Principles of Economics - Assignment Example

1(a) Market Structure and efficiency Market is said to be efficient or Pareto efficient when increasing some one’s benefit in the economy is not possible with making somebody else worse off. This may sound counter intuitive, as how can such a market be called efficient when there is no possibility of increasing welfare in the economy. The rationale is simple that the market is running at its full efficiency and all the potential for further improvement has been exploited, that means there is no wastage in the economy. Market structure is the set of underlying characteristics like level of competition, cost structure etc of a market that help in determining the wastage or efficiency in the market. There may be two types of efficiency in the market Productive efficiency and Allocative efficiency. The perfectly competitive market ensures maximum efficiency. In perfectly competitive the maximum profit point is where the marginal cost is equal to marginal benefit and since for them MR = AR= P. thus the profit maximization point i.e. MC =MR also ensures MC = MU (price). This means that in perfectly competitive markets the marginal benefit to the society derived by customers while consuming the product is just able to cover the marginal cost incurred by the society through the producer. Thus the marginal loss to the society is equal to the marginal benefit to the society which is a condition for efficiency. Which is not case with imperfectly competitive markets whose MU may not equal to MC at the point of profit maximization i.e. MR = MC, as for imperfectly competitive markets MR may not be equal to AR and price. Thus MC and price may not be equal. Examples Perfectly competitive market An example of market very close to perfect competition is street vegetable market in developing countries. The products are almost similar and each buyer and seller is very small thus almost similar prices prevail. Thus MR = P = AR, and for profit maximization MC = MR which means MC = P (MU) which ensures utmost efficiency. Figure 1 shows the profit maximizing point for a competitive market firm. The point for profit maximization is qe, as here MR = MC and since it’s perfectly competitive, AR = P = MR, thus MC = P, which shows the efficiency in the market. Imperfect Competition b) The example of imperfect competition is tooth paste market in the US a lot of firms selling differentiated products to many buyers. In this case the firms don’t sell at similar prices and their demand curves are sloping downwards thus MR falls faster than AR and P. Thus when MC comes equal to MR MC is actually less than AR which keeps the prices higher and thus some customers are not able to buy at higher price which leads to inefficiency in the market. Profit Maximization for Monopolist. The profit Maximizing point is where output is 10 at price 50. Since here at equilibrium point MC = MR, price is higher than MC i.e. P > MC. In this case it’s possible to increase the welfare in the society by producing further as MC is smaller than price. Thus it is inefficient situation. Ans 3 Goods like clean air; street lights etc are required to be produced by the government as businesses don’t find them efficient to produce and deliver as they can do so only when it’s possible to make everybody seller as well as buyer ready to share the benefits and costs of their efforts. But certain goods like clean air do not let that happen and thus marketers are not interested in producing an delivering those products which have no profit potential due to some peculiar characteristics of them. Such goods are called as public goods. Some of their characteristics are Non Rival consumption – The goods consumption of which by one party does not forestall simultaneous consumption by others even without making any extra efforts or paying for it. For example if one house hold pays for getting the street clean or air clean it cannot stop others from enjoying the benefits of it. When marketers find that the non payers cannot be excluded from enjoying the service then this becomes serious issue for the marketers as it leads to free riding. That means if those who have not paid will be enjoying the benefits of the products. This does not stop here this free riding makes the earlier buyers or payers feel that other enjoy at their cost and thus they will be discouraged from buying it and may also be looking for opportunities to ride free . Thus marketers find that the demand for their products go down substantially and they will not be able to make profit at the current price but increasing price is no option either as the demand is already dampened, and thus the government has to intervene and produce those products. Apart from free riding there could be other problems which warrant government’s intervention in producing these products. The externality is a phenomenon which operates when one firm can enjoy benefits at the cost of others like society without compensating them fully for that or one firm benefits others and does not get compensated. The former situation is known as negative externality and the latter one as positive externality. The examples of which are as Positive externality – Eg Positive externality – if the firm finds that it invests in R&D and others just simply copy its inventions the firm may not see any rationale if the benefit is shared by everybody but paid for by just it only. Plz refer diagram 1 Fig- 1. Positive consumption externality Fig 1 In this figure D reflects the marginal private benefit, that shows what people are reday to pay, but D1 being higher than D reflects that society will be deriving some more benefit than they pay for, which would discourage the firm from producing Q* = 12 and it would restrict its supply to only Q = 10. Eg negative externality – if the firm treats its chemical waste in nearby river without paying for it, then the firm would want to produce more than when the firm would have to pay for its water contamination. Fig 2. - Negative production externality Fig 2 In this case the producer the producer may want to produce 5 units if government does not step in. When government steps in it discourages the firm and the firm produces only 4 units. Answer 3 a) Total physical product of labor Marginal Physical Product of labor Price of Product Total revenue Marginal Revenue Product Wage Total factor cost Marginal Factor Cost Total profit # (TPPL) (MPPL) (P) TR (MRP) (W) TC (MFC) T P 1 16 16 10 160 160 70 70 70 90 2 36 20 10 360 200 70 140 70 220 3 60 24 10 600 240 70 210 70 390 4 86 26 10 860 260 70 280 70 580 5 110 24 10 1100 240 70 350 70 750 6 130 20 10 1300 200 70 420 70 880 7 146 16 10 1460 160 70 490 70 970 8 160 24 10 1600 240 70 560 70 1040 9 170 10 10 1700 100 70 630 70 1070 10 176 6 10 1760 60 70 700 70 1060 Answer 3 b) – The wage level though should respond to changes in the quantity demanded but it does not do so because government might have fixed the minimum wage level i.e. at 70. As long as market wage level is below the government fixed level the wage level will not change in response to change in the number demanded. Alternative explanation to this can be that there is perfect competition in the labor market. Ans 3 c) - As we can see the price of the product is not changing in response to higher sales then we may conclude that it must be a perfectly competitive market as that’s the only structure where we can witness a constant demand curve i..e not sloping downward. Had it been imperfect competition we would have seen Ans 3 d) The Company must hire 9 workers neither less nor more than this if it wishes to maximize its profits i.e. a profit of 1070. As this is the point where the difference between MC and MR though not zero but is the least. The rule for profit maximization is MR = MC If MC < MR then firm must increase its production until MC becomes equal to MR And IF MC > MR then firm must cut back on its production to restore MC = MR. Revenue and Cost curves Total Cost and total revenues curves. The straight lines connecting the curves are the profits at each point. We can easily see in the graph that the longest line is at labor 9. This is how much should the company hire. Ans 3 e) The result of hiring any other number of workers is as follows 1) If we hire less than 9 workers we find that the difference between the MFC and MRP is higher. We can see that MFC is lower than MRP thus hiring more labors will increase the revenue by a greater amount than the amount why which cost would increase. Thus hiring would increase the amount of profit. 2) If we hire more that 9 we see the gap between MFC and MRP increases again but here MRP is less than MFC which means we are offsetting some of our profit as this labor is increasing cost by a greater amount than the amount of revenue increase. Answer 2) One shot prisoner’s dilemma is a situation faced by two (or more) competing parties, having different choices open to them, when both of them are aware of the fact that they can maximize their overall gains (or minimize over all loses) by choosing to cooperate with each other and if they try to compete they cancel out each other’s actions and resources of both of them go waste. IF one of them chooses to cooperate while the other one suckers then the suckered firm looses heavily to the betraying firm. This situation is evident in many instances i.e. two countries engaging in arms races, two firms contemplating price reduction or keeping them constant, two firms contemplating on whether to advertize or not to snatch or defend market share. This situation is faced by cola majors Pepsi and Coke, in which they realize that though their advertising may not help in increasing the overall market share substantially but they still engage in heavy promotional wars. This behavior is displayed by the firms as they realize that not advertising will help both the firm i.e. keep their costs low but still they engage in advertising wars bleeding heavily. They do so because they cannot come to cooperative arrangement which would be binding the parties. As if they choose not to advertize and one firm reneges from the promise the other one stands to lose heavily on account of this. Since there can’t be a legally binding agreement for not advertising both the firm fear that they might be suckered thus don’t stay in the cooperative arrangement and compete to the loss of each other and overall losses. b) In oligopoly market structure (for a product with very low elasticity) if all the firms decide to increase the price then they all can enjoy almost same level of demand as they did before increasing the price. But that does not happen rather what we witness that these firms engage in heavy price wars eroding each other’s and overall profit of the industry as a whole. The reason for such seemingly irrational behavior is quite rational. To appreciate that, we need to model their situation as a prisoner’s dilemma game. To keep it simple let’s consider a duopoly market with two firms Natural (N) and pure (P). The market is equally divided among them i.e. each firm enjoying sales of 10m each and the industry sales is 20m, with flat profitability of 20% of sales. Thus both firms enjoy profit of 2m each. The firms have two choices with them either to increase the price or keep them intact. The pay offs of each strategy will be If both N and P increase the price – the revenue increases by 25% and thus the profitability thus their newer profits are 2.5m If N increases the price and P does not then N loses 50 % revenue and 50 % profit to P, which gains 50%. If both keep the prices same then their revenue and profitability remain the same. The pay off matrix for both of them is Firm / Strategy P (price increase) P (price same) N (price increase) 2.5m 2.5m A 3 1 B N (price same) 1 3 C 2m 2m D Cell A, B, C and D reflect different pay offs to both firms in response to their chosen strategies. The firms should ideally operate at A where both will be better off but they would rather choose cell D as if trying to maximize the profit a firm is suckered by the other firm then it stands to lose heavily as reflected in cell C and B. Thus fearing that it might end up in cell B, N will play safe and keep the price same and not increase it. On the other hand P fearing ending up at cell C will also choose to keep the price same thus both the firms out of their fear will settle for cell D. If the fear can be taken care of they would settle for A, but for that there has to a binding contract between them. As far as prices are concerned government does not allow such collusions and thus firms don’t charge higher prices though they can and in extreme cases engage in price wars. The same phenomenon explains why firms spends so much on advertising and incur heavy costs. References Samuelson, P. and Nordhaus, W. (2007) Economics, 18th edition, pp. 128-131, Tata McGraw- Hill, Hubbard, G. and O’Brien, P. (2008) Microeconomics, 1st Edition, pp. 354-364, Pearson Education. Case, K. and Fair, R. (2007) Principles of Economics, 8th Edition, Pearson Education, pp. 259-267. Samuelson, P. and Nordhaus, W. (2007) Economics, 18th edition, pp. 212-218, Tata McGraw- Hill. Read More