Micro and Macroeconomics and Neoricardian Theory - Essay Example

Micro and Macro Economics QUESTION Cournot competition is an economic model that describes an industry whereby firms compete on the amount of output they will produce. This amount is decided independently of each firm ad at the same time. The following assumptions are essential during Cournot competition: All firms make their production decisions simultaneously The cost structure of the competing firms are public information Firms choose their quantities once. Each and every company decides on the quantity to produce. In this competitive model, the output quantity constitutes the strategic variable. As a result each firm chooses how much of a good to produce. Both firms have knowledge about the market demand not forgetting the cost structure of the competitor. Demonstration of Cournot competition Consider two firms with constant marginal cost. p1 and p2 represents firm 1 and firm 2 prices respectively; while q1 and q2 represents firm 1 and firm 2 quantities respectively. The marginal cost is given by C. The equilibrium prices= p1=p2=P (q1+q2) Firm 1’s profit therefore is π=q1 (P (q1+q2)-c) Residual demand for firm 1 the price of firm 1 is determined by the quantity it produce. If firm 1 decides to produce q111 then the prices will be set at P (q111 + q2). That is, for each quantity produced by firm 1, the price is given by the curve d1 (q2). This is (d1 (q2)) firm 1’s residual demand which gives all possible combinations of firm 1’s quantity and price for a given value of q2. Firm 1’s optimum output MC=MR. the assumption that MC is constant is made. The MR curve is given as r1(q2) with twice the slope of d1(q2) and with the same vertical intercept. The point at MC and MR meets corresponds to quantity q1ii(q2) which is the optimum quantity for firm 1. To obtain the equilibrium point, then other values for q2 are derived. If q2=0, then d1 (0)=D (residual DD=market DD). In this case the best option is for firm 1 to go for monopoly quantity; q1ii(0)=qm; where the monopoly quantity is given by qm. If firm 2 favors a quantity corresponding to perfect competition, q2=qc whereby P (qc), then the quantity produced by firm 1 would be 0: q1ii(qc)=0. This is where MC=MR corresponding to d1 (qc) as shown in diagram below: Given the fact that demand is linear and the marginal cost is constant, the function q1ii (q2) is also clear. q1ii (q2) is firm 1’s reaction function. Firm 1’s reaction function is the choice taken by firm 1 given an action taken by firm 2. Cournot equilibrium is the point at which firm 1’s and firm 2’s reaction functions meet given that they have the same cost function. This is shown below: The equilibrium Taking an industry with a price function P(q1 + q2) and a cost structure Ci (qi); the profit of firm I is given by; Πi=P (q1 + q2) q1 –Ci(qi) The optimum output is given by Setting this derivative to 0 as a way of maximizing output: Hence the Nash equilibrium is given by q1 and q2, and are best responses given values of q1 and q2. QUESTION 2 First degree price discrimination is a situation where the firm is charging a price that the consumer is willing to pay. With first degree price discrimination, the producer is able to extract the entire surplus from the consumer. With the 1st degree price discrimination, the profit is equal the sum of consumer surplus and producer surplus Price MC Profit MC A ATC P=MC=$40 0 MR D Q*=100 output (Q) The monopoly firm will sell quantity Q* up to the point where the price of the last unit sold just covers the MC of production. The profit of the firm is given by the difference between the price it is charging on each unit and the average cost of producing Q* units of output. The profit is given by area PAMC. 1st degree price discrimination is most practiced by single seller offering different prices to different individuals. In this regard, perfect competitive markets are characterized by 2nd and 3rd degrees as opposed to 1st degree. Assuming zero cost of determining reservation prices, 1st degree price discrimination is efficient, maximizes social surplus and eliminates deadweight loss. The monopoly seller captures the social surplus as opposed to perfect competition where social surplus is maximized but all of it is captured by buyers. QUESTION 3 (A) Properties of indifference curves i. Indifference curves are negatively sloped: indifference curves slopes down from left to right. The negative slope is because; as the consumer increases the consumption of a commodity-say Y-he has to give up some units of commodity X so as to remain in the same level of satisfaction. ii. Indifference curves are convex to the origin: this is one of the vital properties of indifference curves. Indifference curves bows inward (convex to the origin). That is, as a consumer substitutes product Y for product X, the marginal rate of substitution diminishes of good Y for good X along the same indifference curve. iii. Higher indifference curve represents higher level of satisfaction: a higher level of satisfaction is represented by an indifference curve that lies above and to the right of another indifference curve. That is a consumer will prefer commodity X to commodity Y if commodity X has an indifference curve that lies higher than that of commodity Y. iv. Indifference curves cannot intersect each other: two or more indifference curves cannot intersect. The fact that the higher curve will give as much as the two commodities at the point of tangency explains why they do not intercept. v. Indifference curves do not touch the horizontal or vertical axis. One assumption of indifference curves is that consumers do not buy only one product or rather they purchase combinations of different commodities. This explains the property that indifference curves do not touch the horizontal or vertical axis. b) Substitution and Income effect Considering the fact that the price of commodity B falls below the budget line, the consumer maximizes the utility by consuming Q3 of commodity A and Q4 of commodity B. that is, the fall in price of commodity B has resulted to the increased demand of Q2Q4. This is the demand curve. The substitution effect: this shows the effect of fall in price B compared to commodity A. to demonstrate substitution effect, the new budget line is moved inwards and parallel until it is tangent to the old indifference curve. The utility remains the same even though the new slope reflects the new relative prices. As a result, the substitution effect is represented by Q2Q6. The income effect: contrary to the substitution effect, the income effect is obtained by shifting the budget line back outwards. As a result, the quantity demanded will increase to Q6Q4. In case of a Giffen good, the income effect results to a fall in the quantity demanded hence working against the substitution effect and outweighing it. On the other hand, the quantity demanded will increase with the substitution effect. Overall, a decrease in price Giffen commodity B will result to decrease in quantity demanded and an upward sloping demand curve. This is shown in the diagram below. Deriving the demand curve Suppose an individual consumes oranges. The law of demand states that as the price increases the quantity demanded decrease. The following table outlines the prices and quantity consumed. prices quantity 1 7 2 6 3 5 4 4 5 3 6 2 7 1 By getting the slope, we get the quantity demanded of the price at any given point. Plotting this in a graph, the demand curve is shown in the figure below: QUESTION 4 (A) The Keynesian model emphasizes one basic point. That is, a decrease in aggregate demand can lead to a stable equilibrium with a substantial unemployment. The IS curve is given by the equation Y=C(Y-T(Y)) + I(r) + G + NX(Y), where the consumer spending is given by C(Y-T(Y)) as function of income, investment is given by I(r), G represents government spending and NX(Y) gives the net export. The IS curve is characterized by the interest rate and level of income as the independent and dependent variables respectively. The IS curve is downward sloping with the interest rate (i) on the vertical axis and the GDP on the horizontal axis. Keynes viewed the economy as being unable to maintain itself at full employment unless the government steps in and put under-utilized savings though government spending. According to Keynesian theory, government spending should be used to increase the aggregate demand hence increasing economic activity, thereby reducing inflation and unemployment. Keynes argued that, during the Great Depression, the only sure ways to stimulate the economy was through; reduction in interest rates and government investment in infrastructure. If the central bank reduces the interest rate, the government is setting the stage for the commercial banks to also reduce the interest rates. On the other hand, investment by government in infrastructure add income into the economy through the creation of business opportunity, employment and demand hence help solve the problem of aforementioned imbalance. According to Keynes, excessive savings was the main cause of recession especially if the investment falls. However, this argument was criticized by the classical economist who argued that interest rates would fall due to the excess supply of loanable funds. This is shown in the figure below (argument by classical): On his part, Keynes contradicts this laissez-faire argument by stating that: a) Savings does not fall as much as interest rates. This is because the income and substitution effects go in different directions. b) Spending does not increase as much as interest rates falls because of the fact that planned investment is mostly based on log-term expectation of future profitability. c) According to Keynes, it is worth stating that savings and investment do not constitute the main determinants of interest rates in the short run. On the contrary, interest rates in the short run are determined by the demand and supply for the stock of money. This is shown in the diagram below: b) Quantitative easing (QE) is the process where the central bank buys bonds and other securities from its member banks. The central bank buys the securities and issues credit to the bank’s reserves to buy the bonds. The main aim of quantitative easing is to lower interest rates and spur economic growth. QE is one of the expansionary monetary policies that implement the Keynesian concept of the economic growth. The central bank adds credit to the banks’ reserve accounts in exchange of the securities. With the additional credit, the banks have more than they need in reserves hence more to lend to other banks. In the process, as banks try to unload their extra reserves, they drop the interest rate charged. Quantitative Easing increases the money supply due to lower interest rates enables the banks to make more loans. Consequently, the commercial banks stimulate demand through making money more available to spend and more credit for consumers to buy products. It is worth noting that by increasing money supply, Quantitative Easing keeps the value of local currency low hence making the local stocks to be relatively good for foreign investors to buy. This is shown in figure below: As shown above, QE will increase the amount of money supplied hence reducing the interest rate from 4% to 3%. Work cited Flaschel, Peter. Topics in Classical Micro and Macroeconomics: Elements of a Critique of Neoricardian Theory. Berlin: Springer, 2010. Print. Read More