Week 7 Issues in Microeconomics The Mc GrawHill

Week 7 Issues in Microeconomics ©The Mc. Graw-Hill Companies, 2002

The labour market ©The Mc. Graw-Hill Companies, 2002

Demand for factors in the long run • The optimum mix of capital and labour depends on the relative prices of these factors – This helps to explain why more labour-intensive means of production are used in some countries where labour is relatively abundant. • A change in the price of one factor will have both output and substitution effects • A rise in the wage rate leads to – substitution towards more capital-intensive techniques – but also leads to lower total output 2 ©The Mc. Graw-Hill Companies, 2002

Wage, MVPL The demand for labour in the short run The marginal value product of labour is the revenue obtained by selling the output produced by an extra worker • Under perfect competition, with diminishing marginal productivity: • the firm maximizes profit when the marginal cost of employing an extra worker equals the MVPL. . . W 0 MVPL Employment 3 ©The Mc. Graw-Hill Companies, 2002

Wage, MVPL The demand for labour in the short run W 0 E MVPL …this occurs at E where wage = MVPL. Employment is L*. Below L*, extra employment adds more to revenue than to labour costs. Above L*, the reverse is so. This decision is consistent with the MR = SMC rule for maximizing profit under perfect competition. L* Employment 4 ©The Mc. Graw-Hill Companies, 2002

The supply of labour • The LABOUR FORCE: – all individuals in work or seeking employment • Labour supply – for an individual, the decision on how many hours to offer to work depends on the real wage – an individual’s attitude towards leisure and income determines if more or less hours of work are supplied at a higher real wage rate. 5 ©The Mc. Graw-Hill Companies, 2002

Labour supply in aggregate • If we consider the economy as a whole, or an industry • a higher real wage rate also encourages a higher participation rate • so labour supply is likely to be upwardsloping 6 ©The Mc. Graw-Hill Companies, 2002

Wage Labour market equilibrium for an industry SL DL • The industry supply curve SLSL slopes up – higher wages are needed to attract workers into the industry W 0 DL SL • For a given output demand curve, industry demand for labour slopes down • Equilibrium is W 0, L 0 Quantity of labour 7 ©The Mc. Graw-Hill Companies, 2002

Wage A shift in product demand SL DL D'L Beginning in equilibrium, a fall in demand for the product also shifts the derived demand for labour to D'L W 0 W 1 SL D'L L 1 L 0 DL The new equilibrium is at W 1, L 1. Quantity of labour 8 ©The Mc. Graw-Hill Companies, 2002

A change in wages in another industry Wage S'L SL DL Again starting in equilibrium, An increase in wages in another industry attracts labour, W 2 W 0 so industry supply shifts to the left – S'L DL SL L 2 L 0 The new equilibrium is at W 2, L 2. Quantity of labour 9 ©The Mc. Graw-Hill Companies, 2002

The information economy ©The Mc. Graw-Hill Companies, 2002

11 ©The Mc. Graw-Hill Companies, 2002

Welfare indicators by country group 12 ©The Mc. Graw-Hill Companies, 2002

e-products • An e-product: – can be digitally encoded then transmitted rapidly, accurately and cheaply áe. g. music, films, books, sport … • Fixed costs of producing e-products are huge … • … but marginal costs of distribution are tiny • implying vast economies of scale 13 ©The Mc. Graw-Hill Companies, 2002

Network externalities Suppose D 1 represents the demand curve for a product exhibiting network externalities £ D With price at P 1, demand is limited. P 1 If price is reduced to P 2, more people find the network attractive so not only is there a move along the demand curve, but there is a shift in demand. P 2 D 1 Q 2 D Long-run demand is more elastic (DD). Quantity 14 ©The Mc. Graw-Hill Companies, 2002

Information: the supply side • Given substantial economies of scale, we expect monopoly suppliers of information products: • Dominant firm with competitive fringe áe. g. Microsoft • Niche market monopolies 15 ©The Mc. Graw-Hill Companies, 2002

Pricing information products • Strategies for pricing information products: – two-part tariff • an annual charge to cover fixed costs, and a small price per unit related to marginal costs – versioning • the deliberate creation of different qualities to facilitate price discrimination – bundling • the joint supply of more than one product to reduce the need for price discrimination 16 ©The Mc. Graw-Hill Companies, 2002

Competition vs. collaboration • A strategic alliance is a blend of cooperation and competition, in which a group of suppliers provide a range of products that partly complement one another – e. g. Microsoft and Intel – airline alliances: One World, Star 17 ©The Mc. Graw-Hill Companies, 2002

Understanding the eeconomy • 1 The information revolution is changing our lives – but few of its activities or market tactics are unprecedented • 2 The revolution in technology has not required a corresponding revolution in economic theory 18 ©The Mc. Graw-Hill Companies, 2002

Government spending and Revenue ©The Mc. Graw-Hill Companies, 2002

Government spending 20 ©The Mc. Graw-Hill Companies, 2002

Private and public goods • A private good – if consumed by one person, cannot be consumed by another person. áe. g. dental treatment • A public good – even if consumed by one person, can still be consumed by other people. áe. g. street lighting The strong externalities associated with public goods, mean that government intervention may be justified to ensure appropriate provision. 21 ©The Mc. Graw-Hill Companies, 2002

Merit goods and bads • Merit goods (bads) – goods (bads) that society thinks everyone ought to have (ought not to have) regardless of whether they are wanted by each individual. áe. g. Education, health services, cigarettes – The government may spend money on compulsory education or compulsory vaccination because it recognizes that otherwise individuals act in a way they will subsequently regret. 22 ©The Mc. Graw-Hill Companies, 2002

Varieties of taxes • Direct taxes – taxes on earnings from labour, rents, dividends and interest. áe. g. income tax, corporation tax • Indirect taxes – taxes levied on expenditures on goods and services áe. g. VAT, duty on alcohol • Wealth taxes – capital transfer tax, tax on property 23 ©The Mc. Graw-Hill Companies, 2002

A tax on wages Wage SS' SS W' W W'' DD L' L Hours worked With no tax, the labour market is in equilibrium at wage W, hours L. With a tax, labour supply is effectively at SS', workers receive W'', but firms pay W', the difference being the tax. Employers pay the blue area, and workers the green. The orange area is a welfare loss for society. 24 ©The Mc. Graw-Hill Companies, 2002

The incidence of a tax • Who pays a tax depends upon the elasticity of demand supply for the product. • This also affects the size of distortion caused by the imposition of a tax. 25 ©The Mc. Graw-Hill Companies, 2002

The Laffer curve Tax revenue shows how much tax revenue is raised at each possible tax rate. Beyond t*, higher tax rates reduce revenue because of disincentive effects. t* Tax rate 26 100% ©The Mc. Graw-Hill Companies, 2002

Industrial policy and competition policy ©The Mc. Graw-Hill Companies, 2002

Industrial policy and Competition Policy • Competition policy – aims to enhance economic efficiency by promoting or safeguarding competition between firms • Industrial policy – aims to offset externalities that affect production decisions by firms 28 ©The Mc. Graw-Hill Companies, 2002

Industrial policy • Inventions and the patent system – designed to provide a sufficient incentive for invention without suppressing competition for ever • Research and Development (R&D) – the social return on risky projects may exceed the private return • Dynamic change – coping with sunset and sunrise industries 29 ©The Mc. Graw-Hill Companies, 2002

Price Consumer surplus Consider the demand curve D and suppose price is at P with quantity demanded being Q. A P P represents the value placed on the good by the marginal consumer E D Q Quantity so D can be seen to represent marginal social benefit With all consumers paying the same price P for the good, the triangle APE represents consumer surplus – benefit received by consumers in excess of the amount they need to pay. 30 ©The Mc. Graw-Hill Companies, 2002

Price Producer surplus is the excess of total revenue over total costs P LAC = LMC – as shown by the rectangle. D Q Quantity 31 ©The Mc. Graw-Hill Companies, 2002

The social cost of monopoly: comparing perfect competition and monopoly Price For simplicity, suppose as industry with horizontal long-run average and marginal costs. LAC = LMC Pc D Qc Quantity Under perfect competition, long-run equilibrium would be with industry output Qc selling at price Pc. Consumer surplus is the area of the big green triangle. 32 ©The Mc. Graw-Hill Companies, 2002

The social cost of monopoly: comparing perfect competition and monopoly Price If taken over by a monopolist, profit maximization is at the lower output Qm and higher price Pm. Consumer surplus is now the smaller green triangle. Pm LAC = LMC Pc MR Qm D Qc Quantity The monopoly receives producer surplus (profit) of the blue rectangle. and the red triangle shows the welfare loss – the social cost of monopoly 33 ©The Mc. Graw-Hill Companies, 2002

Perfect competition and monopoly under differing cost conditions Price Suppose that monopoly enjoys lower cost conditions than under perfect competition Pm Under perfect competition equilibrium is at Pc, Qc. LRSSpc Pc LAC = LMC MR Qm Qc Compared with Pm, Qm under monopoly D Quantity 34 ©The Mc. Graw-Hill Companies, 2002

Welfare implications • In comparing the two situations, the loss of consumer surplus under monopoly (the red triangle) • must be balanced against the gains from efficiency (the blue rectangle) 35 ©The Mc. Graw-Hill Companies, 2002

Counting the cost of monopoly • The size of the social cost of monopoly is difficult to evaluate – in part it depends upon the elasticity of demand – which influences the size of the ‘red triangle’ of welfare loss 36 ©The Mc. Graw-Hill Companies, 2002