or X is feasible, then point Z is Pareto-inefficient – more goods can be consumed
  • A move from Z to V makes John better off and Karen worse off. However, we need to make a judgment about the relative value of John’s and Karen’s utility before we can comprehensively state that John 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 a whole and how many goods it can produce. On the diagram the frontier AD shows the maximum quantity of goods that 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. John can only be made better off by making Karen worse off and vice versa. The distribution of goods between John and Karen 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.
  • Moving from a point E to C is Pareto gain – both John and Karen gain output.
  • Moving from point B to C is Pareto-efficient – John gains more goods but Karen loses goods.

The economy should never choose an inefficient allocation inside the frontier. Which of the efficient points on the frontier (A, B, C or D) is the most desirable will depend on the value judgment about the relative value of John’s and Karen’s utility.

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

AS Economics Revision – Income Elasticity of Demand graph

Here are some revision notes on YED which might useful for the CIE AS Economics exam next month. Quite a few of the class had never come across this graph which is popular in multiple-choice questions. It is important that you read the axis.

Usefulness of Income Elasticity of Demand

Knowledge of income elasticity of demand for different products helps firms predict the effect of a business cycle on sales. All countries experience a business cycle where actual GDP moves up and down in a regular pattern causing booms and slowdowns or perhaps a recession. The business cycle means incomes rise and fall.

Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the economic cycle

The NZ economy has enjoyed a period of economic growth over the last few years. So average real incomes have increased, but because of differences in income elasticity of demand, consumer demand for products will have varied greatly over this period.

Over time we expect to see our real incomes rise. And as we become better off, we can afford to increase our spending on different goods and services. Clearly what is happening to the relative prices of these products will play a key role in shaping our consumption decisions. But the income elasticity of demand will also affect the pattern of demand over time. For normal luxury goods, whose income elasticity of demand exceeds +1, as incomes rise, the proportion of a consumer’s income spent on that product will go up. For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall. See table below for a summary of values.

AS Economics – Price Elasticity of Demand

Doing some revision courses for AS students and went over Price Elasticity of Demand. Might be useful for those doing AS at the moment.

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.

A2 Economics – Differing objectives of firms

With mock exams approaching in preparation for the CIE exams in October / November here are some notes on the differing objectives of firms. This could be the second part of an essay question with the first part potentially being about 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).

Read more at: elearn Economics – https://www.elearneconomics.com/section/key_notes/84

A2 Economics – Economic Rent and Transfer Earnings

Economic Rent and Transfer Earnings To most of us “rent” is defined as a periodical payment made for the use of a particular asset – usually a residential or commercial property. However, the concept is not limited to land or buildings because it can also be applied to the other factors of production. When a factor is earning more than its supply price, it is receiving a part of its income in the form of economic rent. This situation arises when demand increases and supply cannot fully respond to the increases in demand. For example, labour already employed will experience an increase in income so that they must be earning more than their supply prices.

Present Wages – Wages when initially employed = Economic Rent

The minimum payment required to prevent a person transferring to another employer or another occupation is know as transfer earnings. It is determined by what the factor could earn in its next best paid employment. Transfer earnings may be regarded as the opportunity cost of keeping an employee in their present job or it may be regarded as the employee’s supply price in their present occupation. For example, if the minimum weekly wage that would persuade someone to work as a shop attendant is $200 but he or she actually receives a wage of $250, then the transfer earnings amount is $200 and he or she is receiving $50 in the form of economic rent. Therefore, economic rent can be defined as any payment to a factor of production that is in excess of transfer earnings.

The graph below shows the demand and supply for labour. The equilibrium wage is $120 with a quantity of 50 units. Total earnings is equal to $120 x 50 units of labour = $6,000 and employees receive the same wage of $120. However, all workers except the last one taken into employment were prepared to offer their services at wages less than $120. Therefore, provided the supply of labour slopes upwards (i.e. it is less than perfectly inelastic) an increase in demand will give rise to rent payments to those factors that were already employed at the original wage of $120. The area of economic rent and transfer earnings is shown in the graph below. Only the last labour unit employed earns no economic rent because the wage of $120 is the supply price to that particular labour unit.

Inelastic and Elastic labour supply

The amount of economic rent and transfer earnings in the return to labour depends upon the elasticity of supply and the level of demand. The greater the occupational mobility of labour, the smaller the element of economic rent. If labour can do a variety of occupations then quite small changes in the wage rate will cause large movements of labour into an industry when wages rise, and out of that industry when wages fall.

Very specialised labour has an inelastic supply curve. This includes surgeons, top CEOs, scientists and jobs that require high skill levels or involve significant danger and skill, eg, deep sea divers. The relatively high rewards to this labour are due to the fact that they are in very scarce supply relative to the demands for their services. Their transfer earnings will be much less than their salary because the market values outside their own specialised professions are probably very low. A frequently quoted example of earnings that contain a large amount of economic rent are those of top sports people. Today these people can earn significant amounts of money in a short period of time. A footballer such as Christiano Ronaldo earns €326 923 per week because of his ability to attract big crowds, merchandise sales and sponsorship deals when he was at Real Madrid Football Club. His skill levels are unique and in very limited supply when considering other players. This reflects a very high marginal productivity leading to a higher wage.

Some other occupations that are held in high regard by society do not command such high salaries because of their low marginal productivity. This includes nurses, firefighters, teachers, etc. Furthermore, the supply of labour for these jobs tends to be elastic because there are many people to choose from, unlike their footballing counterparts who have unique skills.

Quasi rent

Where the supply of labour is less than perfectly elastic an increase in demand will lead to some workers receiving economic rent. This rent may be of a temporary nature, however, because the higher wage may lead to an increase in supply, which in turn, lowers the wage. Increased wages might entice other workers to undertake the necessary training. The economic rent that is earned during the period before supply can be increased is referred to as quasi rent. True economic rent refers to the remuneration of factors that are fixed in supply.

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

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 famers plant more crops and therefore greater supply – Qt+1
  • With supply so high prices drop to meet demand – Pt+1
  • Lower prices mean that famers supply less to the following year – Qt+2
  • This results in higher prices again – Pt+2
  • Because of the higher price famers 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/

A2 Economics – Contestable Markets

I covered this topic today at the Cambridge A2 Economics revision course. The degree of contestability of a market is measured by the extent to which the gains from market entry for a firm exceed the cost of entering (i.e. the cost of overcoming barriers to entry), with the risks associated with failure taken into account (the cost associated with any barriers to exit). Accordingly, the levels of barriers to entry and exit are crucial in determining the level of a market’s contestability. Barriers to exit consist of sunk costs, that is to say costs that cannot be recovered when leaving the market. The contestable markets approach suggests that potential entrants consider post‑entry profit levels, rather than the pre-entry levels suggested by neo‑classical theory.

Obviously no market is perfectly contestable, i.e. with zero sunk costs. In modern economies it is the degree of contestability which is relevant, some markets are more contestable than others. Also just because there have been no new entrants to a market over a given period of time does not mean that this market is not contestable. The threat of entry will be enough to make the existing (incumbent) firms behave in such a way as to recognise this, i.e. by setting a price which doesn’t attract entry and which only makes normal profits.

Markets which are highly contestable are likely to be vulnerable to ‘hit and run competition’. Consider a situation where existing firms are pricing at above the entry‑limit level. Even in the event that existing firms react in a predatory style, new entry will be profitable as long as there is a time lag between entry and the implementation of such action. Having made a profit in the intervening period, the new entrant can then leave the market at very little cost.

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms. Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market.

Entry limit pricing

The fear on the part of existing firms of rendering the market contestable (stimulating new entry) by making high levels of profit is likely to lead to the adoption of entry limit pricing, a concept introduced in the previous unit. This is essentially a defensive strategy, with existing firms setting prices as high as possible but not so high as to enable new corners to enter the industry. If the existing firms set price at P2 and output at Q2 (see diagram below), it would be possible for a new firm to enter the industry and supply Q1. Total market supply would then be Q3 (Q1 + Q2), the price would be P3 and the new firm would be covering its costs. If, instead, the existing firms chose to produce at Q3 (with price level P3), the new firm producing Q1 (total market supply would now be Q4 at price P4) would not be covering its costs and would have to exit the industry in the long run.

The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.

Source:

Anforme – A2 Level Economics Revision Booklet.