The Theory of Market Mechanism - Case Study Example

EC 161: ECONOMICS Question A: After World War II local ities in some European cities (Berlin and Frankfurt, for instance) prescribed ceilings on rental prices for city flats. The idea was to make access to appropriate dwelling space largely independent of income. Although the measures served the purpose for a while, very soon negative side-effects did appear; in particular, black markets for flats developed, and, in the longer run, inner cities' residential houses got dilapidated. Use economic theory to explain the situation and the consequences that arose. Hint: Consider the incentives of landlords, rental agencies and flat-hunters. Solution: The given situation can be analysed with the help of the help of the theory of market mechanism. Considering that the rental price of flat are determined by the forces of demand and supply, then as in the below diagram P0 is the rental of the flats. Once ceiling is imposed the rental declines. Due to a fall in the rental, the supply of flats also decline however the quantity demanded of flats increases. This follows from the law of demand and supply. As a result there is a gap between demand and supply or in other words there arises a shortage in the market for dwelling spaces. This shortage is not a natural outcome but created by the suppliers or the landlords which results in an excess demand situation. This shortage generates scope for black marketing of flats at a higher rental. From the land lord's point of view the creation of shortage is quite justifiable because cost of maintenance and electricity has remained the same. In the process of black marketing, the flats are rented out at market clearing rental or even more. Since dwelling place is a necessary item for any consumer, the tenants are ready to pay the excess amount above the ceiling price. Thus there is discrimination because some are getting the flats at the Government determined rental where as some have to pay out huge amount. Thus there is a reverse effect of what the Government intended. Here the concept of economic rent also comes into play. Because of price ceiling a number of land lords are not willing to rent out their space, they are restricted from entering the market in fear of loss. Now suppose the Government decides to remove the ceiling and the rental price is determined by market mechanism, there will be huge opposition from both land lords and tenants because those who were getting the flats at lower rent will oppose and again the land lords who were operating in the black market will passively support the tenants who were opposing. This is because the land lords are better off in black market where they extract huge profit. The lobbying cost, lawyer fees, public relation costs are substantial. These are pure social waste as these are not increasing the supply of flats in the market. Once artificial scarcity has been created it is very hard to eliminate it from the system. Fig. 1: Artificial Scarcity leading to black marketing in the market for dwelling spaces In the above diagram D0 is the demand curve and S0 is the supply curve for flats in some of the European cities post World War II. P0 is the rental price while Q0 is the quantity demanded of flats at free market mechanism. However to make access to appropriate dwelling space largely independent of income, the Government imposes a ceiling on rental price and fixes it at P1. Although the measures served the purpose for a while, very soon negative side-effects did appear as a rise in demand and fall in supply result in a shortage of amount Q1Q2. This excess demand gives rise to black marketing for flats. Question B: Consider a perfectly competitive market in long-run equilibrium where all firms operate under the same cost conditions. Suppose a new technology becomes available which reduces marginal production costs. Explain graphically and verbally what happens to the market in the short run and in the new long-run equilibrium if factor prices and demand are assumed to remain the same as before. Solution: Demand and factor prices are assumed to remain constant. Therefore Total cost is equal to the sum of Fixed cost and Variable cost. With an improvement in technology, the marginal cost of production declines. The total output increases while the total cost remains fixed and the average cost of production is lowered. In a perfectly competitive market Price, Marginal Cost and Average Cost are all equal. As a result of technological advancement and fall in Marginal Cost, the market price of the product falls and the output of the individual firms increases. This induces new firm to enter the market in the long run thus total industry supply increases. The demand remaining constant the supply curve shifts to the right. Thus the industry supply curve is downward slopping. This is a perfect example of decreasing cost industry. Fig. 2: Introduction of new technology in a perfectly competitive market in the long-run In the above diagram P0, MC0 and AC0 are the price, average cost and marginal cost prior to the introduction of a new technology. Post the introduction, the average cost falls and the curve shifts downward to AC1. With a fall in the average cost of production, the price also falls, however the supply increases and the curve shifts rightward to S1. Question C: Suppose the government considers a rise in alcohol tax purely in order to reduce consumption of alcohol. That means that the government intends to compensate households by a suitable reduction in income tax so as to make the measure neutral with regard to their overall tax payment. Assume that alcohol and the bundle of all other consumables are normal goods, and that the government applies the model of a representative household to explore the consequences of its measures. Use the idea of substitution and income effects to show graphically: (a) The impact on consumption of alcohol and other goods; (b) The impact on the welfare ('utility') of the representative household. Solution: (a) The impact on consumption of alcohol and other goods; Let the price of alcohol be A1 and the price of other consumables be O1. Relative Price of alcohol= A1/ O1 Relative Price of other consumables= O1/ A1 Now after the imposition of tax on alcohol, its price increases to A2 and the relative price of other consumables decreases. This has got two effects: 1. Consumers will tend to buy more of that good that has become relatively cheaper and less of that good which has become expensive i.e. consumers will buy more of the other consumables and less of alcohol. 2. Due to a fall in the relative price of other consumables, the purchasing power of the consumers increases. Substitution effect is the change in a commodity's consumption due to a change in relative price of the goods with real income remaining constant. In case of substitution effect the utility or satisfaction remains constant. When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good. Since the relative price of the other consumables has decreased the budget line will become flatter. The consumer will substitute the consumption of alcohol with other consumables but doing so the consumer will remain on the same indifference curve. Fig. 3: Substitution Effect Income effect is the change in consumption of a commodity brought about by an increase in purchasing power with the relative price of the commodity held constant. The quantity demanded for the commodity may increase or decrease with a corresponding fall or rise of purchasing power. In the above case, the Government imposes tax on alcohol as a result of which price increases and the Government also compensates it with a cut in income tax. As long as the consumers are not purchasing alcohol the impact of alcohol tax will not affect him but on the other hand due to cut in income tax purchasing power increases. To avoid the impact of alcohol tax the consumer will purchase all of other consumable goods. (Fig 4) Other way round, to nullify the effect of alcohol tax income tax is reduced. The money saved from income tax will be utilised in purchasing alcohol. Thus there will be no income effect or substitution effect at all. (Fig 5) Fig.4: Income Effect Fig.5: No Effect Question D: (i) The UK national income account [see UK National Accounts: The Blue Book 2007] for 2006 shows the following simplified figures (in million at current prices): Private consumption expenditure (incl. non-profit institutions serving households [NPISH]): 828,081; Government consumption expenditure (individual and collective): 286,812; Gross capital formation (incl. changes in inventories): 238,531; Fixed capital consumption: 133,936; Exports of goods and services: 369,691; Imports of goods and services: 424,128; Net factor income from the 'rest of the world' [ROW] (net of indirect taxes paid to plus subsidies received from ROW): 17,334; Indirect taxes on domestic products and imports minus subsidies (including taxes paid to and subsidies received from ROW): 144,663. The figures also indicate a statistical discrepancy between output measure of GDP and expenditures approach of m 635. Using these numbers calculate: (a) Gross domestic product (GDP) at market prices according to the expenditures approach; (b) Gross domestic product (GDP) at market prices according to the output approach; (c) Gross national product (GNP) at market prices (taking GDP by its output measure); (d) Net national product (NNP) at market prices; (e) National income (NNP at basic prices). (ii) Suppose the government wants to improve on its income from taxes by increasing taxes on cigarettes from 1 to 2 per pack, which raises the price per pack from 4 to 5. The government, however, is uncertain about the price sensitivity of the demand for cigarettes. Assuming the (direct) price elasticity of this demand to be constant in the relevant domain, it considers two extreme cases of elasticity to explore the range of possible effects: (a) -0.2; (b) -2.0. Calculate the percentage change of total taxes on cigarettes for both scenarios. Solution: (i) Private consumption expenditure (incl. non-profit institutions serving households [NPISH]): 828,081 Government consumption expenditure (individual and collective): 286,812 Gross capital formation (incl. changes in inventories): 238,531 Fixed capital consumption: 133,936 Exports of goods and services: 369,691 Imports of goods and services: 424,128 Net factor income from the 'rest of the world' [ROW] (net of indirect taxes paid to plus subsidies received from ROW): 17,334 Indirect taxes on domestic products and imports minus subsidies (including taxes paid to and subsidies received from ROW): 144,663 (ii) Suppose the government wants to improve on its income from taxes by increasing taxes on cigarettes from 1 to 2 per pack, which raises the price per pack from 4 to 5. The government, however, is uncertain about the price sensitivity of the demand for cigarettes. Assuming the (direct) price elasticity of this demand to be constant in the relevant domain, it considers two extreme cases of elasticity to explore the range of possible effects: (a) -0.2; (b) -2.0. Calculate the percentage change of total taxes on cigarettes for both scenarios. Solution: The law of demand states that price of a commodity and the quantity demanded of the commodity move in opposite direction. However this does not say anything about the amount or degree to which demand varies with change in the commodity's price. Price elasticity of demand is the ratio between the percentage change in demand for a commodity and percentage change in the price of the commodity. Price elasticity or own price elasticity of demand is thus expressed as, e = (-) Percentage change in quantity demanded Percentage change in its own price Since demand and price moves in opposite direction, to make the ratio positive a minus sign is put before the ratio. If it is less than one then demand is relatively inelastic and greater than one implies demand is relatively elastic. T0 = 1 T1= 2 -0.2 = (-) Percentage change in quantity demanded Percentage change in its own price P0 = 4 P1 = 5 P = 1 %age P = 1 * 100 = 25% 4 -0.2 = (-) x 25 X = 5% Bibliography: Barra R., (1996), MarketingIssues and Challenges in Transitional Economies, retrieved January 17, 2009, from www.wdi.umich.edu/files/Publications/WorkingPapers/wp12.pdf Golyaev K., (September 2007), Notes on Income andSubstitution Effects, Department of Economics, University of Minnesota, retrieved January 17, 2009, from http://www.econ.umn.edu/golya002/downloads/1101/1101_Handout_ISE.pdf. Price Elasticity of Demand and Supply, (No Date), Chapter 5, Humboldt State University, retrieved January 17, 2009, from http://www.humboldt.edu/sh2/econ200/e200notes_week5.htm Read More