Principles of Microeconomics: Explicit Costs - Dissertation Example

Ans Explicit costs are money payments a firm makes to outside suppliers of resources while implicit costs are the opportunity costs associated with a firms use of resources it owns” (McConnell et al 2004, Pp. 150,). Explicit costs are “money” payments made by a firm to the factors of production such as rent paid on land, wages paid for labor, interest paid on borrowed capital etc., while implicit costs include all “non monetary” payments which could have been made to self employed resources such as rent for self owned land, salary payable to an entrepreneur of a firm, or goodwill of a firm etc. Explicit costs involve outflow of funds while implicit costs are opportunity costs. Explicit costs are regarded as actual costs and included in accounting, while implicit costs are not regarded as costs, although they are considered to be an integral part of a firm’s cost of doing business (Duffy 1993). The explicit cost of going to a university includes tuition fees, accommodation cost, etc while time spent in studying at the university is the biggest implicit cost of going to university as it could have been invested elsewhere such as working. Economists classify normal profits as costs because it is the opportunity cost of another best alternative forgone i.e., working for salary, or setting up another business. Furthermore, it is the minimum level of profits required to be earned by a firm in order to avoid loss and continue operating the firm. Economic profits are not costs of production because costs of production must include monetary rewards (cost) paid for the factors of production, while economic profits include opportunity costs or notional expenses along with the actual monetary expenses (i.e., economic profits = total revenues – explicit costs – implicit costs). Hence accounting profits rather than economic profits can be considered as cost of production (McConnell et al, 2004). Ans. 2: The basic difference between a competitive firm and a single monopoly firm is the ability of the single monopoly firm to influence the price of its output. A competitive firm is comparatively smaller with regard to the market in which it functions and hence the price of its output is influenced by the market forces. While in case of a single monopoly firm, it has the liberty to alter either the price or output since it is the sole producer of goods in the market (Gregory 1998). This difference can also be explained in accordance with the demand curve faced by each type of firm. In case of competitive firms the market price is represented by a horizontal line. Since a competitive firm can sell any quantity of goods at any given price, the firm faces a horizontal demand curve (See figure 1). Furthermore, the competitive firm has several competitors selling perfect substitutes in the market, hence, the demand curve of any one firm is perfectly elastic (Gregory, Taylor, 2006). Contrary to this situation, the single monopoly firm being the sole producer of goods in the market has no rivals, and hence no cheap or alternate substitutes, faces a downward sloping demand curve. This is so because if the monopolist increases the price of its product the consumers buy less of it. Alternatively, if the monopolist reduces the quantity of the goods sold, the price of its output increases. Since any firm operating in the market aims at maximizing profit, and faced with a dilemma of either altering the price or the output sold, the monopolist prefers to sell less goods at higher price, in order to maximize profits. However such a situation is considered inefficient because the market demand curve acts as a constraint on the ability of the monopolist to maximize its profit by exercising its power on the market. If it were possible the monopolist would opt for selling more goods at higher price, however the market demand curve makes such a decision impossible to achieve. The market demand curve, as shown in the diagrams below, shows the various combinations of price and quantity which are available at the disposal of the monopolist as well as the perfectly competitive firm. It is quite apparent hence, that a monopolist can select any point on the demand curve i.e. the price of the output but is restricted in doing so with respect to the quantity of the output, since it is impossible to select any such point off the demand curve. Figure 1: Demand Curves of a competitive as well as a monopolistic firm Source: Mankiw, N. G., Taylor, M. P., (2006). Microeconomics, CENGAGE Learning, Pp.292 In case of a competitive industry, it operates at a point where the price is equal to the marginal cost while in case of a monopolist industry, it operates at a point where the price is greater than the marginal cost. Hence, the price in case of a monopolist industry will be always higher and the quantity of output will always be lower. Such a price output situation causes inefficiencies in the market since the demand for its product would be higher and the supply would be lower. Also people would be willing to pay higher price than the marginal cost but since any additional sale of output would cause the price to fall the monopolist would not increase the output in spite of the increase in demand, in order to increase its overall revenues. Ans. 3: The effect on aggregate demand and aggregate supply on account of a. Increase in interest rates: “The interest rate is the price of money and it adjusts to equate the supply of and demand for money” (Gillespie 2007, Pp.366). Hence an increase in interest rate leads to a decline in investment spending and a corresponding fall in the aggregate demand. If interest rates are higher, it becomes expensive for people to borrow money and the incentive to spend is also lower. Thus the aggregate demand and aggregate supply for money would be lower in case of a rise in interest rates. b. Fall in value of Australian dollar: A fall in the value of Australian dollar would lead to an increase in the aggregate demand and a fall in aggregate supply, because a fall in the nations currency means that the Euro or the American dollar is relatively more expensive than the Australian dollar hence the citizens of Europe or U.S would be able to buy more Australian goods with less Euro or US dollars. Hence the aggregate demand for Australian goods will increase (i.e. exports will rise) while the supply of imported goods will fall, as they are now relatively more expensive. c. Successful labor market reforms: Successful labor market reforms tends to lower the rates of overall unemployment, increase employment across various sectors and hence expand the output. Increased employment in turn leads to increase in purchasing power and hence increase in aggregate demand as well as aggregate supply. d. An increase in number of skilled migrants: Strong inflow of labor into the economy can have the effect of increasing the labor supply - this puts downward pressure on real wages (for a given level of labor demand) e.g. through helping to relieve labor shortages in particular industries and occupations. If migration provides a boost to the labor supply and to average labor productivity, there is the prospect of an outward shift in a countrys long run aggregate supply. PART – B: Business Cycle: Meaning and Definition The business cycle is one of the central concepts in modern economics. It was defined by renowned economists Arthur Burns and Wesley, Mitchell in their revolutionary 1946 study "Measuring Business Cycles" written for the National Bureau of Economic Research which today is the official arbiter of the U.S. business cycle. According to them a business cycle is defined as: "a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals, which merge into the expansion phase of the next cycle" (Hartley et al 1998, Pp.466). Economies have a general tendency to fluctuate. In situations wherein the firms as well as households become cynical and reduce their overall spending, it leads to a fall in the aggregate demand of goods and services. Such a fall in aggregate demand leads to a decline in production of those goods and services. Fall in production is further followed by lay off of workers by firms, since the demand for output has fallen and hence leads to a rise in unemployment. Ultimately the real GDP as well as other determinants of income decline sharply. The increasing unemployment rates and the resultant decline in household income cause economic downturn, which is an absolute waste of the nation’s resources and has no benefit to the society at large. The situation worsens eventually, since the workers who are willing to work in firms are forced to remain idle since the firms do not have enough demand for products and services. However, such an economic downturn does not necessarily imply any specific harm or damage to the society since booms and busts are an inevitable part of a business cycle. The growth of macroeconomic theory has revealed measures which can be adopted and implemented by the policymakers to achieve a comprehensive decline in the austereness caused by the economic tribulations. By "leaning against the wind" of economic change, monetary and fiscal policies can seek to alleviate the aggregate demand, and thereby, the quantity of output produced as well as employment. When aggregate demand is insufficient to guarantee complete employment, policymakers must strive to enhance government spending, reduce taxes and increase the money supply. Similarly when the aggregate demand is extreme, the policy makers must strive to reduce government spending as well as money supply, and increase taxes even at the risk of causing the inflation to rise even further. Such measures, which strive to enhance the economic situation through prompt and effective intervention and implementation of the macro economic theory at its best, benefits everyone in the society as a whole. However, having said that, such changes in the monetary and / or fiscal policies of the nation, although they are made for the overall benefit of the society, involves certain considerable setbacks with respect to the application and implementation of the policies mentioned above. Theoretically such policies seem to accomplish the objective of stabilizing the business cycles however putting the same into practice invites certain drawbacks. One such predicament is the fact that monetary and fiscal policies do not influence the economy right away however they affect it in the long run. For instance the interventions made in the monetary policy with a view to stabilize the business cycle influences the aggregate demand by altering the interest rates, which causes the spending to rise or fall, especially spending with regard to residential and business investment. However, the key issue of concern here is the fact that such changes cannot be initiated promptly and takes time to take effect. This is because; both households as well as firms plan their spending patterns well in advance. Consequently, such modifications require adequate time for the interest rates to change the aggregate demand for goods and services. Several studies conducted in the past have pointed out the fact that modifications in the monetary policy do not cause the aggregate demand to change for a period of minimum six moths, post the implementation of the said change. In case of fiscal policies the delay caused for the implemented change to take effect, is due to the fact that political process which governs such modifications is a long drawn process, and any suggestions regarding any change in the fiscal policy is required to be passed by various governing bodies, congressional committees as well as senates. Hence while initiating such changes in the monetary as well as fiscal policies the policy makers must take into account the time lag and must plan in advance by studying the impact of the current economic state on the future and its likely effect. Regrettably, predictions related to the economy are highly vague, partly owing to the fact that macroeconomics is a relatively primeval science and partly because the upsets or setbacks caused by these economic fluctuations are essentially erratic in nature. Hence, when policymakers modify the monetary or fiscal policies, they must depend on well-informed presumptions concerning the prospective economic situation. However, more often than not, the policy makers who are attempting to stabilize the economy end up doing just the opposite. Economic situations can effortlessly transform between the time when a policy action commences and the time when it actually implemented. On account of this very reason, the policymakers can accidentally aggravate rather than alleviate the extent / enormity of the economic instabilities. Some economists have debated that a majority of the key economic downturns in history, such as the Great Depression of the 1930s occurred because of destabilizing policy actions on the part of the policy makers. Adopting precautionary measures in spite of an evident need for dependable information / known facts merely makes matter worse. Treating an ailing economy is no mean feat and policy makers must abstain from intervening and let the economy take its natural course. Although stabilizing the business cycle might seem to be an advantageous option in the view of the policy makers, but it cannot be considered as a pragmatic alternative, especially considering the apparent restrictions of the macroeconomic knowledge and the innate randomness of events taking place across the globe. Thus, if the current economic state does not seem to be too harmful for the nation, the economic decision makers must abstain from intervening. The capacity of macroeconomic policy to obliterate the business cycle has consecutively been deeply over - and underestimated over the decades. The extensive agreement currently is that monetary and fiscal policy can reasonably eradicate and stabilize the economic fluctuations but they will never be able to eliminate the cycle altogether. Policy makers, during the 1950s and 60s were of the view that it is possible to prevent inflation and control unemployment by increasing government spending, and cutting down taxes and interest rates. However as inflation intensified during the 1970s causing an explosion of public debt, the beliefs put forward by the policy makers was proved to be ineffective and unfounded. Economic policies implemented during the 1980s and 90s, were aimed mainly at lessening the impact of inflation rather than focusing on stabilizing the output. Governments discarded the dynamic monetary and fiscal policies in favor of obedience of rules. Central banks were made autonomous, and several were designated with overt inflation targets. In the meantime governments geared themselves into fiscal mode. For instance, the U.S., set balanced-budget targets in the 1990s while the euro area implemented a fiscal stability deal with stringent restrictions on administrative borrowing. The prominent exemption was Japan which relied on decade long fiscal expansion plans. Although fiscal policies might prove to be effective, initiating the same at the appropriate time is highly complicated issue. In various countries and remarkably in the U.S. it takes several months to attain political sanction. Hence by the time the suggested incentive is ready to be implemented, the economy may have partly recovered rendering the proposed plan to be invalid and hence ineffective. While interest rates on the other hand can be reduced promptly and reversed swiftly back in case the economy improves suddenly. Flexible budget procedures hence must be avoided, preferably, since clearly fiscal measures of stabilizing the business cycle are relatively much more flexible and effective. The habitual decrease in taxes and increase in unemployed benefits in times of recessions help in sustaining spending. Since monetary and fiscal policy have the capacity to manipulate aggregate demand, the government from time to time implements them with a view to stabilize the economy. Although economists differ in opinion regarding whether such interventions are effective or not and whether or not the government should participate in efforts which aim at stabilizing the economy; advocates of active stabilization policy, argue that alterations such as a change in attitudes of households and firms cause a shift in aggregate demand and non participation of the government to stabilize the situation may result in unwelcome and redundant instability in both output as well as employment, causing the recession to deepen further. But at the same time they also argue that on account of the presence of limitations such as long time lags which are inherent, while applying the policy measures, any effort to stabilize the economy might fatally lead to destabilizing it even further. References: Duffy, J., (1993). Economics, John Wiley and Sons, Pp. 98 Gregory, N., (1998). Principles of Microeconomics, Elsevier, Pp. 308 Gregory, N., Taylor, M. P., (2006). Economics, CENGAGE Learning, Pp. 292 Hartley, J. E., Hoover, K. D., (1998). Real Business Cycles: A Reader, Routledge, Pp.466 McConnell, C. R., Brue, S. L., (2004). Microeconomics: Principles, Problems and Policies, McGraw - Hill Professional, Pp. 150 Read More