Micro Economic Principles - Assignment Example

Answer Adam Smith, in his book Wealth of Nations, had explained the importance of free trade by pointing out that it is foolishness to produce something at home which can be brought from the market at a lower cost than the actual cost of production. COUNTRIES CLOTHING (labour hours per unit) FOOD (labour hours per unit) U.S. 10 hours/unit 15 hours/unit INDIA 12 hours/unit 12 hours/unit Here, it can be seen that if U.S. concentrates only on the production of clothing and India produces only food (i.e. both the nations follow specialization), and then exchange their commodities, both the nations will be able to gain from this set up. Therefore, according to Adam Smith, absolute cost difference provides the basis for international trade. (In this example labour hour is taken to be the only resource of production.) David Ricardo had later extended the above said idea by pointing out that it is comparative advantage and not absolute advantage that forms the basis of international trade. COUNTRIES CLOTHING (labour hours per unit) FOOD (labour hour per unit) RELATIVE COSTS (C/F) RELATIVE COSTS (F/C) U.S. 8 hours/unit 10 hours/unit 0.8 hours/unit 1.25 hours/unit INDIA 10 hours/unit 15 hours/unit 0.67 hours/unit 1.5 hours/unit Here, it can be seen that India has an inferior productivity compared to U.S. in both the goods. In the absence of trade both the nations will have to produce both the goods in order to meet the local demands. But, in the presence of trade, India should produce only clothing as it has a lower opportunity cost. Again, U.S. should specialize in food because here food has a lower opportunity cost. Opportunity cost is the cost incurred when a choice is made, in terms of the next best available option. In the above stated example, India by producing 1 unit of Clothing is losing out on 0.67 units of food but if India were to produce food, then by producing 1 unit of food, India would have lost out on 1.5 units of clothing. Therefore, a country should specialize in a good that has a lower opportunity cost. Considering 100 hours of labour, the figure below shows the gains from trade: For U.S., For India, Production possibility frontier or the production possibility curve is a curve representing the tradeoff between two commodities given the resources is efficiently utilized. The PPC shows the maximum amount of one commodity that can be obtained given fixed amount of second commodity. Terms of trade is (price of exports)/ (price of imports). It is the quantity imports which can be purchased using a certain fixed amount of exports. Trade line is the line representing the terms of trade. Gains from trade are the gains that result from specialization and trade arrangements between two countries. In this example, both U.S. and India are gaining from this arrangement. The price of food post trade will be between 1.25-1.50 and the price for clothing will be between 0.67-0.80. This proves that trade will be beneficial for both the countries. (Pugel, n.d.; Krugman, 2007) Answer 2. a) Given, MPC= 10+10Q P= 70 – 5Q The private market equilibrium will have the MPC = P or, 10+ 10Q = 70 -5Q or, 15Q= 60 therefore, Q’ = 4 substituting the value of Q in the demand equation we get, P = 70 – 5*(4) or, P’ = 50. b) Given, MSC= 10 + 12Q P= 70 -5Q The social market equilibrium will have the MSC = P or, 10 + 12Q = 70 – 5Q or, 17Q = 60 therefore Q*= 3.53 (approx) [socially optimum Q] substituting the value of Q in the demand equation we get, P= 70 -5*(3.53) or, P*= 52.35 [socially optimum P] (Varian, 2010) The equilibrium in (a) is not optimal because in case of negative externalities, marginal social cost > marginal private cost. The diagram above shows that for a profit maximizing producer, for a given cost, the profit maximizing output is Q’ which is greater than the socially optimum output Q*. By producing at Q’, the producer is causing an externality worth AB which the producer is not treating as a cost. (Varian, 2010) The equilibrium in (b) is optimal because here the cost of externality is also included in total cost i.e. socially optimal output is being produced here. d) d) At point B = Q=4; Hence on MSC, P= 58, Deadweight loss = area ABC = ½ *(base)*(height) = ½ *(4-3.53)*(58-50) = ½* (.47)*(8) = $1.88 e) MPC= 10 + 10Q From where, P= 50 and Q=4. Optimum tax of the amount AB (of figure in part-c) is required to reach the equilibrium. This amount is equal to the difference between MSC and MPC. Numerically, MSC = 10 + 12Q = 10 + 12*(3.53) = 10 + 42.36 = 52.36 Again, MPC = 10 +10Q = 10 + 10*(4) = 50 Optimal tariff = 52.36 – 50 =2.36 Government receives revenue equal to 2.36 if it imposes this tax. f) Both pollution taxes and the tradable (or marketable) permits are very similar kinds of policy instruments as they both impose a price on the polluters which in turn leads them to reduce the costs that they impose on the society. In case of Pigouvian taxes, a per unit charge is set on the emissions that equals the value of damage that was caused due to the extra unit of emission. In case of tradable permits the regulatory bodies allocate the permits keeping in mind a pre-determined total quantity of emission. These permits are transferable and therefore their prices are market determined. (Varian, 2010) Economists prefer marketable permits over Pigouvian taxes because here government can reduce the number of permits from year to year and because of this feature the certainty of reaching a desired emission limit is higher. (Desaigues & Rabl, 2001) Answer 3: a) If there is no charge for the tour the consumer surplus (first come first serve basis) = (20+14+30+15) – 0 = $79 (consumer surplus is the difference between the actual price and the willing to pay price; the latter is zero since there is no charge for the tour) b) Now from the willingness to pay of all the participants we find that Francis pays the lowest ($12), John pays the second lowest ($14) and Jack pays the third lowest ($15). Hence their willingness to pay or interest in being a part of the tour on that day will be lowest. The manager would determine the compensation going by the willingness to pay and finally by Contingent Valuation or utility based method the settlement price might come at $12 at max. This is because this tour has zero charge and hence the compensation cannot exceed $12 (this would mean giving some money to Francis for postponing his tour). Hence we may assume the three volunteers to be Francis, John and Jack each of whom gets a compensation of $12. (Varian, 2010) Total economic surplus after deduction of $12 from the maximum willing to pay price of the three volunteers = {20+30+40+17 + (15-12)+(14-12)+(12-12)} – cost to the manager = $112 - $(12*3) = $(112-36) = $ 76 c) In the first come first served policy, three of the tourists (Francis, Penelope and Faith) could not visit the park for late arrival. But in the second condition these three are better off without making the other people worse off. Hence this is a Pareto Optimal Condition. d) d) Now in the second case the economic surplus is $76 which is $3 less than the economic surplus generated in the first case ($79). The manager’s position could be at least equal to the first cum firs served case if he is compensated this $3 by the participants. Now, the question arises who would pay. The manager can put this proposition and say that unless this contribution takes place he would go back to the first policy of first cum first served basis. John is paying $2 and Jack is paying $3 after the compensation while Francis pays $0. Now if the tour takes place on first cum first served basis then John and Jack would be able to go on the first day itself by paying their utility price. But Francis’ position is most threatened. Hence he would be giving $3 minimum in order to make the second option viable for the manager. Answer 4. a) Demand equation P= 10-Q Supply equation P=Q At equilibrium, demand=supply Or, 10-Q = Q Or, Q=5 (thousand per week) Therefore P= $5 (by substitution) Revenue= P*Q =$5*5000 =$25000 b) The new supply equation is: P+ 2= Q c) The new equilibrium is at P+2 = 10- P Or, 2P=8 Or, P= $4 Post tax, P= P+$2 or, P= $6 Again, P= 10 – Q Therefore, Q= 4 (thousand per week) d) Of the $2 tax, $1 is being paid by the consumer and $1 is being paid by the producer. e) The Dead Weight Loss = the area of ABC = ½*height*base = ½*(5-4)*(6-4) [at point c price equals quantity following the supply schedule] = $ 1/2 The Government’s Revenue is = rectangular area d = (6-5)*(4-0) = $4 (Varian, 2010) Answer 5: a) In case of lottery settlement, the allocation is independent of price and depends on luck factor. This is an external factor and considering ceteris paribus rule in demand supply framework, the quantity might be anything at a fixed price. This depends on the price settled as the lottery ticket price. Everyone who participates pays the same price but only the lucky ones manages to get quantity QL. This quantity is fixed by the management. Even if someone is willing to pay a price higher than PL (that is, P’) he will get the same level of quantity QL. Anytime the supply curve may shift to the left and thus providing lesser quantity at the same price PL. Hence this is not free market equilibrium. b) A settlement through willing to pay pricing could be undertaken instead of lottery settlement. c) In case of a lottery, there is no discrimination based on the price paying capacity. In the later case if the price adjustment is based on willing to pay price then it might not consider the social factors like the capacity to pay. A poor person might not be able to pay more than a certain amount despite being equally eager as a rich person. Hence the utility assumption based on the willing to pay pricing might not be foolproof always. Lottery is again based on chance based discrimination and might not lead to Pareto Optimal or efficient allocation system. (Kerr, 1995) The willingness to pay settlement combined with a compensation policy for some people who would be ready to share camps might be Pareto Optimal condition for allocation of tickets for visits at campsites. References Alberini, A. & J.R. Kahn (2006), Handbook on Contingent Valuation, Edward Edgar Publishing Desaigues, B. & Rabl, A. (2001), Pollution Taxes and other Policy Instruments: Who Pays What?, arirabl, retrieved on Sept. 26,2011 from: http://web.me.com/arirabl/Site/Publications_files/PollutionTax-PollAtmos.pdf Kerr, G.N. (1995), Managing Congestion: Economics of Price and Lottery Rationing, Journal of Environmental Management (1995) 45, 347–364 Krugman, P. (2007) International Economics, Pearsons Education. Pugel, T.A. (n.d.). International Economics. New York: Tata Mc Graw-Hill Education Varian, H. R. (2010) Intermediate Microeconomics, W.W. Norton & Co. Read More