3 Economy Book Saif

1
2009 Elan Guides

BOOK 2: ECONOMICS
13. Elasticity
14. Efficiency and Equity
15. Markets in Action
16. Organizing Production
17. Output and Costs
18. Perfect Competition
19. Monopoly
20. Monopolistic Competition and Oligopoly
21. Markets for Factors of Production
22. Monitoring Jobs and the Price Level
23. Aggregate Supply and Aggregate Demand
24. Money, the Price Level, and Inflation
25. U.S. Inflation, Unemployment, and Business Cycles
26. Fiscal Policy
27. Monetary Policy
28. An Overview of Central Banks
3
13
23
37
45
53
65
75
87
101
107
115
125
137
149
157
Sai f Al Hidabi
ESI D-10813
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2009 Elan Guides
LAN STUDY NOTES
LEVEL I BOOK 2
ECONOMICS
2009 lan Guides LLC. All rights reserved.
Published in December 2009 by lan Guides LLC.
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Elasticity
2009 Elan Guides
LOS 13a: Calculate and interpret the elasticities of demand (price elasticity,
cross elasticity and income elasticity) and the elasticity of supply, and discuss
the factors that influence each measure. Vol 2, pg 8-28
Typically demand curves are downward sloping. An increase in price leads to a decrease in
quantity demanded, while a reduction in price results in an increase in quantity demanded.
Total revenue equals price times quantity sold, so firms must determine whether their total
revenues will rise if they were to reduce prices to stimulate sales.
This depends on how responsive quantity demanded is to changes in price, which is measured
by the price elasticity of demand (E
P
)
Changes in quantity demanded and price are calculated using average amounts in the
denominator. This method results in the same value for elasticity whether prices move up
or move down to a particular level.
Because the demand
curve is downward
sloping, quantity
demanded and price
will move in opposite
directions, and the
calculated value for
price elasticity will
be negative. The
negative sign is
usually ignored
because it is the
absolute value of
price elasticity that
tells us how
responsive quantity
demanded is to a
price change.
Example 2: Using Price Elasticity to Calculate the Change in Quantity Demanded
If the price elasticity of demand for a product is 1.2, and the price of the product changes
from $10 to $11, what is the change in quantity demanded in percentage terms?
Solution
1.2 = AQ
d
/ ($1/$10.5)
AQ
d
= - 0.1143 = - 11.43%
If the price elasticity of demand for a product equals 1.2, and the price increases from
$10 to $11, the quantity demanded will decrease by 11.43%.
Example 1: Price Elasticity of Demand
If the price of a product decreases from $7 to $6, its quantity demanded increases from
18 to 20 units. What is the price elasticity of demand for this product?
Solution

ELASTICITY
If we use the absolute
value of price
elasticity to calculate
the change in
quantity, we need to
make sure that the
sign in our answer is
opposite to direction
of the price change.
Alternatively, we can
put a minus sign in
front of the elasticity
value and simply
solve for the change
in quantity.
E
P
=
% change in quantity demanded
% change in price
=
% A Q
d
% A P
(Q
0
- Q
1
)
(Q
0
+ Q
1
)/2
100
(P
0
- P
1
)
(P
0
+ P
1
)/2
100
=
E
P
=
(20 - 18)
(20 + 18)/2
100
(6 - 7)
(6 + 7)/2
100
(-1/6.5) 100
(2/19) 100
= = 0.684
Price elasticity of demand can range from zero to infinity.
- If the percentage change in quantity demanded is the same as the percentage change
in price, demand is unit elastic (Figure 1a).
- If quantity demanded does not change at all in response to a change in price, the
numerator of the elasticity formula will be zero, and the calculated value of price
elasticity will also be zero. This is known as perfectly inelastic demand (Figure 1b).
- If quantity demanded changes by an infinitely large percentage in response to
even the slightest change in price, the denominator in the elasticity formula will be
close to zero (effectively zero), and the calculated value of price elasticity will be
infinity. This is known as perfectly elastic demand (Figure 1c).
- If the absolute value of price elasticity of demand lies between zero and 1, demand
is said to be relatively inelastic.
- If the absolute value of price elasticity of demand is greater than 1, demand is said
to be relatively elastic.
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Factors That Effect Price Elasticity of Demand
Availability of Close Substitutes
If a consumer can easily switch away from a good, her ability to respond to a price increase
(by reducing consumption of the good) is high, and demand for that product is relatively
elastic. For example, if the price of Coke
increases, consumers can easily switch to Pepsi
.
Therefore, one would expect the price elasticity of demand for Coke
to be relatively high.
Figure 1: Price Elasticity Of Demand
D
Quantity
D
Quantity
1b. Perfectly Inelastic
D
Quantity
1c. Perfectly Elastic 1a. Unit Elastic
Whenever we talk
about changes in
quantity or price, we
are referring to
percentage changes.
Elasticity = 1
Elasticity = 0
Elasticity =
|Ep| = 0
0<|Ep|<1
|E
p
| = 1
|Ep| > 1
|Ep| =
perfectly
inelastic
relatively
inelastic
unit
elastic
relatively
elastic
perfectly
elastic
Sai f Al Hidabi
ESI D-10813
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Elasticity
2009 Elan Guides
Proportion of income spent on the good
If a relatively small proportion of a consumers income is spent on a good (e.g. soap), she
will not significantly cut down on consumption if prices increase. However, if consumption
of the good takes up a larger proportion of her income, (e.g. automobiles) she might be forced
to reduce quantity demanded significantly when the price of the good increases.
Time elapsed since price change
The longer the time that has elapsed since the price change, the more elastic demand will
be. For example, if the price of labor goes up, firms may not be able to make radical changes
to their production methods in the short term and therefore, demand for labor will be relatively
inelastic. However, in the long term, if the price of labor remains high, firms may automate
their production process and substitute machinery for labor. In the long run, demand for labor
will be relatively elastic.
Other Elasticities of Demand
Cross Elasticity of Demand
Cross elasticity of demand measures the responsiveness of demand for a particular good to
a change in price of another good.
Substitutes
If the price of Burger King
s burgers were to go up, what would be the effect on demand

for McDonalds
burgers?
For most people, these are close substitutes for each other. An increase in price of Burger
King
s burgers will result in a significant increase in demand for McDonalds
burgers as
consumers switch to the relatively lower priced substitute.
The magnitude of the cross elasticity figure tells us how closely the two products serve as
substitutes for each other. A high value indicates that the products are very close substitutes
i.e., if the price of one rises by only a small amount, demand for the other will rise significantly.
For substitutes, the numerator and denominator of the cross elasticity formula head in the
same direction. Therefore cross elasticity of demand for substitutes is positive.
Complements
If the price of playing a round of golf on a golf course were to rise, what would be the effect
on demand for golf balls?
Since playing a game of golf is impossible without golf balls, these products are complements
for each other. An increase in price of using a golf course will reduce the number of rounds
of golf played, and bring about a decrease in demand for golf balls.
E
C
=
% change in price of substitute or complement
E
C
> 0
substitutes
E
C
< 0
complements
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The absolute value of the cross elasticity figure tells us how closely consumption of the two
products is tied together and how closely they serve as complements for each other. A high
absolute number indicates very close complements. If the price of one rises, consumers will
significantly reduce their demand for the other.
For complements, the numerator and denominator of the cross elasticity formula head in
opposite directions. Therefore, the cross elasticity of demand for complements is negative.
Income Elasticity of Demand
Income elasticity measures the responsiveness of demand for a particular good to a change
in income.
Income elasticity of demand can be positive or negative. Products are classified along the
following lines:
If income elasticity is greater than 1, demand is income elastic and the product is classified
as a normal good.
- As income rises, the percentage increase in demand exceeds the percentage change
in income.
- As income increases, a consumer spends a higher proportion of her income on the
product.
If income elasticity lies between zero and 1, demand is income inelastic, but the product is
still classified as a normal good.
- As income rises, the percentage increase in demand is less than the percentage
increase in income.
- As income increases, a consumer spends a lower proportion of her income on the
product.
If income elasticity is less than zero(negative), the product is classified as an inferior good.
- As income rises, there is a negative change in demand.
- The amount spent on the good decreases as income rises.
Elasticity of Supply
The price elasticity of supply measures the sensitivity of quantity supplied to changes in
price. Typically, supply curves are upward sloping i.e., an increase in price brings about an
increase in quantity supplied.
E
I
=
% change in income
E
I
> 1 Normal
good (income
elastic)
0 < E
I
< 1
Normal good
(income inelastic)
E
I
< 0 Inferior
good
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Factors That Effect Elasticity of Supply
Availability of Substitute Resources
If the raw materials required to produce a good are easily available, or if raw materials can
easily be substituted in the production process, elasticity of supply for the product will be
Figure 2: Inelastic And Elastic Supply
Quantity
S
2c. Perfectly Elastic Supply
Quantity
S
2b. Perfectly Inelastic Supply
Quantity
S
S
2a. Unit Elastic Supply
Elasticity of
supply = 1
Elasticity of
supply =
Elasticity of
supply = 0
Es = 0
0<Es<1
Es = 1
E
s
> 1
Es =
perfectly
inelastic
relatively
inelastic
unit
elastic
relatively
elastic
perfectly
elastic
E
s
=
% change in quantity supplied
% change in price
Values for price elasticity of supply range from zero to infinity.
- If the percentage change in quantity supplied is the same as the percentage change
in price, supply is unit elastic (Figure 2a). Any linear supply curve that passes through
the origin is unit elastic.
- If quantity supplied does not change at all in response to a change in price, the
numerator of the elasticity formula will be zero, and the calculated value of
elasticity of supply will also be zero. The resulting perfectly inelastic supply curve
is illustrated in Figure 2b.
- If quantity supplied changes by an infinitely large percentage in response to even the
slightest change in price, the denominator in the elasticity formula will be very close
to zero (effectively zero), and the calculated value of elasticity of supply will be
infinity. The resulting perfectly elastic supply curve is illustrated in Figure 2c.
- If the value of price elasticity of supply lies between zero and 1, supply is said to be
relatively inelastic.
- If the value of price elasticity of supply is greater than 1, supply is said to be relatively
elastic.
Saif Al Hidabi
ESI D-10813
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Elasticity
2009 Elan Guides
high. It will be easy for producers to respond to an increase in prices by increasing quantity
supplied. However, if the raw material is not readily available and if no substitute raw
materials are available, producers will find it difficult to increase production. Hence, supply
will be relatively inelastic.
Time Frame for Supply Decision
There are three time frames for the supply decision:
1. The momentary supply curve shows the response of quantity supplied immediately
following a price change.
2. The short run supply curve illustrates the response of quantity supplied to a price
change when only some of the technologically possible production advances have
been made (e.g. hiring or laying off labor).
3. The long run supply curve shows the response of quantity supplied to a change in
price after all technological advances in production have been embraced.
With a longer time frame, price elasticity of supply will be higher (more elastic).
LOS 13b: Calculate elasticities on a straight-line demand curve, differentiate
among elastic, inelastic, and unit elastic demand, and describe the relation
between price elasticity of demand and total revenue. Vol 2. pg 13-15
Elasticity Along a Straight Line Demand Curve
A straight line has a constant gradient or slope. However, elasticity differs from a simple
slope calculation because percentage changes are used in calculating elasticity, while slope
calculations use absolute changes in the numerator and denominator. Therefore, even though
a straight line has a constant slope, it does NOT have the same value for elasticity at each
point.
Elasticity of demand changes along a downward sloping straight line demand curve. Price
elasticity equals 1 at the midpoint of the line. At prices higher than the mid-point, demand
is relatively elastic (price elasticity of demand is greater than one) and at prices lower than
the midpoint, demand is relatively inelastic (price elasticity of demand is less than one).
Question
Does elasticity of demand rise or fall as we move down a straight line demand curve?
Answer
Price elasticity decreases as we move down a straight-line demand curve. Do not confuse
the math with the concept of elasticity. Even though calculated price elasticities are
typically negative, the sign is usually ignored. The purpose of calculating price elasticity
is to measure the responsiveness of quantity demanded to changes in price. A high
price elasticity means that quantity demanded is very responsive to changes in price,
and a low elasticity means that quantity demanded is not very responsive to changes in
price. The responsiveness of quantity demanded to changes in price decreases as we
move down a straight line demand curve.
When price elasticity
is greater than one
(relatively elastic),
the numerator
MUST be greater
than the
denominator. If the
denominator changes
by 5%, the numerator
HAS to change by
more than 5%. The
effect of a decrease
in prices will be
outweighed by the
effect of the increase
in quantity
demanded and total
revenue will rise.
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Elasticity
2009 Elan Guides
Total revenues relationship with price depends on price elasticity of demand:
The values in Table 1 are used to construct the demand and total revenue curves in Figure
3.
Table 1: Price, Demand, Total Revenue and Elasticity
- If the price cut increases total revenue, demand is relatively elastic.
- If the price cut decreases total revenue, demand is relatively inelastic.
- If the price cut does not change total revenue, demand is unit elastic.
The total revenue test method gauges price elasticity by looking at the direction of the change
in total revenue in response to a change in price:
- If demand is relatively elastic (elasticity greater than 1), a 5 percent decrease in price
will result in an increase in quantity demanded of more than 5 percent. Therefore,
total revenue will increase.
- If demand is relatively inelastic (elasticity less than 1), a 5 percent decrease in price
will result in an increase in quantity demanded of less than 5 percent. Therefore,
total revenue will decrease.
- If demand is unit elastic, a 5 percent decrease in price will result in an increase
in quantity demanded of exactly 5 percent. Therefore, total revenue will not
change.
Total Revenue and Price Elasticity
Now that we have established that price elasticity changes along the demand curve lets look
into how total revenue changes as prices fluctuate.
Total revenue equals price times quantity sold. If prices are reduced to stimulate sales, total
revenue will only increase if the percentage increase in demand (sales) is greater than the
percentage decrease in prices.
Price
$
1
2
3
4
5
6
7
8
9
10
Quantity
units
50
45
40
35
30
25
20
15
10
5
Total Revenue
$
50
90
120
140
150
150
140
120
90
50
Elasticity
-0.16
-0.29
-0.47
-0.69
-1
-1.44
-2.14
-3.4
-6.33
|Ep|=1
|Ep|<1
|Ep|>1
TR remains
the same
regardless of
the direction
of change in
price
If P, TR
If P, TR
If P, TR
If P, TR
TR is maximized
when |Ep|=1
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Figure 3: Elasticity and Total Revenue
175
150
125
100
75
50
25
0
0 10 20 30 40 50
10
9
8
7
6
5
4
3
2
1
0
Quantity
Quantity
0 10 20 30 40 50
Price elasticity of
demand > 1
Price elasticity of
demand < 1
Elasticity in the $7 to $8 range
= [(20-15)/17.5]/[(7-8)/7.5] = -2.14
= [(40-35)/37.5]/[(3-4)/3.5] = -0.47
= [(30-25)/27.5]/[(5-6)/5.5] = -1
A decrease in price
results in a decrease in
total revenue.
A decrease in price
results in an increase in
total revenue.
Price and total
revenue are
negatively
related.
Price and total
revenue are
positively
related.
At the point where
total revenue is
maximized, price
elasticity of
demand equals 1
(demand is unit
elastic).
Unit elastic
Sai f Al Hidabi
ESI D-10813
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Elasticity
2009 Elan Guides
Total Expenditure and Price Elasticity
Looking at things from a consumers perspective, the change in the total amount of money
spent on a good depends on her price elasticity of demand (her ability to respond to a price
change).
- If her demand for a good is relatively elastic, an increase in price will decrease her
total expenditure on the good.
- If her demand for a good is relatively inelastic, an increase in price will increase her
total expenditure on the good.
- If her demand for a good is unit elastic, an increase in price will not change her total
expenditure on the good.
Exhibit 1: A Summary of Elasticities
When its magnitude is
Infinity
Less than infinity
but greater than 1
1
Greater than 0
but less than 1
0
A relationship is described as
Perfectly elastic
Elastic
Unit elastic
Inelastic
Perfectly inelastic
Which means that
The smallest possible increase is price causes an infinitely
large decrease in quantity demanded.
The percentage decrease in quantity demanded exceeds
the percentage increase in price.
The percentage decrease in the quantity demanded equals
the percentage increase in price.
The percentage decrease in quantity demanded is less
than the percentage increase in price.
The quantity demanded is the same at all prices.
Price Elasticities of Demand
Cross Elasticities of Demand
Close substitutes
Substitutes
Unrelated goods
Complements
When its value is
Infinity
Positive, less than infinity
0
Less than 0
Which means that
The smallest possible increase in price of one good
causes a very large increase in quantity demanded of
the other good.
If the price of one good increases, the quantity demanded
of the other good also increases.
of the other good remains the same.
of the other good decreases.
Income Elasticities of Demand
Income elastic
(normal good)
Income inelastic
(normal good)
Negative income elastic
(inferior good)
When its value is
Greater than 1
Less than 1
but greater than 0
Less than 0
Which means that
The percentage increase in the quantity demanded is
greater than the percentage increase in income.
The percentage increase in the quantity demanded is
less than the percentage increase in income.
When income increases, quantity demanded decreases.
Elasticities of Supply
Perfectly elastic
Inelastic
Perfectly inelastic
When its magnitude is
Infinity
Greater than 0
but less than 1
0
Which means that
The smallest possible increase is price causes an infinitely
large increase in quantity supplied.
The percentage increase in quantity supplied is less than
the percentage increase in price
The quantity supplied is the same at all prices
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Elasticity
2009 Elan Guides
13
Efficiency and Equity
2009 Elan Guides
EFFICIENCY AND EQUITY
The central question in this reading is whether the market attains an efficient and fair use
of resources.
Allocative efficiency is reached when the limited resources of an economy are allocated in
accordance with the wishes of all stakeholders in the economy, including consumers. An
allocatively efficient economy produces an optimal mix of products. It produces the right
goods for the right people at the right price. An allocatively efficient market is therefore one
that has no imperfections.
LOS 14a: Explain the various means of markets to allocate resources, describe
marginal benefit and marginal cost, and demonstrate why the efficient quantity
occurs when marginal benefit equals marginal cost. Vol 2. pg 38-40
Resource Allocation Methods
The basic economic problem is scarcity i.e., there are unlimited wants and only limited
resources to satisfy them. This means that resources have to be allocated to competing uses
through some allocation method. We describe different allocation methods below:
Market price allocates scarce resources to individuals who have the willingness and the
ability to pay for the resource. This method works in most situations except when prohibitive
market prices preclude less-privileged individuals from consuming items that are considered
necessities (e.g. education and healthcare). In these cases, resources are usually allocated
using one of the other allocation methods.
Command: Scarce resources are allocated by an authority through commands and orders.
For example, employees are allocated to various tasks within a firm based on the bosss
orders. Such a system works well when:
- A clear hierarchy is in place.
- The performance of workers can be monitored easily.
Majority rule: Resources are allocated by the decisions of the majority. For example,
democratically elected representative governments determine how tax revenue as a resource
should be allocated between defense, education and other expenditures. Such a system works
well when:
- The choices made will affect a large number of people.
- The benefit that accrues to the society through effective allocation takes precedence
over self-interest.
Contest: Resources are allocated to the winner. For example, when a manager offers his
subordinates a promotion incentive, employees allocate resources (their hours of labor) in
a manner that maximizes their output. Such a system works well when:
- Performance of individual workers is not easy to monitor.
- It is hard to reward workers directly.
First come, first-served: Resources are allocated sequentially, with the first individual in line
getting the resource first. Restaurants seat customers on this basis. This system works well
when the scarce resource can be used over and over again, but only by one user at a time.
Saif Al Hi dabi
ESI D-10813
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2009 Elan Guides
Figure 1: Individual and Market Demand Curves
Quantity
15
10
5
0
0 10 20 30 40 50
1b. Lauras Demand
Laura is willing
to pay $5 for the
5th bottle.
D = MB
Quantity
15
10
5
0
0 10 20 30 40 50
1a. Alans Demand
Alan is willing
to pay $5 for
the 15th bottle.
D = MB
Quantity
15
10
5
0
0 10 20 30 40 50
1c. Market Demand
The society is
willing to pay $5
for the 20th
bottle.
D = MSB
Laura and Alan are the only two consumers in the market for soda bottles. The horizontal summation of their individual
demand (MB) curves is the market demand curve, which is also called the marginal social benefit (MSB) curve.
The demand curve
illustrates your
ability and
willingness to buy a
good or service at
various prices.
LOS 14a:
Explain
marginal benefit
Lottery: A scarce resource is allocated to the individual who holds the winning number.
Rooms in a college dorm are allocated in this manner. Such a system works well when it is
not possible to differentiate between users of the scarce resource.
Personal characteristics: Resources are allocated after taking into account personal
characteristics. The best example is of choosing a marriage partner, where the choice is based
on personal preferences.
Force: Force can be used in a constructive or an unconstructive manner. An example of the
former is the legal authority given to the justice system of a country to protect private property
rights and enforce contracts. An example of the latter is war, when one country forces the
other to allocate resources in a certain manner.
LOS 14b: Distinguish between the price and the value of a product and
explain the demand curve and consumer surplus. Vol 2, pg 41-43
The utility derived from consumption of the last unit of a good or service is known as its
marginal benefit (MB). Consumers express how much utility they derive from consuming
an extra unit of a good or service through the price they are willing to pay for it. If a bottle
of soda gets Akshay $5 worth of utility, he will only be willing to pay $5 for it. In other
words, the marginal benefit curve is the demand curve where the benefit or utility that we
derive from the good is quantified by the maximum price we are willing and able to pay for
it. Marginal benefit is downward sloping because the utility derived from consumption of
the next unit will be lower than the utility derived from consumption of the last unit (law
of diminishing marginal utility), and therefore consumers will be willing to pay a lower price
for each additional unit of a given product.
The market demand curve (which represents the marginal benefit curve for all buyers) is the
horizontal summation of individual demand curves (which illustrate the marginal benefit of
consuming different quantities for each individual). See Figure 1.
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2009 Elan Guides
We are measuring utility here in terms of the price consumers are willing and able to pay
for each soda bottle (in dollars). Alternatively, prices reflect the value of other goods and
services that consumers are willing to forgo consumption of in order to consume one more
bottle of soda.
Consumer Surplus
Consumer surplus occurs when a consumer is able to purchase a good or service for less than
the maximum she is willing and able to pay for it. It equals the difference between the price
that consumers are willing and able to pay for a good (indicated by the demand curve) and
what they actually pay for the good (the market price).
Figure 2a shows Alans consumer surplus from consuming bottles of soda at a price of $5/
bottle. At the market price of $5, he purchases 15 bottles and his marginal benefit from
consuming the 15th unit is the same as the market price. Notice that Alan is willing and able
to pay $7.50 for the 10th bottle, but only pays $5 (the market price) for it. This implies that
his marginal benefit from consuming the tenth unit exceeds its price by $2.50. This is Alans
consumer surplus on the 10th unit. His total consumer surplus is the sum of all the surpluses
that he incurs from the consumption of each bottle of soda. Therefore, his total consumer
surplus, is the area of the triangle between his demand curve, the vertical axis and the market
price. The sum of Alan (Fig. 2a) and Lauras (Fig. 2b) consumer surplus equals total consumer
surplus (Fig. 2c).
Figure 2: Demand and Consumer Surplus
Quantity
15
10
5
0
0 10 20 30 40 50
2a. Alans Consumer Surplus
Alans consumer surplus
= 0.5 ($12.5 - $5) 15
= $56.25
D = MB
Market price
Quantity
15
10
5
0
0 10 20 30 40 50
2b. Lauras Consumer Surplus
D = MB
Market price
Lauras consumer surplus
= 0.5 ($7.5 - $5) 5
= $6.25
Quantity
15
10
5
0
0 10 20 30 40 50
2c. Total Consumer Surplus
D = MSB
Market price
Total consumer surplus
= $56.25 + $6.25
= $62.50
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2009 Elan Guides
LOS 14c: Distinguish between the cost and the price of a product and explain
the supply curve and producer surplus. Vol 2, pg 43-45
Before making a purchasing decision, consumers compare the price of a product to the benefit
or utility that they derive from it. Producers compare the price they will receive for a good
to the cost of producing it in determining whether to produce it. The cost of producing one
more unit of output is known as the marginal cost (MC). Suppliers will only be willing to
produce another unit of a product when the price that they receive for the unit exceeds the
marginal cost of producing it. An individual firms supply curve illustrates its willingness
and ability to produce a good at various prices. Therefore, an individual firms supply curve
is its marginal cost curve. The market supply curve is the horizontal summation of each
individual firms marginal cost curve.
LOS 14a:
Explain
marginal cost.
Vol 2, pg 41
Figure 3: Individual Supply, Market Supply, And Marginal Social Cost
Ryans MC of producing the 20th bottle of soda is $7.50. Therefore, he will only be willing to produce the 20th bottle if
the market price is at least $7.50. Assuming that Ryan and Michelle are the only producers in this industry, the market supply
(MSC) curve is the horizontal summation of their individual MC curves.
Quantity
15
10
5
0
0 10 20 30 40 50
3a. Ryans Supply
S = MC
20 bottles
Ryan is willing to
supply the 20th
bottle for $7.50
Quantity
15
10
5
0
3b. Michelles Supply
S = MC
0 10 20 30 40 50
10 bottles
Michelle is
willing to
supply the 10th
bottle for $7.50
Quantity
15
10
5
0
0 20 40 60 80 100
3c. Market Supply
S = MSC
20 + 10 =
30 bottles
Society is willing to
supply the 30th
bottle for $7.50
Saif Al Hidabi
ESI D-10813
17
2009 Elan Guides
Now we are measuring costs in terms of the value of other goods and services (in dollars)
that society is willing to forgo the production of in order to produce one more bottle of soda.
As more and more of the same unit is produced, the (opportunity) cost of not producing
other items increases.
Producer Surplus
Producer surplus occurs when a supplier is able to sell a good or service for more than the
price that she is willing and able to sell it for. It equals the difference between the market
price and the price at which producers are willing and able to sell their product (indicated
by the supply curve). At a market price of $7.50, Ryan produces 20 bottles because the
marginal cost of producing the 20th bottle equals market price (Figure 3a). Notice that Ryan
is willing to sell the 10th bottle for only $5, but due to the existence of a standard market
price, he will actually get $7.50 for it. This excess of price over MC of the 10th unit is Ryans
producer surplus from producing the 10th bottle. Ryans total producer surplus is the sum
of the individual surpluses that he earns from selling each bottle. Therefore, his total producer
surplus is the area of the triangle between his supply curve, the vertical axis and market
price. The sum of Ryans (Fig. 4a) and Michelles (Fig. 4b) producer surplus equals total
producer surplus (Fig. 4c).
Figure 4: Supply And Producer Surplus
Quantity
15
10
5
0
0 10 20 30 40 50
4a. Ryans Producer Surplus
S = MC
Market price
Ryans producer surplus
= 0.5 ($7.5 - $2.5) 20
= $50
Quantity
15
10
5
0
0 10 20 30 40 50
4b. Michelles Producer Surplus
S = MC
Market price
Michelles producer surplus
= 0.5 ($7.5 - $5) 10
= $12.50
Quantity
15
10
5
0
0 20 40 60 80 100
4c. Total Producer Surplus
S = MSC
Market price
Total producer surplus
= $50 + $12.50
= $62.50
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2009 Elan Guides
LOS 14d: Discuss the relationship between consumer surplus, producer
surplus, and equilibrium. Vol 2, pg 45-46
We have seen that individual demand and supply curves are also the marginal benefit (MB)
and marginal cost (MC) curves respectively. Further, a societys demand and supply curves
for a good are the marginal social benefit (MSB) and marginal social cost (MSC) curves
respectively. The point at which the demand and supply curves (the MSB and MSC curves)
intersect determines the competitive market equilibrium position at which resources are
being used efficiently by society. Notice that this is also the point at which the sum of
consumer surplus and producer surplus is maximized. Figure 5 shows a societys demand
and supply curves for bottles of soda. The equilibrium price is $2/bottle and the allocatively
efficient quantity is 100 bottles.
Figure 5: Allocative Efficiency
Quantity
0 50 100 150 200
4
3
2
1
0
D > S = Shortage S > D = Surplus
S = MSC
D = MSB
Market price
e
MSB
exceeds
MSC
MSC
exceeds
MSB
At Point e the market supply and demand
curves intersect. This is the allocatively
efficient outcome for society because:
1. Marginal social cost equals marginal
social benefit.
2. The sum of consumer surplus and
producer surplus is maximized ($200).
a. CS = 0.5 ($4 - $2) 100 = $100
b. PS = 0.5 ($2 - $0) 100 = $100
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2009 Elan Guides
Figure 6 also illustrates a situation where 150 bottles of soda are being supplied. The 150
th
bottle of soda costs $3 to produce, but consumers are only willing to pay $1 for it. The
marginal bottle of soda costs more than the value consumers place on it. There is inefficiency
as too many soda bottles are being produced i.e., the opportunity cost of producing soda
bottles is too high. The resulting deadweight loss from overproduction is the area shaded in
grey in Figure 6.
Quantity supplied exceeds quantity demanded when 150 units are produced. This surplus
would push down prices. Quantity supplied would fall while quantity demanded would rise.
The competitive market will move towards equilibrium where resources would be allocated
efficiently to produce 100 units at a price of $2/unit.
LOS 14e: Explain 1) how efficient markets ensure optimal resource utilization
and 2) the obstacles to efficiency and the resulting underproduction or
overproduction, including the concept of deadweight loss. Vol 2, pg 45-50
If actual production of sodas is at any level other than equilibrium (100 units), resources are
being used inefficiently. Figure 6 shows the efficient quantity as 100 bottles. Lets examine
a situation where only 50 bottles of soda are being supplied. At this point consumers are
willing to pay $3 for the 50
th
bottle of soda, which is produced at a cost of $1. The marginal
benefit of consuming the 50th unit is greater than the opportunity cost of producing it.
Limiting total output to 50 units results in a reduction in the sum of consumer and producer
surplus. This combined reduction in consumer and producer surplus is known as a deadweight
loss, which is borne by society as a whole. The deadweight loss from underproduction is
the region shaded in green in Figure 6.
However, markets usually tend to readjust to restore allocative efficiency. If the society
produces less than 100 bottles, quantity demanded will exceed quantity supplied. The shortage
of soda bottles would push up prices. Quantity demanded would fall while quantity supplied
would rise. This process will continue until equilibrium price and quantity are established
at $2/unit and 100 units respectively.
Deadweight loss from
overproduction.
Figure 6: Deadweight Losses
Quantity
0 50 100 150 200
4
3
2
1
0
S = MSC
D = MB
Market price
Deadweight loss from
underproduction.
Saif Al Hi dabi
ESI D-108 13
The market dynamics that we have just illustrated are an example of what Adam Smith called
the invisible hand. Smith believed that each participant in a competitive market is led by
an invisible hand to promote an end (the efficient utilization of scarce resources) which was
not part of his intention.
Obstacles to Efficiency
Although competitive markets usually allocate resources efficiently, there are situations
where deviations from the efficient quantity occur, and markets underproduce or overproduce
a good or a service.
Price ceilings and price floors: A price ceiling is a government regulation that prohibits
producers from charging a price above a specified level. Rent control is an example of a
price ceiling. A price floor is a government regulation that prohibits individuals from paying
a price below a specified level. Minimum wage is an example of a price floor. Such price
controls distort the free market mechanism and may result in outcomes that deviate from
those expected from an efficient competitive market. The impact of these regulations is
discussed in greater detail in the next reading.
Taxes, subsidies, and quotas: Taxes increase the price paid by buyers and reduce the price
received by sellers. Subsidies increase the price received by sellers and decrease the price
paid by buyers. Quotas are government-imposed physical limits on maximum production
of a good. They usually result in production below efficient levels. The impact of these
regulations is also discussed in greater detail in the next reading.
Monopoly: A monopoly is a market structure where one firm controls all, or nearly all of the
market of a good, for which no close substitute exists. Monopolies aim to maximize profits
and achieve this goal by increasing prices and producing less than the efficient quantity of
output. Monopolies are discussed in greater detail in Reading 19.
External costs and external benefits: An external cost is the cost that is borne by a third-party
in the production process. A factory that dumps industrial waste in a nearby river provides
an example of an external cost because all citizens in the region suffer from greater pollution.
A producers supply curve (MC curve) only takes into account its explicit production costs;
not external costs. Therefore, she produces more than the socially efficient quantity of the
good. In contrast, an external benefit is the benefit that accrues to a third-party in the
consumption process. An individual who develops a garden outside her house provides an
example of external benefits. Her demand curve (MB curve) only takes into account the
benefit that accrues to her directly, not the benefit that accrues to other residents of the area.
As a result, the quantity produced is less than the socially efficient quantity.
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2009 Elan Guides
Public goods and common resources: Public goods and services are goods that are non-
rivalrous and non-excludable. Non-rivalrous means that consumption of the good by one
person does not reduce the amount that is available for consumption by others. Non-excludable
implies that once the good has been provided, it is not possible to exclude anyone from
consuming it. The non-excludable characteristic of public goods gives rise to the free-rider
problem i.e., a person can benefit from consuming a public good without paying for it.
Because of these characteristics, competitive markets will produce less than the efficient
quantity of public goods. National defense and street-lighting are examples of public goods.
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2009 Elan Guides
LOS 14f: Explain the two groups of ideas about the fairness principle
(utilitarianism and the symmetry principle) and discuss the relation between
fairness and efficiency. Vol 2, pg 51-55
We have determined that in most scenarios, competitive markets ensure efficient allocation
of resources. However, is this allocation also fair? Two different schools of thought have
different criteria for fairness:
1. It is not fair if the results are not fair.
2. It is not fair if the rules are not fair.
According to the first criterion, resource allocation is not fair if the outcome is unfair. If
individual incomes are too polarized then the allocation of money is not fair. From this
general idea stems the concept of utilitarianism, which says that the maximum benefit
accrues to the maximum number of people when wealth is transferred from the rich to the
poor, until absolute equality is achieved. For example, if participants in an economy earn a
total of $100 in income and there are 10 people, utilitarianism asserts that each person should
get $10.
The reasons behind this philosophy are that:
- Everybody has the same basic wants and has the same capacity to enjoy life.
- The increase in marginal benefit from a dollar that is given to a poor person from
the transfer of wealth is greater than the reduction in marginal benefit to a rich person.
Because the gain in marginal benefit (to the poor person) is greater than the loss in
marginal benefit (to the rich person), society is better off after the transfer.
The utilitarianism argument has inherent weaknesses. Wealth is transferred from the rich to
the poor through progressive taxes, where the rich pay a higher proportion of their incomes
in taxes. High income taxes result in a disincentive to work so less labor is supplied in the
economy. Further, taxes on capital income reduce savings, which results in a lower than
efficient quantity of capital being produced. The reduction in the quantity of labor and capital
reduces the total size of the economy.
Common resources are resources that are not owned by anyone and therefore, can be used
freely by everyone. Fish in the ocean are an example of such a resource. If unrestricted
fishing were allowed, pursuit of self-interest in competitive markets would result in overfishing
or overproduction (also known as tragedy of the commons). This is not the socially optimal
outcome because ideally, fishing should be limited in order to ensure long term supply.
High transaction costs: Transaction costs represent the opportunity costs of making trades
in a market. To use market price as the allocator of scarce resources, it must be worth bearing
the opportunity cost of establishing a market. Some markets are just too costly to operate.
When transaction costs are high, the market will usually underproduce.
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2009 Elan Guides
The second source of inefficiency associated with wealth transfers are the administrative
costs involved. Administrative costs include the costs of collecting taxes and the costs
incurred by taxpayers to get their returns audited. These activities require significant time
and effort and the resources devoted to these functions could have been employed to produce
goods and services that people value.
According to the second criterion of fairness, resource allocation is not fair if the rules are
unfair. This is called the symmetry principle, which says that people in similar situations
should be treated similarly. In economic terms, it implies equality of opportunity. This idea
is also backed by Robert Nozick in his book Anarchy, State, and Utopia (1974). He argues
that fair resource allocation requires fair rules, not results. According to him, fairness requires
that:
- The government must establish and protect private property rights.
- Private property can be transferred between individuals only through voluntary
exchange.
If these rules are followed, the results would be fair. An unequal distribution of income in
the economy will be tolerable as long as everyone has an equal opportunity to earn a higher
income through hard work and perseverance. Basically, every individual should have an
equal opportunity to succeed.
The symmetry principal advocates that everything that holds value in society should be
owned by individuals and it is the governments responsibility to protect private property
by enforcing relevant laws. The only way an individual can acquire property from someone
else is by exchanging it for something he owns that is desirable to the seller. At the end of
the day, individuals can get goods and services from the economy that are equal in value to
their contribution to the economy.
Saif Al Hidabi
ESI D-10813
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2009 Elan Guides
LOS 15a: Explain market equilibrium, distinguish between long-term and
short-term effects of outside shocks, and describe the effects of rent ceilings
on the existence of black markets in the housing sector and on the markets
efficiency. Vol 2, pg 66-72
Equilibrium occurs at the point where market demand equals market supply. Outside shocks
may shift demand or supply, forcing the market towards a new equilibrium. In this reading
our purpose is to analyze the effects of outside shocks on markets, and study whether the
governments response to these shocks results in more desirable outcomes.
The Housing Market
The short run supply curve (SRS) for housing shows the change in quantity of housing units
available for rent as rental rates (prices) change, given that the total number of housing units
remains constant.
The long run supply curve (LRS) on the other hand, shows the change in quantity of housing
units available for rent as rental rates change, given there is enough time for new units to
be built or for existing ones to be brought down. The long run supply curve is perfectly
elastic because the marginal cost of building new homes is relatively constant and does not
vary with the number of homes already in existence. Housing developers will build more
units as long as rental rates exceed the marginal cost of building houses. Therefore, long run
supply is perfectly elastic at the rental rate that equals marginal cost.
Outside shocks can temporarily interrupt the supply of goods and services, resulting in a
decrease in supply. An example of an outside shock to the housing market is the occurrence
of a devastating flood that destroys several thousands of homes in a city. People become
homeless overnight and the short run supply of housing falls (shifts to the left from SRS0
to SRS
1
in Figure 1a). The shift in supply breaks initial equilibrium of e
0
and brings the
market to a new equilibrium of e1 where prices are higher, p1, and quantity lower, q1.
At these higher prices there is an incentive for developers to erect more housing units because
market price p
1
exceeds the marginal cost (MC) of building housing units. Therefore,
developers construct more housing units, and over the long run, supply increases (shifts to
the right) gradually back to SRS0 (Figure 1b), restoring initial equilibrium (e0).
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2009 Elan Guides
The key to the LR adjustment was the rise in prices (rents), which made it profitable for
builders to construct more housing units, and brought about the increase in supply.
If the government were to enforce a maximum price, or a rent ceiling on housing, it would
prevent the markets self-adjusting mechanism from functioning. Suppose the government
were to cap rental rates at $20 per unit per month (Figure 2). In this situation, quantity
supplied (60) will be lower than quantity demanded (70). Society will suffer a shortage of
10 units and the following undesirable developments might occur:
Figure 1: SR and LR Effects of Outside Shocks on the Housing Market.
Housing Units
e1
e0
q0 q1
20, p0
25, p1
D0
SRS1
SRS0
LRS = MC
1a. Immediately After Flood
1b. Long Run Adjustment
e0
q0 q1
20, p0
25, p
1
D0
SRS1
SRS0
LRS = MC
Housing Units
Step 2: Prices rise in SR
due to housing shortage.
Step 1: Supply shock- Short run
reduction in supply due to flood
LR supply is perfectly elastic at
the MC of building new housing
units.
Step 3: As rents rise to p1,
quantity demanded falls to q1.
Step 4: At e
1
, market price
is greater than the MC of
building new homes
(LRS). Therefore, housing
developers will build
more units and supply will
move back up to initial
levels (SRS0). Initial
equilibrium will be
restored where price
equals MC of building
new homes.
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2009 Elan Guides
Search activity: People would spend a lot of time, energy, and fuel trying to be the first ones
at the scene of any housing availability. These resources could have been put to some better,
more productive use. Rent ceilings control the explicit rental portion of costs, but do not
control the opportunity costs, which might be higher than the difference in rental rates were
the market unregulated.
Black markets: Housing providers know that there are people willing to pay more than the
ceiling price for a housing unit, but they cannot legally charge them a higher rent. Therefore,
they look for other ways of indirectly increasing rents (e.g. by charging higher rates for other
services, key money, etc.).
Were the rent ceiling of $20 not imposed, market prices would simply rise to $25 (as illustrated
in Figure 1) and allocative efficiency would be reached because:
- The sum of consumer surplus (CS) and producer surplus (PS) would be maximized
at e0.
- Marginal cost (MC) to society would equal marginal benefit (MB) to society at e
0
.
(Demand = Supply)
With the rent ceiling in place however, there is no activity in the market beyond 60 units.
Consumers are better off in the sense that they have to pay $20 instead of $25, but also lose
out because they only get 60 housing units instead of 65. Producers are worse off because
of lower realized prices and lower quantities sold. The loss to consumers and producers is
the dead weight loss (DWL) borne by the society. Allocative efficiency is not reached because:
- The sum of CS and PS is not maximized
- MC does not equal MB. At the ceiling price of $20, MB (demand) exceeds MC
(supply).
Okay, so ceilings are allocatively inefficient. But, are they fair?
According to the fair rules view (symmetry principle) anything that hinders voluntary
exchange in unfair, so rent ceilings are unfair. According to the fair results view (utilitarian
principle) fairness would be achieved were housing units allocated to the poorest members
of society. In practice, we cannot be sure that this will be the case. Most probably, the available
units will be allocated on either first-come, first-served basis, through a lottery, or on the
basis of ones contacts.
The bottom line is that although it sounds like capping rents on housing is a noble idea, it
fails to achieve fairness and efficiency, and prevents the housing market from operating in
social interest.
The rent ceiling only
disrupts market
equilibrium if set
below equilibrium
market prices. If the
ceiling were set
above equilibrium
price it would have
absolutely no effect
on economic activity.
Saif Al Hi dabi
ESI D-108 13
26
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2009 Elan Guides
LOS 15b: Describe labor market equilibrium and explain the effects and
inefficiencies of a minimum wage above the equilibrium wage.Vol 2, pg 72-77
The Labor Market
The short run supply (SRS) curve for unskilled labor shows the change in labor quantity
supplied as the wage rate changes. In order to increase the supply of unskilled labor, a higher
wage must be offered.
In the long run, people can leave the unskilled labor market, go back to school or acquire
new skills that will enable them to enter a higher wage bracket. If unskilled labor wages are
high enough, others will join the unskilled labor force. The long run supply of labor is the
Figure 2: Effects of a Rent Ceiling
Quantity
S
D
20
25
30
e
b
c
d
a
qd
70
qs
60
Rent ceiling = $20
qd > qs
Housing shortage
If the market were left on its own to self-adjust, an
allocatively efficient outcome would be reached:
1. MB=MC at Point e.
2. Sum of CS and PS is maximized.
If Rents were Allowed to Rise to $25
Consumer
Surplus
25
a
e
Producer
Surplus
d
e
25
With Rents Capped at $20
20
a
b
c
Consumer
Surplus
20
d
c
Producer
Surplus
e
c
DWL
b
With a rent ceiling in place
below equilibrium price,
society suffers a dead weight
loss from underproduction.
For a housing supply
of 60 units some
people are willing to
pay a black market
price as high as $30
There is no activity in the market
beyond 60 units once the ceiling
is imposed.
Price that would
exist were markets
allowed to self-
adjust.
Area between y-axis,
demand curve and price
Area between y-axis,
supply curve and price
Consumers now pay a
lower price of $20, but
suffer because of a
lower equilibrium
quantity. Consumer
surplus does not
extend beyond 60
units.
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2009 Elan Guides
relationship between the quantity of labor supplied and the wage rate after enough time has
elapsed to allow people to enter or leave the labor market. If there are no barriers to entry
or exit in the unskilled labor market, the long run supply of labor will be perfectly elastic.
An example of an outside shock to the labor market is a sudden influx of immigrants who
enter the unskilled labor market and increase (shift to the right from S0 to S1) the supply of
unskilled labor. This development will disrupt initial equilibrium, e0, reduce prices to P1 and
set up a new equilibrium at e1 with a higher quantity of labor employed, Q1. (Figure 3a)
The reduction in wages is an undesirable outcome for most people, so over the long run
people would spend time and resources retraining themselves for better (high-paying)
employment opportunities. This would decrease the supply of unskilled labor in the economy
(supply would shift back towards S0) and gradually prop wages back up to the initial level
of P0, which lies on the long run supply (LRS) curve. (Figure 3b)
The key to the long run adjustment towards equilibrium was the decrease in wages, which
spurred some labor force participants to leave the unskilled labor market and acquire new
skills in search of a better wage.
Figure 3: SR and LR Effects on Increase in Supply of Labor
Quantity of Labor
e1
e0
Q0 Q1
10, P0
8, P1
D0
S1
S0
LRS
3a. Immediately After Influx of Immigrants
3b. Long-Run Adjustment
Quantity of Labor
e1
e0
Q0 Q
1
10 P0
8 P1
D0
S1
S0
LRS
Step 2: The increase in
supply brings down wages.
Step 1: Outside shock- A sudden
influx of immigrants increases
short run supply of unskilled
labor.
Step 3: Equilibrium
quantity of labor increases.
Step 4: Low wage rates (P1)
force some workers to leave
the unskilled labor market
and acquire new skills to get
a higher-paying job. The exit
of these individuals reduces
supply and increases wages
back up to original levels (P0).
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If the government were to set a minimum wage at $10 when equilibrium wage rates stand
at $8, it would prevent the markets self-adjusting mechanism from playing out (see Figure
4). At a wage rate of $10, the quantity of labor supplied (40) would exceed quantity demanded
(20). People would spend valuable time and resources looking for work, especially as every
hour of labor would fetch $10 (enforced minimum wage) when they are willing to supply
that hour of labor for only $6 (supply curve).
Were the minimum wage of $10 not imposed, wages would simply fall to $8 due to excess
supply and allocative efficiency would be reached because:
- The sum of consumer and producer surplus would then be maximized (e
0
).
- Marginal cost to society would equal marginal benefit to society (demand would
equal supply).
With the minimum wage in place however, there is no activity in the market beyond 20 units.
Workers are better off in a sense because they receive $10 in wages instead of $8, but also
lose out because only 20 units of labor are employed instead of 30. Firms are worse off
because they have to pay higher wages ($10 instead of $8) and employ less units of labor
than they would ideally like to (At a wage rate of $8, firms would hire 30 units of labor).
Society suffers a dead weight loss and allocative efficiency is not reached because:
- The sum of CS and PS is not maximized.
- MC does not equal MB. At 20 units, MC (supply) exceeds MB (demand).
The minimum wage
only disrupts market
activity if set above
the equilibrium wage
rate. If the minimum
wage is set below the
equilibrium wage
rate it would have
absolutely no effect
Figure 4: The Inefficiency Of A Minimum Wage
Quantity of Labor
S
D
6
8
10
e
b
c
d
qd
20
qs
40
Minimum Wage = $10
qe
30
a
Wage rate that the
20 units that find
employment earn.
Wage rate that the
20 employed units
of labor were
willing to work for.
At a wage rate of $10:
qs > qd => Surplus / Excess Supply
Saif Al Hidabi
ESI D-10813
29
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LOS 15c: Explain the impact of taxes on supply, demand, and market
equilibrium, and describe tax incidence and its relation to demand and supply
elasticity. Vol 2, pg 77-85
The statutory incidence of a tax refers to whom the law levies the tax upon. As we shall learn
soon, just because the government imposes or levies a tax on a particular group does not
necessarily mean that the actual incidence of the tax falls entirely on that group. Actual tax
incidence refers to how the burden of the tax is shared by consumers and producers in terms
of a reduction in consumer and producer surplus respectively.
Lets start with an example in which a tax per-unit of $3 is levied on suppliers (Figure 5).
The tax increases cost of production and as a result, supply falls (shifts to the left to S1).
Consequently, prices rise to $6 and equilibrium quantity falls to 425 units.
The area of the rectangle shaded in green represents government revenue from tax collection.
The government earns $3/unit on 425 units that are sold. Consumers purchase 425 units and
pay $6/unit. Effectively prices paid by consumers have gone up by $2 ($6 - $4). Producers
sell 425 units at $6/unit but only pocket $3/unit after paying the tax. Effectively, their realized
prices have fallen by $1 ($4 - $3).
If the market were left to self-adjust, an allocatively
efficient outcome would be reached:
1. MB = MC at Point e.
2. Sum of CS and PS is maximized.
If Wages were Allowed to Fall to $8
8 e
a
Consumer
Surplus
8 e
d
Producer
Surplus
With Minimum Wage Fixed at $10
10 b
c
d
Producer
Surplus
DWL
e
b
c
10 b
a
Consumer
Surplus
With a minimum wage in place
above equilibrium levels, society
suffers a dead weight loss from
underproduction.
Area between the
y-axis, demand
curve and
equilibrium wage
rate ($8)
Area between the
y-axis, supply
curve and
equilibrium wage
rate ($8)
Area between the y-axis,
demand curve and minimum
wage rate ($10)
Area between the y-axis,
supply curve and minimum
wage rate. Suppliers benefit
from higher prices, but suffer
from being unable to sell
more than 20 units. The
producer surplus does not
extend beyond 20 units.
Despite the fact that price floors in the labor market cause unemployment and give rise to
deadweight losses, a popular movement is seeking to create a higher floor at a living wage.
A living wage is the hourly wage rate that enables a person to rent adequate housing for not
more than 30 percent of the amount earned.
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Even though this tax was levied on suppliers only, consumers end up bearing the brunt of
the tax in the form of an effective increase in prices of $2, versus an effective decrease in
producer realized prices of only $1. The government earns $3/unit in tax revenue, but notice
that the increase in government tax revenue from the imposition of the tax does not entirely
offset the reduction in consumer and producer surplus. The triangle shaded in grey represents
the dead weight loss to society from underproduction caused by the imposition of the tax.
Figure 5 : Tax on Sellers
Allocative efficiency is reached because:
a. MB=MC and demand = supply.
b. Sum of consumer and producer surplus is
maximized.
a
4 e
6 b
3 c
d
4 e
6
b
a
3
d
c
4 f
6
b
There is a dead weight loss because there
is no activity in the market beyond 425
units. The dead weight loss to society
from underproduction equals the
reduction in consumer and producer
surplus that is not offset by government
tax revenue.
e
c
b
3 c
4 f
After the Tax is Imposed Before the Tax is Imposed
S0
S1
D0
$3/unit tax
3
6
4 e
b
c
f
a
Quantity 425 450
d
Price paid
by consumers.
Price received
by producers net
of tax.
A tax of $3/unit on producers reduces supply.
Consumers surplus is
the area of the triangle
between the demand
curve, y-axis and market
price ($4).
Producer surplus is the
area of the triangle
between the supply
curve, y-axis and market
price ($4).
Consumers pay $6/unit
for 425 units.
Producers receive $6-$3
= $3/unit for 425 units.
Total government tax
revenue.
Reduction in consumer
surplus that is offset by tax
revenue for the government.
Reduction in producer surplus
that is offset by tax revenue for
the government.
31
Markets in Action
2009 Elan Guides
Now assume that instead of being levied upon producers, the same $3/unit tax is imposed
on consumers (Figure 6). The demand curve would shift to the left to D
1
. Once again the
increase in government revenue from tax collections will not entirely offset the reduction
in consumer and producer surplus, and society will suffer a dead weight loss from
underproduction (the region shaded in grey in Figure 6).
The factor that determines how the actual tax burden is shared between producers and
consumers is the relative elasticity of the demand and supply curves. The more inelastic the
demand curve, the greater the actual burden borne by consumers regardless of whom the tax
was imposed upon by law. The more inelastic the supply curve, the greater the actual burden
borne by producers regardless of whom the tax was levied upon.
- If demand is relatively more elastic than supply, it implies that consumers are more
flexible and hold leverage in the market to substitute away from the good if the price
rises. In this case, more of the actual burden of the tax will fall on suppliers.
- If demand is less elastic than supply, it implies that consumers cannot respond to
price increases as easily, and hold less leverage in the market to substitute away from
the good when faced with an adverse price change. In this case, more of the actual
burden of the tax will be borne by consumers.
Finally, lets study a situation where demand is perfectly inelastic (Figure 7).
Figure 6 : Tax on Consumers
S0
D0
$3/unit tax
3
6
4
a
Quantity 425 450
d
D1
Price paid
by consumers
inclusive of tax
Price received
by producers.
Saif Al Hidabi
ESI D-10813
Figure 7 shows the effects of a $3/unit tax imposed on suppliers when the demand curve is
perfectly inelastic. What we find is that the entire tax burden is borne by consumers in the
form of reduction in consumer surplus. Another interesting fact is that there is no dead weight
loss to society. The reduction in consumer surplus in entirely offset by an increase in tax
revenue. When supply and demand are relatively inelastic, society suffers less of a dead
weight loss and the government collects greater tax revenue than when supply and demand
are relatively elastic.
Summary:
- An imposition of a tax on buyers reduces demand, while an imposition on producers
reduces supply.
- Actual tax burden does not depend on whom the tax is imposed upon.
- If the demand curve is more inelastic, consumers will actually bear a greater burden
of the tax in the form of a reduction in consumer surplus.
- If the supply curve is more inelastic, producers will actually bear a greater burden
of the tax in the form of a reduction in producer surplus.
- The more inelastic the demand and supply curves, the lower the total dead weight
loss to society from tax imposition, and greater the tax revenue for the government.
LOS 15d: Discuss the impact of subsidies, quotas, and markets for illegal
goods on demand, supply, and market equilibrium. Vol 2, pg 85-92
Subsidies
Think of subsidies as negative taxes. Governments offer subsidies in order to encourage the
production of a good by subsidizing or reducing the cost of producing it. Subsidies bring
about an increase in supply.
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Markets in Action
2009 Elan Guides
Figure 7: Actual Tax Burden when Demand is Perfectly Inelastic
Quantity
S0
200
D0
S1
7
4
Consumers bear the entire
burden of the tax in the
form of a reduction in
consumer surplus. The
reduction in consumer
surplus equals the increase
in government tax revenue
so there is no dead weight
loss to society.
33
2009 Elan Guides
The provision of the subsidy results in an output level (70 units) that is greater than the
allocatively efficient quantity of output (50 units). At this higher level of output, marginal
cost exceeds marginal benefit. Consumers are better off in the form of lower prices paid ($4
versus $5 earlier) and producers are better off in the form of higher take-home prices ($4
from consumers + $2 subsidy = $6, versus $5 earlier). However, the amount that the
government spends on the subsidy outweighs the increase in consumer and producer surplus.
Society suffers a dead weight loss from overproduction.
Summary:
Subsidies result in:
- An increase in realized prices for producers.
- An increase in output.
- A decrease in prices paid by consumers.
- Dead weight losses from overproduction.
Figure 8 analyzes the impact of a $2/unit subsidy that is offered to producers. Suppliers, who
were previously willing and able to supply 50 units at $5/unit, are now willing and able to
supply 50 units at a price of $3/unit because the subsidy compensates them for the difference.
Markets in Action
Figure 8: Subsidies
Quantity
e1
e0
q0
50
q1
70
5
4
D0
S1
S0
a
3
6
e1
e0
a
DWL
6 a
4 e1
Society suffers from a dead weight loss from overproduction. The marginal
cost to society from producing 70 units is greater than the marginal benefit
from consuming 70 units. The subsidy results in too many resources being
dedicated to the production of the good.
The price actually realized by
producers ($6) equals $4/unit
from consumers plus $2/unit
from the government in the
form of subsidy.
Market prices fall to $4/unit The provision of a
subsidy results in
an increase in
supply.
Total government expenditure
on subsidy.
Illegal Goods
If an illegal good were legal, its market would function like any other market, with demand
and supply determining the equilibrium price, p
e
, and equilibrium quantity, q
e
(Figure 10).
When a good is declared illegal, penalties are levied on buyers and sellers who are in
possession of the good (Figure 10). Because there is a risk of having to pay the penalty,
buyers reduce their demand to D1. This is because the amount of the penalty would be
subtracted from the value of the good by buyers to determine the maximum price they would
be willing to pay for the good. Similarly, supply will fall to S1. Suppliers will add the amount
of the penalty to the minimum price at which they would be willing and able to supply the
product.
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Markets in Action
2009 Elan Guides
Production Quotas
A quota limits the total amount of a good that can be produced in the economy. In Figure
9, we assume that a quota of 100 units is set on the production of a particular good, whose
allocatively efficient quantity is 120 units.
The imposition of the quota prevents any activity in the market beyond a quantity of 100
units. The total amount of welfare attributable to consumer and producer surplus is reduced
and there is a dead weight loss due to underproduction. Quotas are usually imposed to
appease lobbyists who are interested in earning higher profits. Quotas reduce costs for
producers and increase prices paid by consumers, and are therefore very effective in increasing
profits.
Summary
- Production quotas limit the production of a good in an economy in order to raise
realized prices for producers.
- They result in inefficiency because at the quantity corresponding to the quota (qQ),
MB exceeds MC, resulting in a dead weight loss due to underproduction.
Quotas only distort
the market when they
are imposed at an
output level that is
lower than the
equilibrium quantity.
If they are imposed
at a quantity higher
than equilibrium
output they will have
no impact on
economic activity.
Figure 9: Quotas
Quantity
e0
D0
S0
25 PQ
20 P0
qQ
100
q0
120
MC falls
DWL
Limiting production
results in higher prices.
Quantity is forced down to 100 units.
Saif Al Hidabi
ESI D-10813
35
Markets in Action
2009 Elan Guides
If the penalty on suppliers and consumers is the same, supply and demand would both shift
to the left by the same magnitude, resulting in the same price level pe, but a lower equilibrium
quantity q1. Notice that the buyer pays pe to the seller, but effectively pays a price of pb (pe
plus the penalty). Similarly, suppliers receive pe, but effectively pocket only ps (pe minus the
penalty).
If the penalty on suppliers is greater than the penalty on buyers, supply will shift by a greater
magnitude, and prices would actually rise. Were a heavier penalty imposed on consumers,
the shift in demand would be more significant, and prices would actually fall.
You might wonder whether it would just be wiser to legalize illegal goods and tax them
heavily. A hefty tax would decrease supply, increase prices and achieve the same decrease
in equilibrium quantity that a penalty does. Further, the tax revenue could be used by the
government for societal welfare programs. However, opponents of legalizing these goods
assert that laws send out a message to society, and decrease the demand for illegal products,
which taxes do not.
Figure 10: Illegal Goods
Quantity
S1
S0
D1
e1
e0
qe q1
pe
ps
pb
D0
Producers add the penalty
amount to the price they were
earlier willing and able to supply
the good.
The benefit from the good to the
consumer is reduced by the amount
of the penalty.
36
Organizing Production
2009 Elan Guides
37
2009 Elan Guides
ORGANIZING PRODUCTION
LOS 16a: Explain the types of opportunity cost and their relation to economic
profit, and calculate economic profit. Vol 2, pg 100-103
Opportunity cost is the value of the next best alternative forgone. For a firm, opportunity
cost is the return that its resources could have earned in their most highly rewarding alternative
use. Opportunity cost includes both explicit and implicit costs.
Explicit costs are paid with money and are incurred whenever payments are made for
resources that are used in the production process. These resources could have been put to
other uses so there is an opportunity cost of using them. Lease payments, raw material
procurement costs, and labor wages are examples of explicit costs.
Implicit costs are related to resources that are used in the production process, but no explicit
payments are made for their use. There are two types of implicit costs:
1. The opportunity cost that is incurred when a firm uses its own capital (financial
and/or physical capital). These resources could have been rented out to earn a
return. This opportunity cost is referred to as the implicit rental rate of capital, and
includes:
o Economic depreciation, which is the reduction in the market value of a firms
assets over time.
o Forgone interest, which is the interest that could have been earned by investing
the resources in interest-bearing assets.
2. The opportunity cost that is incurred when the firms owner uses her own time and
entrepreneurial abilities to run the business. This opportunity cost is referred to as
normal profit and is an opportunity cost because the owner could have used her
expertise in the forgone alternative business to earn a certain amount of money. If
the owner does not earn at least a normal profit (the profit she would earn from
her next best alternative business) from her chosen business, she would shut down
the current business and pursue the alternative one.
Economic profit equals total revenues minus total costs, which include explicit and implicit
costs:
Economic profit = Total revenue - (Explicit costs + Implicit costs)
Example 1 illustrates the calculation of economic profit for Steyn Inc., a soda bottles
manufacturer run by its owner, Ryan.
Saif Al Hidabi
ESI D-10813
Accounting profit is calculated by subtracting only explicit costs from total revenues. In
Steyns case, accounting profit would equal $300,000 ($500,000 - $200,000). Economic
profits are always lower than accounting profits because their calculation subtracts explicit
and implicit costs from total revenue.
LOS 16b: Discuss a companys constraints and their impact on the achievability
of maximum profit. Vol 2, pg 103-104
There are three constraints that limit a companys ability to maximize profits:
Technology constraints: Technology is broadly defined as a method of producing a good or
service. A firm can increase its production by using additional technological resources, which
are costly to procure. The firms ability to generate more profits through increased output
is therefore limited by the cost of acquiring new and more efficient technology.
Information constraints: If firms had perfect information about their employees, customers
and competitors, they could make perfectly informed decisions that would increase their
profits. However, firms do not have access to all desired information and invest considerable
sums of money on research. Spending money on acquiring information is only viable to the
extent that the increase in firm profits from utilizing the information exceeds the cost of
obtaining it.
Market constraints: Profits are also constrained by how much consumers are willing to pay
for the firms goods, how much of the firms output they are willing to buy, and by the
marketing strategies and positioning of competitors. Further, profits may also be constrained
by capital market constraints i.e., the willingness and ability of investors to finance the firms
operations and growth.
38
2009 Elan Guides
Total Revenues
Explicit Costs
Plastic
Electricity
Wages
Interest expense
Total Explicit Costs
Implicit Costs
Ryans wages forgone
Interest forgone
Economic depreciation
Normal profit
Total Implicit Costs
Total Costs
Economic Profit
$
100,000
30,000
60,000
10,000
200,000
30,000
20,000
15,000
55,000
120,000
$
500,000
(320,000)
180,000
39
2009 Elan Guides
LOS 16c: Differentiate between technological efficiency and economic efficiency,
and calculate economic efficiency of various companies under different
scenarios. Vol 2, pg 104-107
Technological efficiency: A firm is technologically efficient when it produces a given level
of output with the least number of input units. Table 1 shows four different production
techniques that a firm can use at its manufacturing facility. Each of the methods produces
10 computers per day. Further, output quality does not vary across the 4 methods.
A comparison of the different production processes shows that:
- Method 1 is the most capital-intensive, and the least labor-intensive technique.
- Method 4 is the most labor-intensive, and the least capital-intensive technique.
- Method 2 and Method 3 lie somewhere in between.
- Method 2 is technologically efficient because it uses the same amount of capital as
Method 3, but fewer units of labor. Method 3 is technologically inefficient.
- Method 1 is also technologically efficient because it uses less labor than Method 2.
- Method 4 is also technologically efficient because it uses less capital than Method
2.
Economic efficiency: A firm is economically efficient when it produces a given level of
output at the lowest possible cost. Table 2 calculates the cost per computer of each of the
four techniques assuming that a unit of labor costs $50 and a unit of capital costs $200.
Table 1
Method Quantities of Inputs
1) Robotic manufacturing
2) Production line
3) Bench manufacturing
4) Hand-tool manufacturing
Labor
10
20
100
1,000
Capital
1,000
50
50
10
Robotic manufacturing
Production line
Bench manufacturing
Hand-tool manufacturing
Labor
10
20
100
1,000
Capital
1,000
50
50
10
Labor
500
1,000
5,000
50,000
Capital
200,000
10,000
10,000
2,000
200,500
11,000
15,000
52,000
20,050
1,100
1,500
5,200
Method
Quantities of
Inputs
Total Costs
of Input
Total Cost
of Output
(10 units)
Cost
per
Unit
Table 2
40
2009 Elan Guides
LOS 16d: Explain command systems and incentive systems to organize
production, the principal agent problem, and measures a firm uses to reduce
the principal-agent problem. Vol 2, pg 107-109
In a command system, resources employed in the production process are allocated by
someone in authority, such as supervising managers. Information passes up and commands
trickle down the hierarchy with the goal of using resources efficiently. Managers spend most
of their time collecting and processing information about the performance of their subordinates,
and making decisions regarding what instructions to issue and how to implement them. The
military provides the purest example of a command system, where the commander-in-chief
makes all the big decisions.
In an incentive system, managers offer their workers performance-based incentives. These
incentives induce workers to perform in a manner that increases personal benefit, and at the
same time, maximizes profits for the firm. For example, sales persons have very low basic
salaries but get large commissions on sales.
Most firms use a combination of command and incentive systems. Command systems are
often used when employee performance can be monitored easily. Incentive systems are used
when it is difficult and costly to monitor employee performance.
The principal-agent problem arises when the interests of agents and principals are not
aligned. Agents (managers and workers) try to find ways to enjoy on-the-job leisure and are
driven to maximize personal income and benefit. Principals, who are the owners of the firm,
want to maximize the firms profits and value. The principal-agent problem would not exist
if principals were able to monitor their agents effectively. Unfortunately, this is not only
difficult, but costly as well. To counter the principal-agent problem, interests of workers and
owners must be aligned. This is usually accomplished by offering agents:
- Ownership interests: If an agent is given an ownership interest in the firm, she will
have an incentive to perform in a manner that will increase the firms value. This
method is primarily used to incentivize senior management.
- Incentive pay: These compensation schemes pay workers based on their performance.
Agents can be compensated in the form of bonuses and promotions.
- Long-term contracts: These induce agents to make decisions and lay down strategies
that will improve the long-term prospects of the firm. CEOs are often awarded
multi-year contracts so that they develop strategies that will achieve maximum profits
over a sustained period.
- Method 2 is the economically efficient method. It results in the lowest cost per
computer.
- Method 3, which is technologically inefficient, is also economically inefficient. A
technologically inefficient method can never be economically efficient.
- Although Method 2 is economically efficient in this example, Method 1 and Method
4 could have been economically efficient if input prices were different.
Saif Al Hidabi
ESI D-10813
41
2009 Elan Guides
LOS 16e: Describe the different types of business organizations and the
advantages and disadvantages of each. Vol 2, pg 109-112
Type of
Organization
Proprietorship
Partnership
Corporation
Description
- One owner who has
unlimited liability
for the firms debts
and legal obligations.
- Profits are taxed at
the personal income
tax rate of the owner.
- Two or more owners
with unlimited
liability for the firms
debt and legal
obligations.
- Profit-sharing based
on proportional
ownership.
personal income tax
rate of the owners.
- Firm is owned by
shareholders, who
enjoy limited
liability.
the corporate income
tax rate.
Advantages
- Easy to set up
- Decision making
process is simple and
quick.
- Profits are taxed only
once.
- Easy to set up.
- Decision making is
diversified.
- Profits are only taxed
once.
- Can survive
withdrawal of a
partner.
- Owners have limited
liability, which
means that their legal
obligations are
limited to the money
that they have
invested.
- Capital is usually
available at a low
cost.
- Management
expertise is not
limited to the
owners.
- Perpetual life.
- LT labor contracts
reduce costs.
Disadvantages
- Decision-making is
not diversified.
- Unlimited liability
puts the owners
entire wealth at risk.
- Raising capital and
obtaining bank loans
is difficult.
- If the owner dies, the
firm ceases to exist.
- Diversified decision-
making could result
in disagreements.
- Unlimited liability
puts the owners
wealth at risk.
- Reduction in capital
when a partner
chooses to leave.
- Difficult to raise
capital.
- Decision-making
process is slow and
bureaucratic.
- Profits are taxed
twice- once as
company profits and
then as dividends.
42
2009 Elan Guides
LOS 16f: Calculate and interpret the four-firm concentration ratio and the
Herfindahl-Hirschman Index, and discuss the limitations of the concentration
ratios. Vol 2, pg 113-117
Concentration ratios are used to evaluate the level of competitiveness of the market that a
firm operates in.
Four-firm concentration ratio: This ratio measures the proportion of total industry sales
that are accounted for by the four largest firms in the industry. The ratio lies between almost
zero and 100%, with 0 indicating perfect competition (high competition with lots of firms
sharing the market) and 100% indicating a monopoly (low competition with just one firm
serving the entire market). A ratio below 40% suggests that a relatively competitive market
exists, while a ratio above 60% indicates that a few firms dominate the industry (oligopoly).
Herfindahl-Hirschman Index (HHI): This ratio is calculated by summing the squared
percentage market shares of the 50 largest firms in an industry. The HHI is very low for
highly competitive markets and it equals 10,000 (100
2
) for a monopoly. An HHI of less than
1,000 indicates a competitive market (with lots of firms), while an index that lies between
1,000 and 1,800 is indicative of a moderately competitive market. An HHI above 1,800
suggests that the market is relatively uncompetitive.
Limitations of Concentration Measures
Geographical scope of the market: This refers to the reach of product, which could be local,
national or international. For example, concentration ratios for newspapers in the international
market would be low and indicate a high level of competition. However, within cities these
ratios are high, indicating a lack of competition.
Barriers to entry and firm turnover: Concentration ratios fail to consider barriers to entry and
firm turnover in industries. Markets may be highly concentrated, as indicated by high ratios,
but there may be very low barriers to entry. Even though ratios indicate low levels of
competition in the industry, they ignore the ease of entry for potential competitors. For
example, there might be very few hairdressers in a small town, but it is relatively easy to
enter this market, which makes the threat of potential entrants high, and the market relatively
competitive.
The relationship between the market and industry: When calculating concentration ratios,
we assume that every firm fits into one specific industry. However, this is not always the
case. First, markets are more narrowly defined than industries. For example, the shoe
manufacturing industry may be highly competitive and have a low concentration ratio.
However, some firms might specialize in different markets within the industry, such as sports
shoes, men's shoes, children's shoes, and so on; not necessarily competing with each other.
Therefore, competition within the different markets may be relatively low. Second, many
large firms offer a wide range of products and operate in different markets, while concentration
measures assume that any company operates in only one market. Finally, firms may easily
move between markets in search of higher profits. Low barriers to entry make such movements
possible and reduce the usefulness of concentration ratios in evaluating competition levels
in various markets.
43
2009 Elan Guides
LOS 16g: Explain why firms are often more efficient than markets in
coordinating economic activity. Vol 2, pg 118-121
Market coordination: Economic activity refers to the organization of factors of production
to produce goods and services. An example of markets coordinating economic activity is the
organization of a tennis match- the organizers rent a stadium, invite popular tennis players,
hire publicity agents to advertise the match, employ ticketing agents to sell tickets and sell
the broadcasting rights to a TV channel. These are all examples of market transactions as
opposed to firm level coordination where the organizers would own all the capital (stadium,
video equipment, etc.) and employ all the labor needed (players, referees, salespeople, etc.).
In essence, the match is produced by coordinating different markets. Outsourcing is another
example of markets coordinating economic activity.
Companies decide whether to purchase goods or services from other firms (market coordination)
or to produce the good or service themselves (firm coordination) based on relative costs.
Firm coordination occurs when firms can organize economic activity more efficiently than
markets. Usually firms are more efficient than markets at coordinating economic activity
because of:
- Lower transaction costs: Transaction costs are incurred as numerous buyers and
sellers negotiate and organize economic activity (market coordination). These costs
are lower when one single firm coordinates economic activities as the number of
individual transactions is reduced. Consider the following example of getting your
car fixed:
o Firm coordination: You take the car to a garage where the owner organizes
everything from the purchasing, replacing and repairing of parts to the hiring
of the mechanic. He charges you for the entire job.
o Market coordination: You hire a mechanic to recognize the problem, then
go to a store yourself to purchase parts, and to rent tools. Then you hire the
mechanic again to fix the problem, and you return the tools. You pay the
mechanic separately, the tool rental store separately, and for the parts separately.
Firm coordination will probably result in a more cost and time effective solution.
- Economies of scale: Economies of scale refer to falling average costs as more and
more units of a good are produced. Economies of scale arise from specialization and
division of labor. These benefits can be realized more effectively by firms than
markets.
Saif Al Hidabi
ESI D-10813
44
2009 Elan Guides
- Economies of scope: Economies of scope refer to a firms use of specialized resources
for the production of a range of goods and services. For example, a company like
Unilever
produces a wide range of consumer products. It can afford to hire research

and marketing specialists because their skills will be used to develop and market
Unilever
s entire range of products. This spreads out Unilever
s costs across several

product lines and reduces average costs for all products.
- Economies of team production: These are realized when a team of individuals
becomes highly specialized in the production of a good or the performance of a
service. Firms have specialized teams for certain tasks (e.g. purchasers of raw
materials, production and assembly line workers, and marketing people).
Because of all these benefits, it is firms rather than markets that coordinate most economic
activity.
45
Output and Costs
2009 Elan Guides
LOS 17a: Differentiate between short-run and long-run decision time frames.
Vol 2, pg 132-133
In the short run, only one factor of production is variable, while the rest are fixed. Usually
we assume that labor is the only variable factor of production in the short run. Therefore,
the only way that a firm can respond to changing market conditions in the short run is by
changing the quantity of labor that it employs. In hard times, firms lay off labor and in good
times, firms employ more labor. However, the quantities of capital and land employed remain
fixed. A firm cannot increase output in the short run by acquiring more machinery or
equipment. Short term decisions are also easily reversed via layoffs or rehiring of labor.
In the long run, quantities of all factors of production can be varied. Output can be increased
by employing more labor, acquiring more machinery or even buying a whole new plant.
Once a long run decision has been made (e.g. the acquisition of a new plant), it cannot be
easily reversed. A sunk cost is an expense that has already been incurred and has no bearing
on current decision making. We will study sunk costs in detail in Reading 44.
LOS 17b: Describe and explain the relations among total product of labor,
marginal product of labor, and average product of labor, and describe
increasing and decreasing marginal returns. Vol 2, pg 133-139
In Table 1 we assume that in the short run, the firm invests in 2 units of capital, which
comprise its fixed costs. The only factor of production whose quantities it can vary is labor.
As more units of labor are employed to work with 2 units of capital, total output increases.
Table 1: Total Product, Marginal Product and Average Product
OUTPUT AND COSTS
- Total product (TP) is the maximum output that a given quantity of labor can produce
when working with a given quantity of capital units.
- Marginal product (MP) is the increase in total product brought about by hiring one
more unit of labor, while holding quantities of all other factors of production constant.
- Average product (AP) equals total product of labor divided by the quantity of labor
units employed.
Change in TP
Change in QL
0 2 0
1 2 5
5
5.00
2 2 12
7
6.00
3 2 17
5
5.67
4 2 20
3
5.00
5 2 22
2
4.4
Quantity of
Labor
(Q
L
)
Quantity of
Capital
(Q
K
)
Total
Product
(TP)
Marginal
Product
(MP)
Average Product
(AP)
TP
QL
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Output and Costs
2009 Elan Guides
Figure 1 illustrates the firms total product (TP) curve. In the initial stages (as the first and
second units of labor are employed), total product increases at an increasing rate. The slope
of the total product curve is steep at this stage. Later, as more units of labor are employed
to work with the fixed 2 units of capital, total output increases at a decreasing rate, and the
slope of the TP curve becomes flatter.
The TP curve separates output levels attainable using 2 units of capital from those not
attainable using only 2 units of capital. For example, with 3 units of labor working on 2 units
of capital, the firm can achieve a total output of 17 units. Output levels above 17 are not
achievable with the same resources (3 labor + 2 capital), and output levels below 17 are
inefficient because they use more labor units than necessary to produce the given output.
Therefore, all points on the TP curve are technologically efficient.
Figure 2: Average and Marginal Product Curves
Labor (units)
8
7
6
5
4
3
2
1
0
0 1 2 3 4 5
AP
MP
Maximum
Average
Product
Figure 1: Total Product Curve
Labor (units)
25
20
15
10
5
0
Attainable
0 1 2 3 4 5
Unattainable
17
Saif Al Hidabi
ESI D-10 813
47
Output and Costs
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The marginal product (MP) curve (Figure 2) shows the change in total product from hiring
one additional unit of labor. The MP curve is simply the slope of the TP curve. Recall that
MP is calculated as the change in TP (change on y-axis) divided by the change in labor units
(change on x-axis). The MP curve rises initially (over the first two units of labor when TP
is increasing at an increasing rate) and then falls (as the third, fourth and fifth units of labor
are added and TP increases at a decreasing rate).
The firm benefits from increasing marginal returns to labor over the first two units of labor
and then suffers from decreasing marginal returns over the last three units of labor. Increasing
marginal returns occur because of specialization and division of labor, and decreasing marginal
returns set in because of inefficiency, over-crowdedness and underemployment of some units
of labor given the fixed amount of capital.
The average product (AP) curve (Figure 2) shows output per worker, which equals total
product divided by total labor. Observe two important relationships from the AP and MP
curves:
1. MP intersects AP from above through the maximum point of AP.
2. When MP is above AP, AP rises, and when MP is below AP, AP falls.
An interesting way to remember the relationship stated in Point 2 is by analyzing the historical
returns earned by a fund manager. If her 5-year average return is 10%, and she earns 15%
this year (marginal return) her average would rise. If however, she were to earn only 5% this
year, her average would fall.
LOS 17c: Distinguish among total cost (including both fixed and variable
cost), marginal cost, and average cost, and explain the relationship amongst
the various cost curves. Vol 2, pg 139-145
Total cost (TC) includes all fixed costs and variable costs incurred in the production process.
In Table 2, we assume that the firm has rented 2 units of capital (QK) in the short run at $20
per unit. Labor is the only variable factor of production and the firm pays a wage of $10 per
unit of labor employed. Even if the firm shuts down in the short run, it will still have to pay
its total fixed costs (TFC), and if it wants to increase production in the short run, only total
variable costs (TVC) will rise.
QL
0
1
2
3
4
5
QK
2
2
2
2
2
2
TP
0
5
12
17
20
22
TFC
TP
TC
TP
TVC
TP
Change in TC
Change in TP
TFC
40
40
40
40
40
40
TVC
0
10
20
30
40
50
TC
40
50
60
70
80
90
AFC
8
3.33
2.35
2
1.82
AVC
2
1.67
1.76
2
2.27
ATC
10
5
4.12
4
4.09
MC
2
1.43
2
3.33
5
Table 2:Total cost, Average cost and Marginal Cost
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Notice in Figure 3 that the TC and TVC increase at a decreasing rate at low levels of output,
and increase at an increasing rate at higher levels of output. The difference between TC and
TVC equals TFC.
- Marginal cost (MC) equals the increase in total costs brought about by the production
of one more unit of output.
- Average total cost (ATC) is simply total cost (TC) divided by total output (TP).
10
8
6
4
2
Output
0 5 10 15 20 25
AFC
ATC
AVC
MC
Figure 4: Marginal And Average Cost Curves
A firms MC is the increase in total cost from producing the last unit of output. For example
when output increases from 12 to 17 units (Table 2), TC increases by $10, to $70. The MC
of any of these 5 units (the thirteenth to seventeenth units) equals $10 divided by 5, or $2.
Just as MP measures the slope of the TP curve, MC illustrates the slope of the TC curve at
various levels of output. MC initially decreases (Figure 4) because of the benefits from
specialization, but eventually increases because of diminishing marginal returns. To produce
Figure 3: Total Cost Curves
Output
0 5 10 15 20 25
100
80
60
40
20
0
TC
TVC
TFC
TC = TFC + TVC
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Output and Costs
2009 Elan Guides
more output given the same amount of capital, more and more units of labor must be employed
because each additional unit of labor is less productive than the previous one. Since more
workers are required to produce one more unit of output, the cost of producing that additional
unit (the marginal cost) increases. From Figure 4, also notice that:
- As output levels rise, total fixed costs are spread over more and more units and AFC
continues to fall at a decreasing rate.
- The average total cost curve is U-shaped. It falls initially as fixed costs are spread
over an increasing number of units. Later however, the effect of falling AFC is offset
by diminishing marginal returns so ATC starts rising.
- The vertical distance between the AVC and ATC curves equals AFC. The vertical
distance between the AVC and ATC curves gets smaller as output increases because
AFC decreases as output expands.
Important Relationships between Average and Marginal Cost Curves
- MC intersects ATC and AVC from below at their respective minimum points.
- When MC is below AVC, AVC falls, and when MC is above AVC, AVC rises.
- When MC is below ATC, ATC falls, and when MC is above ATC, ATC rises.
Figure 5 illustrates important relationships between cost and product curves.
Figure 5: Cost And Product Curves
Labor
Output
MP
AP
MC
AVC
Rising MP and
falling MC,
rising AP and
falling AVC
Falling MP and
rising MC,
rising AP and
falling AVC
Falling MP and
rising MC,
falling AP and
rising AVC
- A firms MP curve is linked to its MC
curve. Initially, as more labor is hired,
MP rises and MC falls.
- At the point where MP reaches its
maximum, MC stands at its
minimum.
- As output expands further, MP falls
and MC rises.
- A firms AP curve is linked to its AVC
curve. Initially, as the firm hires more
labor, AP rises and AVC falls.
- At the point where AP reaches its
maximum, AVC is at its minimum.
- As the firm increases output further,
AP falls and AVC rises.
Max MP,
Min MC
Max AP,
Min AVC
Saif Al Hidabi
ESI D-10 813
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Output and Costs
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A firms short run cost curves can shift because of two factors:
1. Technology
A technological change that increases productivity will move the total product curve
upwards as more output can be produced using the same resources. The firms MP
and AP curves will also move up. Further, as fewer resources will be required to
produce the same output, the firms cost curves will move downwards.
2. Changes in prices of factors of production
- If there is an increase in the price of labor (a variable factor of production in the SR)
the firms TC, ATC, TVC and AVC move upwards. Further, the MC curve will
also move up, but TFC and AFC will remain unchanged.
- If there is an increase in the price of capital (a fixed factor of production in the SR),
the firms TC, ATC, TFC and AFC curves will move up, but AVC, TVC and MC will
remain unchanged.
LOS 17d: Explain the companys production function, its properties of
diminishing returns and diminishing marginal product of capital, the relation
between short-run and long-run costs, and how economies and diseconomies
of scale affect long-run costs. Vol 2, pg 146-150
At the beginning of this reading we mentioned that in the long run, quantities of all factors
of production can be changed, and there are no fixed costs. Table 3 illustrates a companys
production function, which shows how different quantities of labor and capital affect total
product. In our short run scenario, different quantities of labor were combined with fixed
quantities of capital (2 units). Now we explore the effects of varying capital quantities (QK)
as well. Plant 1 has 2 units of capital (the SR scenario that we analyzed earlier), Plant 2 has
4 units of capital, Plant 3 has 6 and Plant 4 has 8 units of capital.
1 5 11 15 18
2 12 25 34 39
3 17 36 48 56
4 20 42 57 67
5 22 45 59 68
Units of Labor
Plant 1
Q
K
= 2
Plant 2
Q
K
= 4
Plant 3
Q
K
= 6
Plant 4
Q
K
= 8
Table 3: A Firms Production Function
Diminishing Marginal Returns to Capital
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The effect of diminishing marginal returns to labor is obvious. Marginal product declines
as more and more units of labor are added to each plant (move down the columns in Table
3). But now, we also see diminishing marginal returns to capital (see Table 4, and move
right along the rows in Table 3 ). For example, with 3 units of labor, moving from Plant 1
to Plant 2 (increasing quantity of capital by 2 units) increases production by 19 units from
17 to 36 (MP of capital = change in output/change in qty. of capital = 19/2 = 9.5). Adding
a further 2 units of capital and moving to Plant 3 increases production by only 12 units from
36 to 48 (MP of capital = change in output/change in qty. of capital = 12/2 = 6). Finally,
adding another 2 units of capital and moving to Plant 4 and holding quantity of labor constant
at 3 units increases output only by 8 units (MP of capital = 4).
When we map the average cost curves for all 4 plants on one graph (Figure 5). Notice that:
1. Short run ATC curves are U-shaped.
2. The larger the plant, the greater the output at which short run ATC is at its minimum.
Figure 5: Average Cost Curves For Different Plant Sizes
Output
ATCPlant 1 ATCPlant 2
ATCPlant 3 ATCPlant 4
Plant 1 2 17 8.5
Plant 2 4 36 9.5
Plant 3 6 48 6
Plant 4 8 56 4
Units of capital
combined with 3
units of labor
Total Product
when Q
L
=3
Marginal
Product
Table 4: Diminishing Marginal returns to Capital
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Economies and Diseconomies of Scale
Economies and diseconomies of scale are long-run concepts. They relate to conditions of
production when all factors of production are variable. In contrast, increasing and diminishing
returns are short-run concepts, applicable only when the firm has one variable factor of
production.
Economies of scale refer to reductions in the firms average costs that are associated with
the use of larger plant sizes to produce a large volume of output. They are present over the
range of output when the LRAC curve is falling. Economies of scale occur because mass
production is more economical, the specialization of labor and equipment improves productivity,
and costs such as advertising can be spread across more units of output.
Diseconomies of scale occur in the upward sloping region of the LRAC curve. A typical
reason for an increase in average costs as output levels rise is an increase in bureaucratic
inefficiencies as effective management, supervision and communication become difficult in
large organizations.
In the horizontal portion of the LRAC curve, when an increase in output does not result in
any change in average costs, a firm realizes constant returns to scale.
The minimum efficient scale is the smallest quantity of output at which a firms long run
average cost reaches its lowest level.
The optimal output level for each plant is when its ATC curve is at its minimum . The long
run average cost (LRAC) curve illustrates the relationship between the lowest attainable
average total cost and output when all factors of production are variable. The LRAC curve
is also known as a planning curve because it shows the expected per-unit cost of producing
various levels of output using different combinations of factors of production.
Figure 6: The Planning Curve
Output
Q*
LRAC
Economies of Scale Diseconomies of Scale Constant Returns
to Scale
Minimum
Efficient Scale
Saif Al Hi dabi
ESI D-108 13
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2009 Elan Guides
LOS 18a: Describe the characteristics of perfect competition, explain why
companies in a perfectly competitive market are price takers, and differentiate
between market and company demand curves. Vol 2, pg 160-162
A perfectly competitive industry is characterized by the following features:
1. There are a large number of buyers and sellers, and each of them is small relative
to the size of the market.
2. There are absolutely no barriers to entry or exit.
3. All producers sell an identical product.
4. Established firms have no advantage over new entrants.
5. There is perfect information. Buyers and sellers are all well-informed about prices.
Perfect competition arises when the minimum efficient scale of each producer lies at an
output quantity that is very small relative to the size of the market.
Prices are determined by market demand and supply (Figure 1a). Since each seller is too
small compared to the size of the market, she has to take or accept the prices determined
by the market. She cannot sell at a higher price because buyers are perfectly informed about
prices and will simply go to some other producer who is selling at the lower market prices.
Individual producers see no point in setting prices below market levels because they can sell
as much as they want at market prices anyway. Therefore, the demand curve facing each
individual producer in a perfectly competitive environment is perfectly elastic at PMe (Figure
1b)..
A firms minimum
efficient scale is the
smallest quantity of
output where the firm
reaches its minimum
long run average
cost. Since each firm
finds it efficient to
produce a quantity
that is small relative
to the size of the
market, there is room
for a large number of
producers.
PERFECT COMPETITION
Figure 1: Perfect Competition
Quantity
1a. Market
Quantity
1b. Individual Firm
PMe
PMe
QMe
Me
Market demand and supply interact to determine equilibrium market price, PMe, which no individual firm
has the power to change.
D = Price
DM
SM
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LOS 18b: Determine the profit maximizing (loss minimizing) output for a
perfectly competitive company, and explain marginal cost, marginal revenue,
and economic profit and loss. Vol 2, pg 163-167
Each firm takes the price offered by the market, so the only decision in each producers
hands is how much to produce. In Figure 2 we illustrate an individual firms marginal cost
curve and demand curve.
In a perfectly competitive environment, an individual firm can sell as many units of output
as it desires at the given market price. If the price is $8/unit, each unit sold increases revenue
by $8 so MR is constant at the same level as price ($8).
The key decision for the firm is to decide on how much it wants to produce in the short run.
This decision is governed by the incentive to maximize profits. In Figure 2, profit maximizing
output occurs at 22 units where the increase in revenue from selling the last unit (MR) equals
the increase in costs from producing the last unit (MC).
Profit maximizing output is the quantity where the difference between TR and TC is
maximized. This level of output corresponds to the point where MC equals MR. At production
levels lower than 22 units, an additional unit produced adds more to revenues than to costs.
For example, the 20
th
unit adds $8 to revenue, $6 to costs, and therefore $2 to total profit.
At production levels greater than 22 units, the cost of producing an extra unit exceeds the
revenue from selling it. For example, the 23
rd
unit costs $9 and sells for only $8. There is
no point in increasing production beyond 22 units given current prices and the firms cost
structure.
Whether the firm makes a profit or a loss depends on the position of the AC curve relative
to demand (which represents average revenue). Three possible scenarios are illustrated in
Figure 3. If the average cost curve lies above the firms demand curve, the firm will make
economic losses (Figure 3b). However, the point where marginal cost equals marginal revenue
will continue to be the quantity that the firm should produce. However, in this case, the
corresponding quantity will define the loss-minimizing level of output.
Figure 2: Profit Maximizing Output
Quantity
MC
6
7
8
9
20 21 22 23
MR = P = D
MR equals price only for price takers. As we shall see
later, for firms facing downward sloping demand, MR
is lower than price.
The 20th unit increases revenue by $8 (selling price)
and costs $6 (marginal cost) to make.The increase in
profit from 20th unit = $2.
Unit
20th
21st
22nd
23rd
Price/MR
8
8
8
8
MC
6
7
8
9
Profit on
unit
2
1
0
-1
8
hsiadi af bail
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Perfect Competition
2009 Elan Guides
Figure 3: Possible Perfect Competition Scenarios in the Short Run
Quantity
8
22
Quantity
8
22
3b
Scenario B: Short run economic losses.
At the profit maximizing quantity where MC = MR
(22 units) price is lower than average cost (AC).
Therefore, the firm makes an economic loss. The
firm earns $8/unit and spends $9/unit so loss/unit
equals $1.
Total loss equals ($8 - $9) 22 = $22, which is the
area of the rectangle shaded in grey.
3c
Scenario C: Short run economic profits.
At the quantity where MC equals MR (22 units),
the firms price/unit is greater than its cost/unit
(AC) so it makes an economic profit. The firm still
produces 22 units. It earns $8/unit and spends $7/unit
so profit/unit equals $1. Total profit equals ($8 -
$7) 22 = $22, which is the area of the rectangle
shaded in green.
9
MC
AC
AC
Quantity
8
22
3a
Scenario A : Short run breakeven Zero
economic profit.
MC equals MR at the point where AC is at its
minimum and the AC curve is tangent to the demand
curve. Firms only make normal profits as price
equals AC.
MC
MC
AC
MR
MR
MR
7
Sai f Al Hidabi
ESI D-10813
56
Perfect Competition
2009 Elan Guides
LOS 18c: Describe a perfectly competitive companys short-run supply curve
and explain the impact of changes in demand, entry and exit of companies,
and changes in plant size on the long-run equilibrium. Vol 2, pg 167-174
The question that we ask ourselves now is: Would a firm in perfect competition, remain in
production if it were making an economic loss?
Recall that in the short run, a firm has fixed and variable costs of production. If the firm
decides to shut down, it would still incur fixed costs in the short run and make a loss equal
to total fixed cost. This loss can be reduced by continuing production and earning revenues
that are greater than the variable costs of production. This surplus (excess of revenues over
variable costs) would serve to meet some of the fixed costs that the firm is stuck with in
the short run. A firm should shut down immediately if it does not expect revenues to exceed
variable costs of production. If the firm continues to operate in such an environment it would
suffer a loss greater than just total fixed cost.
At this stage you must make sure that you understand two things:
- Given the prices prevailing in the market, a firm will produce at the output level
where its marginal cost (MC) equals marginal revenue (MR). In a perfectly competitive
environment marginal revenue equals price. In subsequent readings, we will see that
marginal revenue for firms with downward sloping demand curves is lower than
price.
- In the short run the firm will only continue to operate if its revenues enable it to at
least meet its variable costs.
With these two things in mind we can conclude that an individual firms supply curve is the
portion of its MC curve that lies above the TVC curve (Figure 4). At price levels below TVC,
the firm will not be willing to produce as it would only extend its losses beyond simply total
fixed costs. At price levels greater than AVC, the firm will remain in production in the short run
and produce the quantity where marginal costs equal marginal revenue (loss minimizing level).
Once prices exceed ATC, firms in perfect competition make economic profits.
All firms in a perfectly competitive industry produce an identical product and face identical cost
curves. None of them will remain in production if prices are below AVC, so there will be no
industry supply at lower prices. Firms would produce in the short run if prices were greater than
AVC as they would be able to limit losses to a level below total fixed costs. Each firms individual
supply curve is identical, and the market supply curve is the horizontal summation of the
individual firms supply curves. Every firm in the industry has the same cost structure, faces
the same price, and consequently produces at the same profit maximizing (loss minimizing)
output level.
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Equilibrium in the Long Run
The three scenarios illustrated in Figure 3 are only possible in the short run. In the long run
in a perfectly competitive industry, only one of those scenarios is possible because the industry
adjusts in two ways:
1. Entry and Exit of Firms
One of the key assumptions we made regarding perfect competition was that there are no
barriers to entry or exit. Firms can enter the industry easily when they see persistent economic
profits, and may leave if they foresee persistent economic losses. Lets see what happens
under each scenario:
Economic Profits (Figure 5)
If the firms in a particular industry are making economic profits, entrepreneurs will flock
to the industry to capture some of the economic profits available. Remember that established
firms enjoy no advantage over new entrants under perfect competition and each firm has an
identical cost structure. The increase in the number of firms increases market supply to S1
(Figure 5a). Consequently, market prices fall till they reach the point where price equals
minimum ATC and economic profits are eliminated (P1).
Figure 4: Short Run Supply Curves
Quantity
MC
ATC
AVC
Quantity
SSHORT-RUN
- There is no supply in the industry at prices
below AVC.
- Each firm will only produce in the short run
once price is greater than AVC.
- The industry supply curve is the horizontal
summation of each individual firms supply
curve.
- Each individual producers supply curve is
identical.
Individual Firms Industry Supply
P < AVC
The firm shuts
down as revenues
do not even meet
variable costs. SR
losses equal total
fixed costs.
AVC < P < ATC
The firm continues to operate
in the short run as the excess
of price over AVC allow
losses to be reduced to a level
lower than total fixed costs.
P > ATC
The firm makes
economic profits
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Remember the following conclusions from the analysis in Figure 5.
1. There are no LR economic profits in a perfectly competitive industry.
2. In the LR, price equals minimum average cost.
3. In LR equilibrium, each firm produces less than the amount it was producing when
economic profits were being made in the industry (Q
PM1 < Q
PM0). However, the
industry as whole produces more than it was previously (Q
1
> Q
0
).
4. The only viable explanation for this is that there must be more firms in the industry
in the long run than there were when firms were making economic profits in the
short run.
Economic Losses (Figure 6)
If an industry is making economic losses, participating entrepreneurs will exit in order to
make at least normal profits elsewhere. There are no barriers to exit, and every firm has an
identical cost structure. When firms leave the industry, supply falls, prices rise and eventually,
economic losses are eliminated as illustrated in Figure 6. Remaining firms earn normal
profits in the long run.
Figure 5: SR Economic Profits, LR Zero Economic Profits
Quantity
MC
AC
QPM0
SR: Each firm produces QPM0
where MR = MC.
Prices exceed AC at QPM0
resulting in economic profits
(region shaded in green) equal
to (P0 - AC) QPM0.
5b. Short Run:
Individual Firm
MR
Quantity
MC
AC
LR: Market price, P1 is tangent
to the AC curve at its minimum
point. Profit maximizing
quantity is now QPM1 , which is
lower than QPM0. In the long
run, firms only make normal
profits, or zero economic
profits.
QPM0 QPM1
5c. Long Run:
Individual Firm
Each firms individual supply falls
Quantity
S0
S1
P0
P1
Q0 Q1
D0
SR: S0 and D0 interact to set
prices at P0.
LR: Other firms are drawn to
the industry so industry supply
gradually moves to S1 to set
LR market prices at P1.
5a. Short Run and
Long Run: Industry
Market supply increases
Saif Al Hidabi
ESI D-1 0813
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Perfect Competition
2009 Elan Guides
Important takeaways from the analysis in Figure 6:
1. There are no long run economic profits in a perfectly competitive industry.
2. Price equals minimum average cost in the long run.
3. Each remaining firm produces more than the amount it was producing when economic
losses were prevalent in the industry (Q
PM1 > Q
PM0). The industry however, now
produces less (Q
1
< Q
0
).
4. The only way this is possible is that there must be fewer firms in the industry in
the long run than there were when economic losses were being made in the short
run.
2. Changes in Plant Size
In the reading on output and costs, we learned that when plant size is increased, initially
firms realize economies of scale (falling average costs), and later suffer from diseconomies
of scale. A firm already operating at its minimum short run average cost in a perfectly
competitive environment would make zero economic profits. However, there is always the
incentive to increase plant size, move onto another (lower) short run average cost curve,
which would give the firm a chance to earn economic profits. Firms will continue to increase
plant size in the long run till they operate on the SRAC curve whose minimum point coincides
with the minimum point of the LRAC curve (Point M in Figure 7). There is no point in
expanding beyond this size as diseconomies of scale would set in and actually increase the
firms average costs.
Figure 6: SR Losses, LR Normal Profits
Quantity
MC
AC
QPM0
SR: Each firm produces QPM0
where MR = MC.
AC exceeds price at QPM0
resulting in economic losses
(region shaded in grey) equal
to (AC - P0) QPM0.
6b. Short Run:
Individual Firm
MR
Quantity
MC
AC
QPM0 QPM1
LR: Market price, P1 is tangent
to the AC curve at its minimum
point. Profit maximizing
quantity is now QPM1 , which is
greater than QPM0. In the long
run, firms only make normal
profits, or zero economic
profits.
6c. Long Run:
Individual Firm
Each firms individual supply rises
Quantity
S0
S1
P0
P1
Q0 Q1
D0
SR: S0 and D0 interact to set
prices at P0.
LR: Some firms exit the
industry so the industry supply
gradually moves to S1 to set
LR market prices at P1.
6a. Short Run and
Long Run: Industry
Market supply decreases
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Each short run average cost curve has an associated marginal cost curve, which intersects
it from below through its minimum point. If a firm moves from SRAC0 to SRAC1, it will
also move from MC0 to MC1. Because the MC curve defines an individual firms supply
curve, the firms move to MC1 implies a rightward shift (increase) in individual firm supply.
As more firms expand and move to their respective SRAC1s, the market supply curve also
shifts to the right. Consequently, prices fall to the level where SRAC1 is at its minimum (P1),
and once again, economic profits are eliminated.
Conclusion: A firm might increase plant size to reduce average costs and realize economic
profits, but its ability to do so will be limited because as more firms increase their respective
plant sizes, industry supply will increase and prices will fall to the level where they equal
the firms new minimum average cost.
If firms in perfect competition are incurring economic losses some will exit the industry.
Others, who can reduce average costs by cutting down production, will choose to downsize.
Each of these actions will reduce industry supply to a point where economic losses are
eliminated and replaced by normal profits for the firms remaining in the industry.
LOS 18d: Discuss how a permanent change in demand or changes in technology
affect price, output, and economic profit. Vol 2, pg 175-179
1. Permanent Decrease in Demand for a Product
A permanent reduction in demand results in lower prices. Perfectly competitive firms that
were previously making normal profits will now suffer economic losses. Lower prices force
each firm to reduce output to point Q
PM1 (Figure 8), where its marginal cost curve intersects
the new (lower) marginal revenue curve. The reduction in each firms output results in a
decrease in quantity supplied from Q
0
to Q
1
.
Economic losses prompt some firms to exit the industry. Their exit reduces market supply
to S1 and boosts prices for all remaining firms back to P0. These firms see an upward shift
in their individual demand curves and now once again produce at their original profit
maximizing levels, q
PM0, where they earn normal profits
Figure 7: Plant Size And LR Equilibrium
Quantity
MC0
MC1
SRAC0
SRAC1
LRAC
MR0 = D0
MR1 = D1
M
SR profit
maximizing
point
LR competitive
equilibrium
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External economies are factors outside the control of the firm that decrease average costs
for individual firms as industry output increases. Examples of external economies are
specialists who develop consulting practices when the number of firms in the industry
(potential clients) increases. They use their experience and knowledge to help firms become
more cost-effective and efficient, bringing average costs lower.
External diseconomies are factors outside the control of the firm that increase average costs
for individual firms as industry output increases. An example of external diseconomies is
how an increase in flights and number of airlines causes congestion at airports and results
in longer waiting times and airport charges for all airlines, which increase average costs.
The LR industry supply curve shows how quantity supplied changes as market prices vary
after all possible adjustments have occurred (including changes in plant size and changes in
the number of firms in the industry).
An increase in demand in a perfectly competitive industry results in higher prices, which
attract new entrants. Over the long run, the entry of these new firms increases industry supply,
which brings prices down to a level where economic profits are eliminated.
In constant-cost industries, supply increases by as much as the initial increase in demand
such that prices return to their original levels in the long run. As a result, the long run supply
curve is perfectly elastic (Figure 9a).
2. External Economies and Diseconomies
Figure 8: Permanent Decrease In Demand For A Product
Quantity Quantity
P0 P0
P1 P1
D0
D1
S0
S1
D0
D1
MC
AC
QPM0 QPM1 Q0 Q1 Q2
Step 6: Firms now face prices that are lower
than AC at the profit maximizing output level.
Foreseeing economic losses, some firms exit.
Step 8: Demand/MR
facing each
individual firm
increases as prices
rise.
Step 7: The exit of some
firms reduces industry
supply to S1, increasing
prices for firms that
remain in production.
Step 9: Each
remaining firm
increases output back
to QPM0 and earns
normal profits.
Step 2:
Reduction in
demand
reduces prices.
Step 5: Reduction in
each individual
firms output reduces
industry quantity
supplied.
Step 1: Permanent
decrease in demand.
Step 4: The profit maximizing quantity
falls as MR falls. Individual firms now
produce less. At these new production
levels all firms in the industry make
economic losses because price is lower
than AC.
Step 3:
Demand/MR
facing each
individual firm
falls.
Saif Al Hi dabi
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In industries with external economies (decreasing-cost industries), the presence of a larger
number of firm lowers costs for all firms. As a result, the magnitude of shift in supply is
greater than that of the initial shift in demand, and prices fall below original levels. The long
run supply curve for decreasing-cost industries is downward sloping (Figure 9b).
In industries with external diseconomies (increasing-cost industries), an increase in demand
boosts prices, but as more firms enter, average costs for all firms rise. Therefore, supply
increases by less than the initial increase in demand. This results in prices that are higher
than original levels, and a long run supply curve that is upward sloping (Figure 9c).
Figure 9: External Economies And Diseconomies
9a. Constant-Cost Industry
No external economies.
Short run: When demand
increases to D1, prices rise to P1,
and equilibrium quantity moves
to Q1.
Firms enter industry in search of
economic profits. Therefore,
supply increases to S1, prices
revert to P0, and equilibrium
quantity increases further to Q2.
Long run: Flat LRS curve.
Quantity
S0
S1
D1
D0
LRS
Q0 Q1 Q2
P0
P1
9b. Decreasing-Cost Industry
External economies.
to Q1.
economic profits. The entry of
more firms results in a decrease
in costs for all firms. Therefore,
the magnitude of the increase in
supply is greater than that of the
initial increase in demand. Prices
end up at P2, which is lower than
original prices.
Long run: LRS has a negative
slope.
Quantity
S0
S1
D1
D0
LRS
Q0 Q1 Q2
P1
P2
P0
9c. Increasing-Cost Industry
External diseconomies.
to Q1.
economic profits. The entry of
more firms results in an increase
in costs for all firms. Therefore,
the magnitude of the increase in
supply is lower than that of the
initial increase in demand. Prices
end up at P2, which is higher than
original prices.
Long run: LRS has a positive
slope.
Quantity
S0
S1
D1
D0
LRS
Q0 Q1 Q2
P0
P1
P2
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Perfect Competition
3. Changes in Technology
Advances in technology usually result in lower costs, but require a significant initial
investment. Once a firm makes the investing decision, it incurs the benefits of new technology
in the form of lower average costs. Faced with the same prices, firms that are quickest to
embrace new technologies realize economic profits as their average cost curves lie below
those of firms that remain loyal to older production techniques. As the lagging firms see the
users of new technology make economic profits, they also move towards adopting the new
technology.
Firms that embrace the new technology are willing to supply more at current prices because
they are now more efficient. The increase in supply puts a downward pressure on prices. As
prices start falling, users of older techniques suffer economic losses, while users of the new
technology continue to make economic profits. Gradually more and more firms either exit
the industry because of economic losses, or adopt the new technology in pursuit of economic
profits. Eventually old-technique firms disappear, and as more new-technology firms enter,
supply increases and prices fall to a level where they equal the minimum average cost of
new-technology firms. In the long run, perfectly competitive firms can never make economic
profits.
Technological changes can only bring temporary gains to producers. They bring long term
gains to consumers in the form of lower prices.
Some comments about perfect competition (Figure 10):
1. Perfect competition is allocatively efficient because:
a. It results in an industry output where MC (supply) equals MB (demand).
b. The sum of producer and consumer surplus is maximized.
2. Perfect competition also results in an efficient scale of production. In the long-run
all firms produce quantity where average costs are minimized.
2009 Elan Guides
Figure 10: Efficiency Under Perfect Competition
Quantity
10a. Efficient Scale of Production
MC
SRAC
LRAC
MR p*
q*
10b. Allocative Efficiency
Quantity
Consumer
Surplus
Producer
Surplus
S = MSC
D = MSB
p*
Q*
INDIVIDUAL FIRM INDUSTRY
LR
competitive
equilibrium
Efficient
allocation
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ESI D-10813
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LOS 19a: Describe the characteristics of a monopoly, including factors that
allow a monopoly to arise, and monopoly price-setting strategies.
Vol 3, pg 190-193
A monopoly is the sole producer of a good or a service for which no close substitutes exist.
The monopoly maintains its dominant position through high barriers to entry that limit
competition. There are two types of barriers to entry.
1. Legal Barriers
Legal barriers include public franchises, patents, copyrights and government licenses. These
barriers restrict competition by controlling the entry of competitors.
- A public franchise grants a firm the sole right to produce a particular good or service.
For example, USPS (U.S. Postal Service) is a public franchise that has the exclusive
right to carry first-class mail in the U.S.
- Patents and copyrights grant the creator of a product the exclusive right to produce
it for a period of time.
- A government license controls entry into particular occupations, professions and
industries.
2. Natural Barriers
Natural barriers to entry give rise to natural monopolies. A natural monopoly is an industry
where a companys average cost is still falling even when it satisfies total market demand
entirely on its own. A natural monopoly has high fixed costs, but low and relatively constant
marginal costs. Therefore, it is able to reduce its average costs significantly through economies
of scale. The higher the quantity sold by a natural monopoly, the lower its average cost of
production. If two firms were sharing the market, each would produce a lower output and
incur higher average costs. Therefore, governments allow only one firm to continue to
dominate the industry, and find it more effective to regulate it.
An example of a natural monopoly is a power distribution company. The cost of providing
electricity to one more house is just the little bit of additional wiring and labor required (low
marginal cost). The distribution company has already incurred the high initial fixed costs
(setting up the grid). As the number of users increases, power distribution companies see
their average costs fall, and their scale of production becomes more efficient. We shall discuss
regulation of natural monopolies in the last section of this reading.
Monopoly Price-Setting Strategies
In a monopoly, one producer dominates the industry, and faces a downward sloping market
demand curve. When faced with downward-sloping demand, a supplier has to bring down
prices to sell additional units of output. A monopoly therefore, is a price-searcher. Unlike
a firm in perfect competition, it must determine the price that it should charge in order to
maximize its profits.
MONOPOLY
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LOS 19b: Explain the relation between price, marginal revenue, and elasticity
for a monopoly, and determine a monopolys profit-maximizing price and
quantity. Vol 2, pg 193-198
We have already established that the demand curve facing an individual firm operating in a
perfectly competitive environment is perfectly elastic at the market price. A producer can
sell as much output as it desires at the prevailing market price and as marginal revenue equals
price, the MR curve is the same as the demand curve.
In the case of a monopoly, the producer faces a downward sloping demand curve, and must
bring prices down to sell more units of output. Not only does the producer sell the additional
units at a lower price, but previous units will also be sold at the lower price. Therefore,
marginal revenue from selling another unit does not equal price. (Table 1)
Lets study the price change required to increase quantity sold from 3 to 4 units under perfect
competition, and under a monopoly.
Under perfect competition, no price change is required (perfectly elastic demand curve) to
sell the additional unit of output. Initially 3 units were selling at $8 each, and to sell the 4
th
unit, no decrease in price is required. The 4
th
unit also sells for $8, resulting in an increase
in total revenue from $24 to $32. Marginal revenue from selling the 4
th
unit equals $8.
A monopoly can follow two pricing strategies a single price strategy or price discrimination.
If the market is clearly segmented, and consumers in one segment cannot resell the product
to those in another, a monopoly can maximize its profits by charging different prices in
different segments. However, if price discrimination is not possible, a monopoly would
charge a single profit-maximizing price.
These strategies will be revisited in greater later in the reading.
Qty.
1
2
3
4
5
6
7
Price
8
8
8
8
8
8
8
TR
8
16
24
32
40
48
56
MR
8
8
8
8
8
8
8
Perfect Competition
Note: Under perfect competition, MR = Price
MR curve is the same as the demand
curve.
Monopoly
Note: Under monopolies, MR does not equal
price The MR curve has a steeper slope
than demand.
Qty.
1
2
3
4
5
6
7
Price
15
13
11
9
7
5
3
TR
15
26
33
36
35
30
21
MR
15
11
7
3
-1
-5
-9
Table 1
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Elasticity of Demand Facing a Monopoly
Recall from our chapter on elasticity that elasticity of a downward sloping demand curve is
different at every point. At high price levels, a reduction in price serves to increase total
revenue (TR) as demand is relatively elastic. TR increases at a decreasing rate till it reaches
its maximum at the output level where the demand curve is unit elastic. Total revenue then
starts decreasing at an increasing rate as prices are brought even lower into the relatively
inelastic region of the demand curve.
In the region where the demand curve is inelastic, an increase in price (leftward movement
along a demand curve) will increase TR. Would a monopoly ever produce an output level
where demand is inelastic?
No. The monopoly will simply produce a lower quantity, which would increase prices, and
benefit from an increase in total revenue. At lower quantities its total costs will also be lower
and consequently, profits will rise.
Conclusion: In a monopoly demand effectively is always relatively elastic.
Now lets get into a monopolys pricing decisions.
Single-Price Strategy
A monopoly will produce a quantity where it maximizes profits. Table 2 shows the price,
revenue and cost structure for a monopoly. The monopoly will maximize its total profit by
producing 4 units. Interestingly, this output level occurs where MR equals MC.
Under a monopoly however, to sell the 4
th
unit, further consumption must be enticed by
reducing prices to $9. Moreover, not only does the buyer of the 4
th
unit pay a reduced price
of $9, but the 3 previous consumers also benefit from reduced prices and now only pay $9
instead of $11. On one hand, revenue increases by selling a larger quantity, (4
th
unit sells for
$9 resulting in an increase in TR of $9). On the other hand, revenue falls (from selling the
first three units at new lower market prices) by ($11 - $9) 3 = $6. The net increase in total
revenue from selling the 4
th
unit is only $3 ($9 - $6).
Conclusion: For firms facing downward sloping demand curves, MR is also downward
sloping with a slope that is steeper than that of the demand curve.
Marginal cost
equals marginal
revenue at 4 units.
Q
1
2
3
4
5
6
7
P
10
9
8
7
6
5
4
TR
10
18
24
28
30
30
28
MR
10
8
6
4
2
0
-2
MC
0.50
1.25
2.15
4
6
9
13
FC
15
15
15
15
15
15
15
TC
15.50
16.75
18.90
22.90
28.90
37.90
50.90
Profit
-5.50
+1.25
+5.10
+5.10
+1.10
-7.90
-22.90
Table 2: A Single-Price Monopolys Price and Output Decision
Sai f Al Hidabi
ESI D-10813
If there is an increase in fixed costs for the monopoly (we had assumed $15 rent in Table
2), the average cost curve will shift up, but the marginal cost and marginal revenue curves
will retain their positions. Hence, the profit maximizing output will not change. However,
if the increase in rent is significant, the average cost curve will move up to such an extent
that at the quantity where marginal cost equals marginal revenue, the firm may make no
economic profits, or even an economic loss (in which case the quantity where MC equals
MR will be the loss-minimizing level). If the monopoly does not foresee demand moving
up, or fixed costs coming down in the long run, it would exit the industry.
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Figure 1: Analysis Of Single Price Monopoly
Quantity
MC
AC
D
MR
MC = MR
PM
AC
M
Q
PM
Notice that at QPM, AC is not at
its minimum. This implies that
the output level that a monopoly
produces represents an inefficient
scale of production
Economic profit =
(PM - ACM) x QPM
Profit maximizing quantity is the output level where MC = MR
Price/unit at QPM
Cost/unit at QPM
The profit maximizing output level for the monopoly (Q
PM
) occurs at the point where MC
equals MR. The monopolist can sell this quantity in the market for P
M
(price derived from
demand curve) and incurs an average cost per unit of AC
M
. The monopoly earns economic
profits equal to the area of the rectangle shaded in green, (P
M
- AC
M
) Q
PM
.
Remember that a monopoly will never charge the highest possible price. The highest possible
price is the price at which only one unit of output will be sold, which represents an output
level that is usually far less than the profit maximizing level. Instead, a monopoly will produce
where marginal cost equals marginal revenue and sell that quantity at the highest possible
price.
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LOS 19c: Explain price discrimination and why perfect price discrimination
is efficient. Vol 2, pg 203-208
Price Discrimination
Price discrimination is the practice of charging different prices to different sets of consumers
for the same good or service. To be able to price discriminate a monopoly must:
1. Have at least two separate identifiable groups of buyers; and
2. Produce a product that cannot be resold.
Price discrimination is best explained through an example. Suppose that a monopolist produces
a good that has 7 potential buyers. The individual buyers marginal benefit from consuming
the good is reflected in the demand curve (Table 3). The first buyer is willing to pay $10 for
the good, while the 7
th
one is willing to pay only $4. Table 3 also lists the firms marginal
cost at various levels of output.
The profit maximizing output level occurs at 4 units where marginal cost ($4) equals marginal
revenue ($4).
The firm will have an opportunity to discriminate on prices if the first user (the user who
is willing to pay $10) can be separated from the others and charged the price that she is
willing and able to pay for that unit ($10). The advantage to the monopolist would be that
it would earn revenue of $10 from her, and $7 from each of the other 3 consumers. This will
increase total revenue from $28 to $31 [($73) + ($101)]. The first users consumer surplus
of $3 (the difference between the maximum price she is willing to pay and the market price)
has now been captured by the monopolist (Figure 2).
Remember that this practice will only be possible if the monopolist knows that the first user
is willing and able to pay $10 for the product. Further, the consumers who purchase the
product for $7 cannot resell it to the first user.
Q
1
2
3
4
5
6
7
P
10
9
8
7
6
5
4
TR
10
18
24
28
30
30
28
MR
10
8
6
4
2
0
-2
MC
0.5
1.25
2.10
4
6
9
13
Table 3: Price Discriminating Monopolys Price and Output Decision
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Under perfect price discrimination, each consumer who incurs the benefit of consumer
surplus from the existence of a single market price is charged the maximum she is willing
and able to pay for the good. In this extreme scenario, the first user will pay $10; the second,
$9; the third, $8; and the fourth, $7 and so on. The monopolist is able to capture all of the
consumer surplus and increase its economic profit. Also notice that under perfect price
discrimination, the monopolists marginal revenue curve is the same as the demand curve.
In order to increase sales, prices do not have to be brought down for all previous consumers.
Each consumer pays the maximum she is willing to pay, and the beneficiary of a price
reduction is only the last buyer. The increase in revenue (marginal revenue) from the last
unit of output equals price that is paid by the purchaser of the last unit. Effectively, under
perfect price discrimination the MR curve equals the demand curve.
Since the MR curve equals the demand curve for a monopoly that is able to engage in perfect
price discrimination, the profit maximizing level of output increases. The entire consumer
surplus is eaten up by the producer, and there is no dead weight loss as output expands to
5 units (Figure 3). This is because MC ($6, which also equals price) now equals MR ($6)
at 5 units of output. Therefore, with perfect price discrimination, allocative efficiency is
reached- the sum of consumer and producer surplus is maximized, and marginal benefit
equals marginal cost. The more perfectly a monopolist can price discriminate, the more
efficient the outcome.
Figure 2: Price Discrimination
MC
AC
D
0 1 2 3 4 5 Quantity
10
9
8
7
6
Increase in economic
profit from price
discrimination
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However, there are two important differences between perfect competition and perfect price
discrimination with regards to efficiency:
- In perfect competition, the surplus is shared between consumers and producers. In
perfect price discrimination, the producer grabs the entire surplus.
- Rent seeking is a profitable activity under perfect price discrimination because any
producer can potentially become large enough to establish a monopoly and try to
redistribute surpluses in its favor. Resources are inefficiently used in trying to establish
monopolies. Under perfect competition, because of the insignificant size of each
supplier, and ease of entry and exit, every producer knows that there is no chance
of getting a piece of the pie large enough to enable it to dictate terms to other market
participants. Therefore, rent seeking activities are not pursued.
LOS 19d: Explain how consumer and producer surplus are redistributed in
a monopoly, including the occurrence of deadweight loss and rent seeking.
Vol 2, pg 199-202
In perfect competition, market demand and supply intersect to determine equilibrium price
and quantity. Therefore, allocative efficiency is reached because the sum of producer and
consumer surplus is maximized, and MB equals MC (Figure 4b).
However in a monopoly, one firm represents entire market supply, and it chooses to produce
the output level where its marginal cost equals marginal revenue. Typically, this level occurs
at an output level short of the allocatively efficient outcome (Figure 4a). Further, monopolists
charge the maximum possible price for their output, which usually is higher than prices under
Recall that in perfect
competition, each
producers minimum
efficient scale is at an
output level that is
insignificant compared to
the size of the market.
Figure 3: Perfect Price Discrimination
MC
AC
D = MR
0 1 2 3 4 5 Quantity
10
9
8
7
6
Increase in
output
Increase in economic
profit from perfect price
discrimination
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LOS 19e: Explain the potential gains from monopoly and the regulation of
a natural monopoly. Vol 2, pg 208-212
The existence of monopolies is attributed to the advantages they enjoy over more competitive
markets.
perfect competition. At the profit maximizing level of output, demand (marginal benefit) is
greater than supply (marginal cost), and the society suffers from a dead weight loss from
underproduction.
The eventual total cost to society may be greater than just the dead weight loss due to rent
seeking. All surpluses (consumer and producer surplus, and economic profits) are included
in economic rent, and any attempt to gain a greater portion of societal economic rent is known
as rent seeking.
A monopoly is able to redistribute societal surpluses in its favor by capturing some of the
consumer surplus via price discrimination. Firms can increase their share of societal surpluses
by either acquiring a monopoly or working towards establishing a monopoly by lobbying
with government officials for favorable legislation. The resources spent in trying to establish
a monopoly could have been utilized more efficiently elsewhere.
Figure 4: Efficiency Under Monopoly And Perfect Competition
1) Monopoly produces QM, where demand exceeds
supply and MB is greater than MC.
2) The sum of consumer surplus and producer
surplus is not maximized.
3) Therefore, there is inefficient allocation of
resources in a monopoly. Society suffers a
dead weight loss
4) QM is lower than QPC
5) PM is higher than PPC
Quantity
MR
D
S, MC
4a. Monopoly:
Market Demand and Supply
Producer
surplus
QM
PM
1) The industry produces QPC ,where demand
equals supply and MB equals MC.
2) The sum of consumer surplus and
producer surplus is maximized.
3) Therefore, perfect competition results in
allocative efficiency. There is no dead weight
loss.
4) QPC is greater than QM
5) PPC is lower than PM.
Quantity
D
S
4b. Perfect Competition:
Market Demand and Supply
Consumer
surplus
Producer
surplus
QPC
PPC
Consumer
surplus
Deadweight loss due
to underproduction
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Incentives for innovation: A patent grants the creator of a product the exclusive right to
produce the product and earn economic profits from her innovation. If this protection were
not provided, people would not have any incentive to innovate. Monopolists also have a
higher incentive to innovate because they want to maintain their dominant position in the
industry. Further, monopolists have the necessary funds to invest in research and development.
Economies of scale and scope: Economies of scale exist when average costs decrease as
output increases. Economies of scope exist when average costs decrease as a broader range
of goods and services is produced. If large economies of scope and scale exist, it is cheaper
and more efficient for one firm to produce the good.
Regulation of Natural Monopolies (Figure 5)
The profit maximizing output for a monopoly occurs where MC equals MR. At this output
level, monopolies charge a relatively high price (PPM) and earn economic profits.
Governments can regulate a natural monopoly and force it to charge a price equal to its
marginal cost. This is known as efficient regulation. At this point, allocative efficiency is
reached as marginal benefit equals marginal cost (demand equals supply). At P
MCP
, the entire
surplus goes to consumers, as they benefit from lower prices and increased output (QMCP).
However, under marginal cost pricing, the monopoly will suffer economic losses, and will
cease operations if it does not foresee a favorable change in government policy. In order to
convince the monopoly to remain in production, the government might have to offer a subsidy
that at least covers the monopolys economic losses. The government could also allow the
natural monopoly to price discriminate or to charge two-part prices to enable it to make
normal profits.
Another option available to the government is to restrict prices to average cost (PACP). In this
situation, the monopolist makes a normal profit, where it covers opportunity costs, and is
not tempted to exit the industry.
Figure 5: Regulating A Natural Monopoly
Quantity
MC
LRAC
D
MR
QPM QMCP QACP
PPM
PMCP
PACP
Monopoly profit-maximizing price:
Price corresponding to QPM on the demand curve.
Monopoly makes economic profits.
Average cost pricing: AC = D
Monopoly makes zero economic profit
Marginal cost pricing: MC = D
Monopoly makes economic losses,
The government must subsidize
these losses to convince the firm to
stay in production.
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MONOPOLISTIC COMPETITION AND OLIGOPOLY
LOS 20a: Describe the characteristics of monopolistic competition and
oligopoly. Vol 2, pg 220-222, 233-235
Monopolistic competition has the following characteristics:
Large number of firms. This characteristic has three implications:
o Each firm controls a small share of the market and is unable to influence prices.
o Firms do not focus on the price of each individual competitor, but only on the average
market price.
o Collusion is not possible as there are too many producers.
Product differentiation. Each firm makes a product that is slightly different from its competitors.
Competing products are good substitutes, which make the demand curve highly elastic.
Firms compete on quality, price and marketing. Product differentiation allows firms in
monopolistic competition to compete on different grounds.
o The quality of a product can be attributed to its design, reliability, and ease of purchase.
Quality plays a key role in product differentiation.
o Firms operating in monopolistic competition face downward sloping demand curves.
There is a tradeoff between quality and price. Firms with higher-quality goods can
charge higher prices.
o Marketing includes advertising to inform consumers about the differentiated
products and convince them to purchase the firms products.
Low barriers to entry and exit. In monopolistic competition, there are very low barriers to
entry and exit. New firms enter the industry when economic profits are being made, which
reduces prices and eliminates economic profits in the long-run. Similarly, when firms
experience losses, some of them exit the industry, which increases prices and eliminates
economic losses in the long-run.
The demand for each producers output is highly elastic, as opposed to perfectly elastic
demand in perfect competition. Firms in monopolistic competition command a premium for
the quality associated with their brands and therefore are not price-takers. The toothpaste
and soap industries provide examples of monopolistic competition.
Oligopolies have the following characteristics:
Small number of firms. This characteristic has two implications:
o There is interdependence among the firms as the actions of one firm influence
demand, price and profits of other firms. For instance, if there are three firms in
an industry and one of them reduces its price, the other two will probably see a
reduction in their market shares and profits. As a result, the two firms will be forced
to follow suit and reduce their prices as well.
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o Firms in an oligopoly have an incentive to cooperate (collude) because they can get
together to form a cartel and operate as a monopoly. The small number of firms
makes collusion possible.
Similar or differentiated products. Firms in an oligopoly can produce similar products and
compete on price or produce differentiated products and compete on price, quality and
marketing.
Barriers to entry. Barriers to entry differentiate oligopolies from monopolistic competition.
With substantial barriers to entry in an oligopoly, new firms cannot enter the industry so
existing firms can maintain their grip on the market. These barriers can be in the form of
legal restrictions or economies of scale.
LOS 20b: Determine the profit-maximizing (loss-minimizing) output under
monopolistic competition, explain why long-run economic profit under
monopolistic competition is zero, and determine if monopolistic competition
is efficient. Vol 2, pg 223-228.
In the short run, a firm operating in monopolistic competition will make its price and output
decision just like a monopoly does. It will produce at the output level where MC equals MR,
and earn economic profits equal to the shaded region in Figure 1.
Figure 1: Economic Profit in the Short Run
Quantity
MC
AC
D
MR
MC = MR
AC
Economic
profit
QPM
Profit maximizing
output where
MC = MR
PMC
Demand is highly elastic.
Availability of close
substitutes makes
consumers very sensitive
to price changes.
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ESI D-108 13
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However, it is also possible for a firm in monopolistic competition to face relatively low
demand for its product. In this situation, the firms average cost curve will lie above its
demand curve and the firm will suffer economic losses in the short run.
In the short run, a firm in monopolistic competition operates in a very similar manner to how
a monopoly operates. It produces the output level where MC equals MR, and charges the
maximum possible price that buyers are willing to pay for its product (determined by the
demand curve). The key difference between the two industry structures lies in what happens
in the long run in response to short run economic profits and losses.
If firms in monopolistic competition are making economic profits in the short run, new firms
will try to move into the industry. As there are low barriers to entry and demand is highly
elastic, new firms will make similar products and successfully capture some market share
in the industry. This eventually reduces demand faced by each individual firm to a level
where demand is tangent to the average cost curve. No economic profits or losses are made
(only normal profits are made) and the industry reaches long run equilibrium (Figure 3).
If demand is lower than average cost, and firms make economic losses in the short run, some
firms will exit the industry. This will result in an increase in demand faced by each remaining
firm. Eventually, firms in the industry make normal profits and in long run equilibrium, there
is no incentive for new firms to enter, or for existing firms to exit the industry.
Figure 2: Economic Loss in the Short Run
Quantity
MC
AC
D
MR
MC = MR
AC
QLM
Loss minimizing
output where
MC = MR
PMC
Economic loss
Price is lower
than average
total cost.
If demand facing an individual
firm lies below its ATC curve,
the firm will make economic
losses.
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Efficiency under Monopolistic Competition
A firm in monopolistic competition generally produces lower output and charges a higher
price than a firm in perfect competition. Significantly, the price charged under monopolistic
competition is higher than the marginal cost of production, which implies that the outcome
is not allocatively efficient. Recall that allocative efficiency is reached when price (marginal
benefit) equals marginal cost.
In perfect competition, price equals marginal cost, while in monopolistic competition, price
exceeds marginal cost (Figure 4). This excess of price over marginal cost is known as markup.
In monopolistic competition, consumers pay a price that is higher than the price they would
pay under perfect competition.
In the long run, firms in perfect competition and monopolistic competition both produce at
levels where marginal cost equals marginal revenue (Figure 4). For a firm in monopolistic
competition, this output level occurs at a level of output where demand is tangent to the
average cost curve, but at a stage where average costs are still falling. In perfect competition,
all firms produce an output level where average cost is at its minimum, or at the efficient
scale of production. Firms in monopolistic competition therefore, have excess capacity.
Excess capacity is a situation where a firm produces an output level that is short of its
minimum efficient scale.
However, monopolistic competition has its supporters. Monopolistic competition offers
consumers variety, and gives them options to choose from.
Figure 3: Long Run Equilibrium
Quantity
MC
AC
D
MR
MC = MR
PMC, AC
No Economic Profits or Losses
QPM
Profit maximizing
output where
MC = MR
Price equals
average total
cost.
Zero
economic
profits.
P =AC
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LOS 20c: Explain the importance of innovation, product development,
advertising, and branding under monopolistic competition. Vol 2, pg 228-233
Innovation and product development: Development of new and differentiated products
enables firms in monopolistic competition to obtain a competitive edge over their rivals. It
results in a less elastic demand curve, which allows firms to increase profits by charging
higher prices. However, these economic profits will only be temporary as competitors will
eventually produce close substitutes or imitations. If a firm in monopolistic competition
wishes to continue making economic profits, it must continue to innovate.
While innovation can help generate additional revenue, it also entails additional costs. Firms
should aim to undertake the optimal quantity of product development activities, which is the
quantity where the marginal cost of innovation equals the marginal revenue from innovation.
Advertising: Creating new products is one way of achieving product differentiation. Companies
may also differentiate their products by advertising aggressively. Therefore, firms in
monopolistic competition tend to spend significant amounts on advertising compared to firms
in perfect competition and monopolies.
Advertising expenditures are fixed costs, so average advertising cost (advertising cost per
unit) declines as output increases. Even though advertising increases total costs, it can actually
decrease average total costs if the benefit of higher output and sales from advertising outweighs
the cost of advertising.
Figure 4: Excess Capacity and Markup
MR
P
QPM
MC
Quantity
MC
AC
D
Qmin AC
4a. Monopolistic Competition
Quantity
MC
AC
D = MR
Q
PM
,Q
min AC
P = Min AC at QPM.
P
P = MC at QPM
4b. Perfect Competition
Markup
P > MC
At QPM price
equals AC but not
minimum AC.
Minimum
efficient scale.
Excess Capacity
QPM < Qmin AC
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Brand names: Brand names provide consumers information about the quality of a product.
For instance, if a consumer has a choice between purchasing a pair of Levis
jeans or a pair
of jeans made by a lesser-known denim manufacturer she would associate the Levis
brand
with higher quality. A companys investment in its brand is so valuable and significant that
it does not want to dilute the quality of its brand by producing low quality goods.
LOS 20d: Explain the kinked demand curve model and the dominant firm
model, and determine the profit-maximizing (loss-minimizing) output under
each model. Vol 2, pg 236-237
OLIGOPOLIES
Kinked Demand Curve Model
The kinked demand curve model assumes that if a firm operating in an oligopoly increases
its price, others will not follow suit and the firm will suffer a large decrease in quantity
demanded (elastic demand). However, if the firm were to reduce its price, competitors would
follow its lead, and the increase in quantity demanded for the firm would not be significant
(inelastic demand). These two contrasting shapes of the demand curve i.e., relatively elastic
above current prices, and relatively inelastic below current prices, results in a kink in the
firms demand curve and a break in its marginal revenue curve. (Figure 5)
The break in the marginal revenue curve (between Points A and B) implies that if an increase
in cost of production were to shift the marginal cost curve from MC1 to MC2, the firm would
still produce the same level of output. It would take a significant change in cost of production
(one that forces the MC curve to shift outside the range between Point A and B) to change
the firms profit maximizing output level.
Figure 5: Kinked Demand Curve Model
Quantity
MC2
D
MC1
MR
A
B
QPM
Elastic region.
Kink
Inelastic region.
Break
in MR
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Dominant Firm Model
This model assumes that the industry is dominated by one large firm that has a significant
cost advantage over all its rivals, and therefore produces the bulk of industry output. This
dominant firm produces the output level where its marginal cost equals marginal revenue,
and charges the maximum possible price. All the other smaller firms are price-takers in that
they have no influence on market price, and can sell their output at the price charged by the
dominant firm.
Unfortunately neither of these models enables us to understand how oligopoly markets
actually work. We shall now study a newer model that is based on Game theory.
Prisoner As Strategies
A Confess
B Silent
Punishment:
A only gets 1 year in jail.
B gets 10 years in jail.
A Silent
B Silent
Punishment:
A and B both walk away free in 3
months.
A Confess
B Confess
Punishment:
A and B get 2 years in jail.
A Silent
B Confess
Punishment:
A gets 10 years in jail.
B only gets 1 year in jail.
LOS 20e: Describe oligopoly games including the Prisoners Dilemma.
Vol 2, pg 238-247
Game Theory and the Prisoners Dilemma
In order to understand Game theory, we will first go through the classic prisoners dilemma.
Assume that the District Attorney (DA) has two bank robbery suspects in custody. The DA
would prefer that the suspects confess to the crime so that she may close the case immediately.
The two prisoners are taken to separate interrogation rooms and are given the choice to either
confess to the crime or face prosecution in court. The punishment for a criminal who confesses
is obviously more lenient than for one who chooses to remain silent and is subsequently
convicted.
The following matrix illustrates the scenarios that each prisoner is looking at:
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Lets look at things from Prisoner As perspective. He has no idea what Prisoner B will do
in the other room. He knows the best outcome occurs is if neither he nor Prisoner B confesses,
but can he trust Prisoner B to remain silent?
o If A remains silent, he will either see 10 years in jail (if B confesses) or go free in 3
months (if B also remains silent).
o If A confesses, he will either get 2 years in jail (if B also confesses) or just the 1 year
(if B remains silent).
It is fairly clear that Prisoner A will confess, and so will Prisoner B. The risk of remaining
silent is too high- 10 years in jail if the other confesses. The prisoners will confess despite
the fact that remaining silent offers the best (socially optimal) outcome (both walk away in
three months). Each prisoner knows that it is too risky to assume that the other will remain
silent.
In the case of the prisoners dilemma, Nash equilibrium occurs when A makes his best choice
given Bs choice and when B makes his best choice given As choice. The most likely outcome
is that both prisoners confess and accept the relatively lenient punishment, and the DA closes
the case immediately.
Applying the Prisoners Dilemma to an Oligopoly
Assume that there are only two firms in an industry. The two firms produce an identical
product, charge the same price, and quantity demanded depends on prices (downward sloping
demand). This industry is a natural duopoly- each firm produces at the level where its average
cost is minimized, and entire industry demand is met by these two firms efficiently. If there
were three firms in the industry, they would share industry output, and not be able to produce
at their minimum efficient scale.
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Figure 6: Oligopoly
Industry
Quantity Quantity
D
Individual Firm
Quantity Quantity
SI
D
MR
Individual Firm
Industry
MCF
AC
MC
AC
Industry
output.
P0
Min AC0, P0
Q0/2
Q0
PC
ACC
PC
QPM/2 QPM
MC = MR
BEFORE COLLUSION
AFTER COLLUSION
Each firm
charges the
lowest
possible
price.
Each firm produces half
the industry output.
Step 2: By limiting
industry output, the
firms manage to
increase prices to Pc.
Step 1: The two firms
decide to limit their
combined output to the
level where the
industry MC (supply)
equals industry MR.
They join hands to
effectively dominate
the industry like a
profit maximizing
monopoly.
Step 3: Each firm produces (QPM/2),
which is half of the decided industry
output. It charges PC and earns an
economic profit of (PC - ACC)
QPM/2.
Note: The industry marginal cost or supply curve SI
is the horizontal summation of the two firms MC
curves (MCF).
Before joining hands, neither of the companies were earning economic profits (Figure 6).
Lets examine how entering a collusive agreement, and functioning like one big firm
(essentially a monopoly) would benefit them.
A monopoly would produce the output level where its MC curve (the market supply curve)
intersects its MR curve. If the firms limit their combined output to QPM, they would each
produce lower output (QPM/2 versus Q0/2 earlier), charge a higher price (PC versus P0 earlier),
but incur higher average costs due to a lower scale of production (ACC versus AC0 earlier).
However, the increase in price exceeds the increase in average costs, and each firm makes
an economic profit (the region shaded in green).
This scenario is highly dependent on each firm limiting its output. There is an incentive for
each firm to cheat on the arrangement by producing a quantity higher than the agreed upon
level.
If one firm cheats on the arrangement, while the other complies, industry output will move
beyond profit maximizing output and prices would fall to PCH (Figure 7). In this scenario,
the complying firm will produce the agreed upon quantity, (QPM/2) while the cheating firm
will expand its individual output to Q0/2, where it would minimize its average cost.
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7c. Industry
Figure 7: One Firm Cheats
Quantity Quantity Quantity
D
AC AC
QPM/2 QPM Q0 Q0/2 QCH
PCH
P0
PC
PCH
AC0, P0
7a. Complying Firm 7b. Cheating Firm
ACC
The complying firm still operates at
the agreed upon output level but sees
realized prices fall to a level below its
average cost. It makes economic losses
of (ACC - PCH) QPM/2.
The cheating firm expands its output
to the level that it was producing before
the collusion arrangement was in place.
It earns economic profits of
(PCH - AC0) Q0/2
For the cheating firm, prices fall from
PC to PCH and its average cost falls from
ACC to AC0. Crucially its output goes
up from QPM/2 to Q0/2. The overall
effect of all these changes is a net
increase in economic profit for the
cheating firm as long as the other firm
does not cheat.
Price when one firm cheats.
Profit
maximizing
industry
output.
Output
when one
firm
cheats.
Original
industry
output.
AC0
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Given the new price level (PCH), and the different average costs of the two firms, the cheating
firm will make an economic profit, while the complying firm will make a loss. Total industry
profits are now lower compared to when both firms were compliant with the collusion
agreement.
Question: Why would the complying firm continue to adhere to the terms of the arrangement,
and not suspect the other firm of cheating even when it makes economic losses?
Answer: The complying firm might believe that the reason for the lower price is a downward
shift in industry demand; not the excess production by the cheating firm. If the firm has no
reason to suspect the other of higher production, it might just assume that industry demand
has fallen.
In essence, when one firm cheats while the other complies, industry output expands beyond
the profit maximizing level, and total industry profits fall. However, the cheating firm makes
more economic profits than it was earlier, while the compliant firm makes an economic loss.
If both firms cheat on the agreement, they each expand their output to Q0/2. In this case, the
total output of the industry returns to the pre-collusion-arrangement output, where both firms
operate at their minimum efficient scale, produce at levels where AC is minimized, and make
zero economic profits.
Now lets make the payoff matrix for both companies.
A Cheats
B Cheats
Outcome:
Neither firm makes an economic profit.
A Complies
B Cheats
Outcome:
- A makes an economic loss.
- B makes economic profits that are
larger than the profits it would
make if both firms were to abide
by the terms of the arrangement.
- Economic profits for the industry are
not maximized.
A Cheats
B Complies
Outcome:
- A makes economic profits that
are larger than the profits it
would make if both firms were
to abide by the terms of the
arrangement.
- B makes an economic loss.
- Economic profits for the industry
are not maximized.
A Complies
B Complies
Outcome:
- A and B both make economic
profits.
- Industry profits are maximized.
Company As Strategies
Sai f Al Hidabi
ESI D-10813
If we were to look at things from Company As perspective we would notice that:
- If it cheats, Company A will either make no economic profits or make very large
economic profits.
- If it complies, Company A will either make an economic loss or a certain level of
economic profit.
Both firms are aware of the choices available to the other. It is in each firms interest to cheat
on the arrangement given that they have no control over the others actions. Nash equilibrium
for this hypothetical occurs where both firms cheat, charge the same price and produce the
same output as they would in a competitive industry.
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Markets for Factors of Production
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LOS 21a: Explain why demand for the factors of production is called derived
demand, differentiate between marginal revenue and marginal revenue
product (MRP), and describe how the MRP determines the demand for labor
and the wage rate. Vol 2, pg 264-270
Like goods and services, factors of production are also traded in markets where demand and
supply determine equilibrium quantity and price. The demand for a factor of production is
a derived demand- its demand is a function of the demand for the goods and services that it
is used to produce. For example, an increase in demand for housing leads to an increase in
demand for construction workers.
Marginal revenue (MR) is the increase in revenue from selling one more unit of output.
Marginal revenue equals price when the firm is a price-taker and faces a perfectly elastic
demand curve (perfect competition). When a firm faces a downward sloping demand curve,
marginal revenue is lower than price because in order to sell an additional unit of output,
prices must be reduced for all units.
Marginal product (MP) of labor is the increase in output from employing one more unit
of labor, holding quantities of other factors of production constant. Since marginal product
is measured in terms of physical units produced, it is also called marginal physical product.
Marginal revenue product (MRP) of labor is the increase in total revenue from selling the
additional output (marginal product) of the last unit of labor employed.
Given the information in Table 1, how much would you, as an employer, pay for the 4
th
unit
of labor? The 4
th
unit of labor allows you to produce 4 more chairs (MP = 4).
MARKETS FOR FACTORS OF PRODUCTION
Quantity of
Labor (QL)
0
1
2
3
4
5
Total
Product
(TP)
0
10
18
24
28
30
Price
(P)
$
-
10
9
8
7
6
Marginal
Product
(MP)
0
10
8
6
4
2
Total
Revenue
(TR)
$
0
100
162
192
196
180
Marginal
Revenue
Product (MRP)
$
0
100
62
30
4
-16
Table 1: Marginal Revenue Product
MRP of labor = Change in total revenue / Change in quantity of labor
Table 1 shows how the employment of additional units of labor in a factory affects total
production of chairs and how MP and MRP of labor are different.
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While it is true that hiring the 4
th
unit of labor increases output by 4 chairs, and each of these
chairs sells for $7, an employer would not be willing to pay $28 (price times MP) for the
4
th
unit of labor. This is because in order to sell the 4 additional chairs produced by the 4
th
unit of labor, prices of all chairs sold have to be brought down to $7. Faced with a downward
sloping demand for its product, the firm will only see an increase in total revenue of $4 from
employing the 4
th
unit of labor and selling its output. The maximum that a profit-maximizing
firm will be willing to pay for an additional unit of labor is that particular units contribution
to total revenue, which equals its MRP. A profit-maximizing firm will hire more labor until:
MRPLabor = PriceLabor
- If the price of labor, or wage rate, is less than the marginal revenue product of labor,
a firm can increase its profit by employing one more unit of labor.
- If the wage rate is greater than the marginal revenue product of labor, profit can be
increased by employing one less unit of labor.
Therefore, MRP for labor represents the demand for labor.
LOS 21b: Describe the factors that cause changes in the demand for labor
and the factors that determine the elasticity of the demand for labor. Vol 2,
pg 270-273
Three factors affect demand for labor.
1. Price of the firms output: This factor affects demand for labor through its effect on
marginal revenue product. If the price of output increases, marginal revenue will also increase,
and in turn the marginal revenue product of labor will also rise. An increase in MRP is
equivalent to an increase in the demand for labor (the demand curve for labor curve shifts
to the right).
2. Other factor prices: Demand for labor is negatively related to the price of other factors
of production that are complements for it in the production process. If the price of a complement
factor of production falls, the demand for labor will rise. Labor demand is positively related
to the prices of factors of production that are substitutes for it in the production process. If
the price of a substitute factor of production increases, demand for labor will increase. Note
that the effect of other factors prices on demand for labor is only applicable in the long-run,
when all factors of production are variable.
3. Technology: Technologies and capital can either be substitutes or complements for different
types of jobs. Historically, technological developments have improved the marginal product
of labor and hence resulted in an increase in demand for labor.
Table 2 summarizes the influences on a firms demand for labor.
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Elasticity of Demand for Labor
Elasticity of demand for labor refers to the responsiveness of quantity demanded of labor
to changes in the wage rate. There are four factors that affect the elasticity of labor.
1. Time period: Demand for labor is more elastic in the long run than in the short run. In the
long-run, all factors of production are variable so labor can easily be substituted by other
factors.
2. Labor intensiveness of the production process: If a production process is labor-intensive,
labor forms a larger proportion of the total cost of production and, therefore, will have more
elastic demand. For example, if labors share in total costs is only 20% then a 10% increase
in the wage rate will increase total costs by only 2%. However, if labors share of total costs
is 80% then the same 10% increase in wages will raise total costs by 8%. An employer will
be more tempted to substitute away from labor in the situation where labor wages constitute
the bulk of production costs.
3. Substitutability of capital and labor: The more easily capital can replace labor in the
production process, the more elastic the demand for labor.
Table 2: A Firms Demand for Labor
Changes in Demand
(Shifts in the Demand Curve for Labor)
Decreases if:
- The wage rate increases.
A firms demand for labor
Decreases if:
- The price of the firms output
decreases.
- The price of a substitute for a labor
falls.
- The price of a complement of labor
rises.
- A new technology or new capital
decreases the marginal product of
labor.
Increases if:
- The wage rate decreases.
Increases if:
- The price of the firms output
increases.
- The price of a substitute for a labor
rises.
- The price of a complement of labor
falls.
- A new technology or new capital
increases the marginal product of
labor.
The quantity of labor demanded by a firm
The Law of Demand
(Movements along the Demand Curve for Labor)
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LOS 21c: Describe the factors determining the supply of labor, including the
substitution and income effects, and discuss the factors related to changes in
the supply of labor, including capital accumulation. Vol 2, pg 274-276
Workers that supply labor have two choices- they can work and earn a wage as compensation
for their efforts, or engage in leisure activities. The decision to work and supply labor depends
on the wage rate. Wages are the opportunity cost of leisure, so the higher the wage rate, the
more workers will substitute work for leisure. This positive relationship between wage rates
and the quantity of labor supplied is due to the substitution effect. However, after attaining
a certain wage rate, workers begin to prioritize leisure. At these high wage levels, workers
cut back on their supply of labor, which causes the labor supply curve to bend backwards
due to the income effect. (Figure 1).
Two factors affect the supply of labor:
- The higher the adult population of a country, the greater the supply of labor.
- Technological improvements in home production (e.g. microwaves and laundry
services) have reduced the time required to perform domestic chores, and led to an
increase in labor supply.
4. Elasticity of demand for the product: If demand for the final product is relatively elastic,
a change in price of the good will result in a significant change in its quantity demanded.
Consequently, demand for labor employed in production of the good will also be relatively
elastic.
Figure 1: The Supply Of Labor
Quantity of Labor
S
Income effect: The
higher the wage rate
the lower the
quantity of labor
supplied.
Substitution effect:
The higher the wage
rate the greater the
quantity of labor
supplied.
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LOS 21d: Describe the effects on wages of labor unions and of a monopsony,
and explain the possible consequences for a market that offers an efficient
wage. Vol 2, pg 276-283
A labor union is an organization of workers that is formed with the objective of serving the
interests of its members. Labor unions aim to increase wages, improve working conditions,
and increase job opportunities. They try to achieve their goals through collective bargaining.
To increase equilibrium wage rates, labor unions can either decrease the supply of labor or
increase the demand for labor. Figure 2 shows the equilibrium wage rate in a competitive
labor market, and how a labor union tries to influence the wage rate.
If a labor union has enough power, it can artificially restrict the supply of labor. The labor
unions success with this measure also depends on how effectively it can control the supply
of workers who are not part of the union. The more effectively it can control the supply of
non-union workers, the more control it will have over total labor supply. Restricting supply
shifts the supply curve to the left to S1, which increases the wage rate to w1. However, this
measure also reduces the equilibrium quantity of labor employed to q1.
To mitigate or eliminate the reduction in the quantity of labor employed as a consequence
of their efforts to increase wages, labor unions have two options:
1. Try to make the demand for labor less elastic. This does not eliminate the tradeoff
between wage rates and employment levels, but does reduce the size of the tradeoff.
If the demand for labor is relatively inelastic, an increase in wages will reduce
quantity demanded of labor to a lesser degree than if demand for labor were relatively
elastic.
Figure 2: Entrance Of A Union In A Competitive Labor Market
Quantity of Labor
S
0
S
1
D
0
w
1
w
0
q
0
q
1
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2. Try to increase demand for labor (shift demand for labor to the right): This will
increase wage rates and the employment levels. Labor unions try to increase the
demand for labor by:
- Increasing the marginal product of union members: An increase in marginal
product will also increase the marginal revenue product of labor, which
equates to an increase in demand. Unions try to improve MP by arranging
training workshops and encouraging apprenticeship.
- Encouraging import restrictions: Unions lobby to restrict imports to protect
the local industry that they work for.
- Supporting minimum-wage laws: Minimum wage laws provide support to
low-skilled workers. Unions support minimum wage laws because higher
wages reduce quantity demanded of low-skilled labor (which is a substitute
for unionized labor) and increases demand for skilled, unionized labor.
- Supporting immigration restrictions: Immigration restrictions prevent
foreigners, who are possible substitutes for unionized workers, from entering
the country.
- Increasing demand for goods produced: Labor derives its demand from the
demand for goods that it produces. Unions increase the demand for their
products by encouraging consumers to purchase goods made by unionized
workers.
Evidence suggests that after allowing for skill differences, the wage differential between
unionized and non-unionized workers lies between 10 and 25%.
Monopsony in the Labor Market
A monopsony is a market in which there is only one buyer for a product, so in case of a
monopsony labor market, there is only one employer who hires labor.
Figure 3 illustrates how wages are determined in a monopsony labor market. The MRP curve
is the demand curve for labor and S0 is the supply curve for labor. The figure also shows the
marginal cost curve for labor (MCL), which lies above the supply curve. To hire one more
unit of labor, the employer will have to increase the wage rate for all units already employed.
This results in an increase in total costs that is greater than simply the higher wage paid to
the last unit of labor employed. The gap between the marginal cost curve and supply curve
of labor widens as wage rates increase.
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Notice the similarity
between the
relationship between
MR and demand, and
between MC and
supply. For
downward sloping
demand curves, MR
falls faster than
demand because in
order to sell one
more unit of output,
prices must be
reduced for all units
sold previously. MC
rises faster than
supply of labor
because, more units
of labor must be
hired to increase
production levels.
More units of labor
are only supplied at
higher wage rates
and these higher
wage rates must be
paid to all currently
employed units of
labor as well.
In a competitive market, where there are large numbers of employers and workers, equilibrium
quantity and wage rates are determined by the intersection of market demand and supply.
In Figure 3, the competitive market wage rate will be $20, and 200 units of labor will be
hired.
A profit-maximizing monopsonist will hire a quantity of labor where the marginal cost of
hiring labor equals the marginal revenue product of labor. This means that 150 units of labor
will be hired, and workers will receive the wage rate corresponding to the profit maximizing
quantity on the supply curve ($15). The monopsony employer makes an economic profit per
unit of labor equal to the excess of MRP over the wage rate i.e., $10.
A monopsony in the labor market results in a lower wage rate and a lower employment level
compared to a competitive labor market. The ability of a monopsony to reduce the wage rate
and employment levels to make an economic profit depends on the elasticity of supply of
labor. The more elastic the supply of labor, the less power a monopsony has to reduce the
wage rate and employment to increase profits.
A Union and a Monopsony
When labor unions monopolize the supply of labor, and the monopsony employer monopolizes
labor demand, a bilateral monopoly exists, and wages are determined through negotiations
between the union and the employer. In Figure 3, we determined that the monopsony would
only hire 150 units of labor and offer a wage rate of $15. Labor unions might agree on the
quantity of labor employed, but will demand wages equal to the MRP of labor ($25). The
negotiated wage rate will lie somewhere between $15 and $25 and will depend on the relative
bargaining power of the union and the employer.
Figure 3: A Monopsony Labor Market
Quantity of Labor
S0
MCL
MRP = D
25
20
15
150 200
Wage rate
Economic profit
for a
monopsony
employer.
Competitive
equilibrium.
Monopsony
equilibrium.
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Efficiency Wages
An efficiency wage is an above-market wage rate that a firm pays its employees to attract
the most productive workers.
It is not always easy for managers to monitor workers performance. If a firm pays the
competitive market wage rate to all its workers, those who shirk will get the same wage as
those who work hard. If a firm pays an efficiency wage, the cost to the employee of losing
her job due to shirking will increase because she will only find alternative employment at
the (lower) market equilibrium wage. Workers earning an efficiency wage also refrain from
shirking because employers can easily replace them with other (currently unemployed or
lower paid) workers.
A firm will set the efficient wage at the level where the marginal increase in productivity
from the higher wage equals the marginal cost of the higher wage.
Monopsony and the Minimum Wage
In Reading 15, we concluded that when a minimum wage rate is set above the equilibrium
wage rate, wages rise but lower quantities of labor are employed. However, when a minimum
wage rate is imposed on a monopsony employer, wage rates and quantity of labor employed
both rise. Once a minimum wage is set at $20 (Figure 4), it results in a perfectly elastic labor
supply curve (at a wage rate of $20) till 200 units. Further, the MC curve is the same as the
supply curve in this region. Quantities above 200 units will only be supplied at wage levels
higher than $20. The imposition of the minimum wage moves the profit maximizing point
for the monopsony employer to 200 units. The minimum wage effectively increases wages
by $5 and quantity of labor employed by 50 units.
Figure 4: Minimum Wage In Monopsony
Quantity of Labor
S
MCL
MRP = D
Minimum Wage
25
20
15
150 200
Increase in
employment.
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LOS 21e:.Differentiate between physical capital and financial capital, and
explain the relation between the demand for physical capital and the demand
for financial capital. Vol 2, pg 283-284
Financial capital refers to the funds provided by lenders (and investors) to a business so
that it can invest in physical capital to produce goods and services. The greater the demand
for physical assets, the greater the demand for financial capital.
Financial capital is provided by lenders for a price (interest). The equilibrium interest rate
is determined at the point where the quantity supplied of financial capital equals quantity
demanded. The demand for financial capital depends on firms demand for physical capital,
and is therefore, a derived demand. The decision of how much physical capital a firm needs
for its planned investments is driven by its aim to maximize profits.
The demand and supply for capital works in the same way as demand and supply for labor.
However, one special feature of the capital market is that because a unit of capital provides
benefits over an extended period of time, firms must consider its total marginal revenue
product over its entire productive life. Thus, present expenditure on capital must be compared
to the future income it will earn.
LOS 21f: Explain the factors the influence the demand and supply of capital.
Vol 2, pg 285-287
Demand for capital is influenced by the following factors:
Marginal revenue product: MRP of capital is the increase in total revenue realized by
selling the additional output produced by the last unit of capital employed. MRP of capital
diminishes as more units of capital are employed.
Interest rate: A company may purchase physical assets with borrowed funds (on which it
must pay interest) or with its own equity (on which there is an opportunity cost in the form
of interest forgone). The higher the interest rate, the lower the quantity of capital demanded
as it becomes more expensive for a firm to borrow funds or use its own resources to acquire
more capital units.
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A profit-maximizing firm will demand more units of capital until the marginal revenue
product of capital equals the marginal cost of capital. The cost of capital is a present cash
outflow whereas the marginal revenue product of capital is represented by future cash inflows.
These expected inflows must be discounted and then compared with present outlays. The
higher the interest rate, the lower the present value of expected inflows and hence, lower the
demand for capital.
The supply of capital is influenced by savings decisions. Savings are affected by:
Income: Given a certain level of income, people save a proportion and spend the rest. An
increase in incomes will result in a greater total amount of savings in the economy, and an
increase in the supply of capital.
Expected future income: If people expect future incomes to decline (rise), they are more
(less) likely to save in the current period to provide for future consumption. The supply of
capital would rise (fall) as a result.
Interest rates: High interest rates stimulate people to save and increase the quantity of capital
supplied.
The supply of capital is an upward sloping function of interest rates. Changes in interest rates
cause movements along the supply curve, while changes in incomes and expected future
incomes result in shifts in the supply curve.
Equilibrium in capital markets occurs where the demand curve for capital intersects the
supply curve.
Equilibrium quantity
in capital markets
determines the
quantity of savings
and investment in the
economy.
Figure 5: Capital Market Equilibrium
Quantity of Capital
S1 S0
D1
D0
Growth in population
and incomes increases
the supply of capital.
Growth in population
and advances in
technology increase the
demand for capital.
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A renewable resource is one that continues to be replenished by nature. Water in the lakes,
seas and oceans of the world is the best example of a renewable resource. Humans consume
water for so many different purposes, but it continues to be replenished through a natural
process. The total supply of that water at any given point in time is fixed and does not vary
with prices. Therefore, the supply of a renewable resource is perfectly inelastic, and its price
is determined by the demand curve. The higher the demand for a renewable resource, the
greater its price. Figure 6 illustrates the supply curve of a natural resource.
A non-renewable resource is no longer available for consumption once it has been used.
Oil is an example of a non-renewable resource. The stock of oil is the quantity in existence
at a given point in time. This quantity is fixed and is independent of the price of oil. The
known stock of oil is the quantity of oil that has been discovered (known oil reserves). The
stock of oil only has an indirect affect on oil prices. A more direct influence over oil prices
is the rate at which oil is currently supplied for use. This is known as the flow supply of oil.
The flow supply of oil is perfectly elastic at the present value of the expected price in the
next period. Saudi Arabia, the largest oil producer in the world, has a choice regarding when
to increase its oil output. Assume that oil is currently trading at $80/barrel. Saudi Arabia can
either supply oil today at current prices and invest the proceeds in U.S. bonds at 5%, or wait
and sell oil in the next period if it expects prices to be higher.
- If the price of oil is expected to increase at a rate greater than the interest rate, Saudi
Arabia is better off selling oil in the next period. If oil prices are expected to rise by
10% to $88/barrel, Saudi Arabia would be better off reducing supply in the current
period and selling its oil in the next period for $88. Selling oil in the current period
for $80 and investing the proceeds for one period will leave it with only $84/barrel
at the end of the period.
Figure 6: The Supply Of A Renewable Natural Resource
Quantity
S
LOS 21g: Differentiate between renewable and nonrenewable natural resources
and describe the supply curve for each. Vol 2, pg 288-292
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- If Saudi Arabia expects oil prices to increase in line with current interest rates, its
supply curve will be perfectly elastic. If next periods expected price is $84/barrel,
Saudi Arabia would be indifferent between selling today for $80 and investing the
proceeds at 5%, and selling in the next period at $84.
- If oil prices are expected to increase at a rate lower than current interest rates, selling
now and investing the proceeds offers the better return. Saudi Arabia will try to sell
as much oil as it can in the current period.
Keep in mind that prices of nonrenewable resources do not exactly follow this pattern because
the future is always uncertain. Technological changes and political uncertainties are two of
the many factors that make it extremely difficult to predict future prices.
LOS 21h: Differentiate between economic rent and opportunity cost. Vol 2,
pg 292-294
Demand and supply for factors of production determine equilibrium prices and quantities.
A resource with a high marginal revenue product (demand) and limited supply earns a high
price. On the other hand, a resource with a low marginal revenue product and abundant
supply receives a low price.
The income earned by a resource or factor of production is composed of opportunity cost
and economic rent. Opportunity cost represents the income that the factor would earn in
its next best alternative use, and is the minimum amount of compensation required by the
resource for its current use. Any amount that a resource receives in excess of its opportunity
cost is known as economic rent.
Figure 7: The Supply Of A Nonrenewable Resource
Quantity
S
The minimum price that Saudi
Arabia is willing to sell oil at is
the present value of the price
expected in the next period. At
this price, it will sell as much as
buyers demand, so its supply curve
will be perfectly elastic.
P
The idea that next
periods prices will
increase at a rate
equal to the current
interest rate is called
the Hotelling
Principle.
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The division of a factor of productions income between opportunity cost and economic rent
depends on elasticity of supply. Economic rent is similar to producer surplus and is represented
by the area between the supply curve and the market price. The area below the supply curve
is opportunity cost.
- When the supply curve is perfectly inelastic, the factors entire income is composed
of economic rent (Figure 8a). For example, most of the income received by Tiger
Woods (arguably the best golfer of all time) is economic rent.
- When supply is perfectly elastic, the factors entire income is composed of opportunity
cost (Figure 8b). The wages of unskilled workers who are willing to work at the
going wage rate are almost entirely composed of opportunity cost.
- If supply is neither elastic nor inelastic (Figure 8c), it will be upward sloping and
income will be composed of economic rent and opportunity cost.
As the supply curve becomes more inelastic, economic rent as a proportion of total income
increases. However, scarcity of supply does not adequately explain the disparity in incomes
earned by resources with inelastic supply. Consider the annual earnings of Michael Jordan
(the greatest basketball player of his era) and Joko Suprianto (the best badminton player of
his era). Jordan was to basketball what Suprianto was to badminton, and their supply was
limited, so why did Jordan earn so much more than Suprianto?
The answer lies in the fact that Jordans MRP was much higher than Supriantos. Basketball
as a sport is more widely followed, and products endorsed by Jordan sold in millions. The
intersecting point of Jordans MRP (demand) with inelastic supply was at a much higher
level than the intersecting point of Supriantos MRP with his inelastic supply.
Figure 8: Economic Rent and Opportunity Cost
8c. Upward Sloping Supply
Quantity
D
S
Opportunity
Cost
Economic
Rent
8a. Perfectly Inelastic Supply
Quantity
D
S
Economic
Rent
8b. Perfectly Elastic Supply
D
S
Opportunity
Cost
Quantity
Implications of Economic Rent for Taxes
We have seen in Reading 15 that elasticity of supply has an effect on the inefficiency created
by a tax. If supply is perfectly inelastic, the actual burden of the tax is borne entirely by the
supplier. Therefore,
- If the tax is imposed on the income of a factor of production with perfectly inelastic
supply, the supplier bears the entire tax. In this case, the tax has no effect on quantity
supplied and no effect on efficiency. The tax simply transfers purchasing power from
the factor owner to the government. This situation arises when factor income is
entirely composed of economic rent. Taxing economic rent is efficient.
- If the tax is imposed on the income of a factor of production whose supply is not
perfectly inelastic, the tax is partly borne by the buyer. In this case, quantity demanded
decreases and an inefficiency arises. This occurs when a part of factor income is
composed of opportunity cost.
- In the extreme case, where supply is perfectly elastic and entire factor income is
opportunity cost, the buyer pays the entire tax.
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Monitoring Jobs and the Price Level
2009 Elan Guides
LOS 22a: Define an unemployed person, and interpret the main labor market
indicators. Vol 2, pg 302-305
An unemployed person is one who is available for work and satisfies any of the following
three conditions:
- She is without work, but has actively searched for employment opportunities in the
last 4 weeks.
- She has been laid off from a job but is waiting to be called back to the same job.
- She will be starting a new job within the next 30 days.
Labor Market Indicators
There are three indicators that are used to evaluate the state of the labor market.
1. The unemployment rate is an indicator of the extent to which people who want jobs
cannot find them. The unemployment rate rises during recessions and falls in
expansions.
Fluctuations in the labor force participation rate occur due to changes in the number
of discouraged workers. These are people who are willing and able to work, but have
not made specific efforts to find a job in the previous four weeks, which results in
them not being classified as unemployed and not being included in the labor force.
They temporarily leave the labor force during recessions and start actively seeking
work as expansions get underway.
3. The employment-to-population ratio is an indicator of both the availability of jobs
and the degree to which peoples skills and available jobs currently match. The ratio
falls during a recession and increases during an expansion.
MONITORING JOBS AND THE PRICE LEVEL
Labor force participation rate =
Labor force
100
Working-age population
Unemployment rate =
Number of people unemployed
100
Labor force
where:
Labor force = Number of people unemployed + Number of people employed.
2. The labor force participation rate is an indicator of the willingness of people of
working age to take jobs
Employment-to-population ratio =
Number of people employed
100
Working-age population
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LOS 22b: Define aggregate hours and real wage rates, and explain their
relation to gross domestic product (GDP). Vol 2, pg 306-308
The three labor market indicators that we described in the previous LOS help us understand
the state of the economy. However, they do not measure the quantity of labor employed in
the production of an economys real GDP, nor can they be used to assess the productivity
of labor. To determine the total amount of labor employed in an economy, we measure the
aggregate hours clocked by workers, part-time and full-time, over a given year. Aggregate
hours allow us to evaluate labor productivity by comparing total output to the number of
labor hours employed.
Aggregate hours increase during expansions and decrease during recessions. Aggregate hours
have shown an increasing trend over the past four decades. However, the increase in aggregate
hours has been slower than the increase in the number of jobs. This is because the average
number of hours worked by each individual has decreased as part-time jobs have become
more popular.
The real wage rate equals the nominal wage rate adjusted for inflation. It is a measure of
purchasing power, or the quantity of goods and services that can be purchased with an hours
work. Generally speaking, the higher the rate of productivity growth in an economy, the
higher the rate of real wage rate growth.
LOS 22c: Explain the types of unemployment, full employment, the natural
rate of unemployment, and the relation between unemployment and real
GDP. Vol 2, pg 312-314
Frictional unemployment results from the constant economic changes that create the need
for people to switch jobs and for businesses to search for workers. Workers and employers
spend a fair amount of time searching for the job or the resource that they believe best
matches their needs. While these unemployed people are searching for suitable jobs, they
are frictionally unemployed. Frictional unemployment is temporary and voluntary, and is a
healthy phenomenon in any dynamic, growing economy. Frictional unemployment levels
are greatly influenced by unemployment compensation. The higher the number of unemployed
people covered by unemployment insurance and/or the higher the unemployment benefits
paid out, the longer the average time taken by job search activities, and greater the amount
of frictional unemployment.
Structural unemployment results from structural changes in the economy that make some
skills obsolete and leave previously employed people jobless. These structural changes may
arise due to changes in technology or international competition. Structural unemployment
usually lasts longer than frictional unemployment because workers must retrain or relocate
to find suitable jobs. An example of structural unemployment is how automation at steel
plants has eliminated jobs for steelworkers.
Cyclical unemployment is the unemployment generated as an economy goes through the
phases of a business cycle. Cyclical unemployment decreases during expansions and increases
during recessions.
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Figure 1: Unemployment and Real GDP
Real GDP
At Point a the economy is at full
employment level where potential GDP
equals real GDP and the unemployment
rate equals the natural rate of
unemployment. This scenario
represents long run equilibrium for an
economy.
At Point b the economy is functioning
above full employment level where
real GDP exceeds potential GDP and
the unemployment rate is less than the
natural rate.
At Point c the economy is operating
below full employment level where
real GDP falls short of potential GDP
and the unemployment rate is greater
than the natural rate.
SAS0
AD2
Y Y2
SAS1
AD1
SAS2
AD0
Y1
a b c
Recessionary
Gap
Inflationary
Gap
Full employment: An economy reaches its full employment level when it operates at full
capacity and does not suffer from any cyclical unemployment.
Natural rate of unemployment: This is the level of unemployment that exists when an
economy is operating at full employment. It is composed of frictional and structural
unemployment.
Relation between unemployment and real GDP: When an economy operates at full
employment, its real GDP equals its potential GDP. Business cycles cause real GDP to
fluctuate around potential GDP and by extension, cause the level of unemployment to fluctuate
around the natural rate of unemployment.
During an expansion, real GDP exceeds potential GDP, which results in an unemployment
rate that is lower than the natural rate of unemployment.
During a recession, real GDP is lower than potential output so unemployment exceeds the
natural rate.
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LOS 22d: Explain and calculate the consumer price index (CPI) and the
inflation rate, describe the relation between the CPI and the inflation rate,
and explain the main sources of CPI bias. Vol 2, pg 315-321
Inflation is defined as a persistent increase in the general level of prices of goods and services
in an economy over a period of time. When the general price level rises, each unit of currency
buys fewer goods and services. The primary measure of price inflation is the inflation rate,
which equals the percentage change in a price index over a period.
The consumer price index (CPI) is a measure of the average prices paid by a typical urban
household for a particular basket of goods and services. Calculating CPI is a three step
process:
1. Selection of the CPI basket: The CPI basket is a collection of goods and services that
are purchased by typical households. Each good is allocated a weight based on the percentage
of income that a typical consumer spends on it. For example, consumers spend more on
housing than on transportation, so the weight allocated to housing is higher than that of
transportation. Spending patterns are determined by consumer expenditure surveys.
2. Monthly price survey: Monthly price surveys are conducted in 30 urban areas to examine
the changes in prices of goods and services that make up the basket. Adjustments are then
made for non-price factors, such as quality and packaging, so that price changes are isolated.
3. Calculate the CPI: The CPI calculation is performed as follows:
- Find the cost of the CPI basket for the base period.
- Find the cost of the CPI basket for the current period.
- Calculate the CPI for both the periods.
CPI

=
Cost of CPI basket at current prices
Cost of CPI basket at base prices
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Example 1: Calculating the CPI
The table below shows the prices for a basket of goods. Calculate the CPI for this basket
in the current period.
(current period)
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Relation between CPI and inflation rate: The inflation rate is calculated as the change in
CPI from one year to the next.
CPI Bias: It is believed that CPI is not a perfect measure of inflation and tends to overstate
the inflation rate. This upward bias can be attributed to four sources:
1. New goods: With the passage of time, newer and more expensive products are introduced
in the market. The CPI calculation simply replaces the newer, more expensive products for
the older, less expensive ones if they are seen to perform a similar function. This creates an
upward bias in current-period CPI and overstates the inflation rate.
2. Quality changes: Improvements in quality of products are compensated by higher prices,
but the CPI does not account for quality improvements. For example, increases in the prices
of cars inflate the CPI because it does not account for improvements in vehicle life and
mileage.
3. Commodity substitution bias: Changes in the relative prices of goods motivate consumers
to replace expensive goods with cheaper substitutes. Over time, these changes in the
consumption basket make the CPI basket a weak representative of actual spending patterns.
4. Outlet substitution: An increase in prices of goods encourages consumers to purchase from
discount outlets more frequently. This reduces the cost of living for households, but the CPI
does not capture the affect of such behavior.
It is estimated that the CPI causes an upward bias in the inflation rate of approximately 1%.
This bias has consequences in that it distorts economic decisions. For instance, many wage
contracts are adjusted for inflation. The upward bias in CPI favors workers and goes against
employers. Similarly, government payments such as social security benefits are also inflation-
adjusted. In order to mitigate this bias, consumer surveys are now carried out more frequently
and the CPI basket of goods is updated every two years.
Inflation Rate

=
Current CPI - Last years CPI
Last years CPI
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AGGREGATE SUPPLY AND AGGREGATE DEMAND
The potential output of any economy does not vary with the price level. The economys
ability to produce goods and services is limited to the output level where all its resources
are fully employed. In the long run, real wages are constant at the level that achieves full
employment. Whenever the price level changes, money wages and prices of other factors
of production change by the same percentage, which leaves real prices, real wages and real
GDP constant. For example, if price levels were to rise 5%, wages would also rise 5%,
leaving real wages and real output unchanged.
Figure 1: Long Run Aggregate Supply Curve
Real GDP
LRAS
LOS 23a: Explain the factors that influence real GDP and long-run and short-
run aggregate supply, explain movement along the long-run and short-run
aggregate supply curves (LAS and SAS), and discuss the reasons for changes
in potential GDP and aggregate supply. Vol 2, pg 328-335
The macroeconomic long run is the time frame long enough for money (nominal) wages
to change so that the economy achieves full employment. Over the long run:
- An economys real GDP equals its potential GDP.
- Real wage rates remain constant at the level where full employment is achieved.
The macroeconomic short run is the time period during which money wages are assumed
constant. In the short run:
- Real GDP can be above, below or at potential GDP.
- Real wages fluctuate with varying price levels.
The quantity of real GDP supplied is the total output produced by firms and individuals
during a given period. This quantity depends on the quantity of labor employed, the quantity
of capital employed, and the state of technology. The quantity of capital and the state of
technology at any given point in time are fixed because they are determined by decisions
made in the past. However, the quantity of labor is not fixed and is determined by demand
and supply in the labor market.
Long-run aggregate supply (LRAS): The long run aggregate supply curve shows the
relationship between potential GDP and the price level (Figure 1). In the long run, real GDP
equals potential GDP as the labor market and the economy operate at full employment .
At the full
employment level,
there is frictional and
structural
unemployment, but
no cyclical
unemployment.
Potential GDP
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The LRAS curve (potential GDP) shifts when there is a change in the full-employment
quantity of labor and/or capital in the economy, or when there are changes in technology.
Short-run aggregate supply (SRAS): The short run aggregate supply curve shows the
relationship between the quantity of real GDP supplied and the price level, where the money
wage rate and prices of other factors of production are assumed constant.The SRAS curve
is constructed with three assumptions:
1. Prices of final goods and services are variable.
2. Prices of factors of production are constant.
3. Potential GDP is constant.
The first and second assumptions explain the positive slope of the SRAS curve. As prices
of goods and services increase while prices of factors of production remain the same, producers
will be willing and able to supply more output to increase their profits.
- A change in the prices of goods and services represents a movement along the SRAS
curve.
- Changes in prices of factors of production and in potential GDP cause shifts in the
SRAS curve. For example, an increase in money wages shifts the supply curve to
the left because costs of production rise.
Money wages can change for two reasons.
- Unemployment: An increase in unemployment above the natural rate puts a downward
pressure on wages as there are abundant resources in the economy. A decrease in
unemployment below the natural rate puts an upward pressure on money wages as
producers struggle to find unutilized resources.
- Expected inflation: If workers expect inflation to rise in the future, i.e. the purchasing
power of their wages to fall, they will demand higher wages.
When potential GDP changes both LRAS and SRAS shift to the right (Figure 2).
Remember that
changes in the prices
of factors of
production will shift
the SRAS curve, but
not affect LRAS.
Changes in potential
GDP will shift both
the LRAS and
SRAS.
Figure 2: Effect of Increase in Potential GDP on LRAS and SRAS
Real GDP
LRAS0 LRAS1
SRAS0
SRAS1
Let us work with an example of a factory that manufactures T-shirts to illustrate the difference
between the macroeconomic long run and short run. Given its size and equipment, a factory
has the capacity to produce 1,000 T-shirts per day (potential output). In the long run, if the
price of T-shirts increases by 10%, the factorys costs of production will also rise 10% (factor
of production costs remain constant in real terms in the LR, so they must rise in nominal
terms given the increase in price levels). Given the increase in costs, the factory has no
incentive to increase production as prices rise (inelastic LRAS curve).
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In the short run however, money wages and other factor costs are fixed, so an increase in
the price of T-shirts will increase profit margins for the company. Therefore, the company
will respond to the increase in price with an increase in quantity supplied (upward sloping
SRAS curve).
Due to a persistent increase in demand in the LR, the factory can acquire more capital in the
long run. This would increase its potential output and shift its LRAS and SRAS curves.
LOS 23b: Explain the components of and the factors that affect real GDP
demanded, describe the aggregate demand curve and why it slopes downward,
and explain the factors that can change aggregate demand. Vol 2, pg 335-339
Aggregate demand (AD): Aggregate demand shows the relationship between the quantity
of real GDP demanded and the price level.
AD = C + G + I + (X-M)
where:
C = Consumption expenditure.
G = Government expenditure.
I = Investment expenditure.
X - M = Net exports.
The aggregate demand curve is downward sloping. Its negative slope is explained by the
following effects:
1. Wealth effect: An increase in the price level results in a reduction in real wealth (purchasing
power) and forces individuals to consume lower quantities.
2. Substitution effect: An increase in price levels is usually accompanied by higher interest
rates. Higher interest rates force businesses to defer investment expenditure (I), and individuals
to postpone purchases of consumer-durables (C) (e.g. cars). This is known as intertemporal
substitution or substitution between time periods.
While changes in price levels explain movements along the aggregate demand curve, three
factors explain shifts in the aggregate demand curve:
1. Expectations about future incomes, inflation, and profits: An increase in expected
future incomes encourages people to consume more in the current period. An increase in
expected inflation will make consumers spend more at the current (lower) prices. An increase
in expected future profits will tempt companies to invest more heavily in their business.
2. Fiscal and monetary policy: Government spending and taxes are components of fiscal
policy that we will study in Reading 26. An increase in government spending increases the
government expenditure component (G) of AD, while taxes directly affect disposable income.
A decrease in taxes increases the amount of money consumers can spend. We will study
monetary policy in Reading 27. A central bank decision to increase money supply will reduce
interest rates and stimulate aggregate demand through higher consumption (C) and investment
(I) expenditure.
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3. World economy: The world economy influences AD in two ways. Fluctuations in exchange
rates affect export and import prices in domestic currency terms. A depreciation of the
domestic currency effectively reduces export prices and increases prices of imports, and
generally leads to an increase in net exports and an increase in AD. Income levels in other
countries affect exports from the domestic market. For example, the recent recession in the
U.S. has had an adverse affect on AD in China, India, and Japan as their export volumes
have significantly declined.
LOS 23c: Differentiate between short-run and long-run macroeconomic
equilibrium, and explain how economic growth, inflation and changes in
aggregate demand and supply influence the macroeconomic equilibrium.
Vol 2, pg 339-346
Short run macroeconomic equilibrium occurs at the point where aggregate demand equals
short-run aggregate supply. Figure 3 illustrates short-run macroeconomic equilibrium with
a price level of P
0
and real GDP level to Y
0
.
At price levels above P
0
, quantity supplied exceeds quantity demanded. As a result of excess
supply, inventories pile up on store shelves forcing producers to sell their stock at lower
prices. This continues till equilibrium is restored at a price level of P0. At price levels below
P
0
, there is a shortage in the economy, which forces prices to rise until equilibrium is restored
at a price level of P
0
.
It is important to remember that we construct the short-run aggregate supply curve with the
assumption that money wages are constant. In the short-run there is no adjustment of money
wages to achieve full-employment. Therefore an economy can operate at a level below, above
or at full employment in the short run.
Long run equilibrium (Figure 4) is achieved at the intersection of the aggregate demand
curve and the long run aggregate supply curve. At this point, real GDP equals potential GDP.
Figure 3: Short Run Equilibrium
Real GDP
SRAS
AD
P
0
Y
0
Excess Supply
Excess Demand
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In the long-run, money wages are not assumed constant; they are allowed to adjust to changing
price levels. The short run aggregate supply curve intersects the LRAS and AD curves at the
long-run equilibrium price level (P
LR
).
We will now examine how economic growth, inflation, business cycles and changes in
aggregate demand and supply affect macroeconomic equilibrium.
Economic Growth and Inflation
Economic growth is defined as the persistent increase in the potential GDP of an economy.
Potential GDP rises over time with increases in the full employment quantity of labor, capital
accumulation and technological innovation. Inflation is defined as the persistent increase in
price level in an economy, which occurs when the increase in aggregate demand is more
significant than the increase in potential GDP (Figure 5).
Real GDP
PLR
SRAS
AD
Figure 4: Long Run Equilibrium
LR equilibrium
YLR
Figure 5: Economic Growth and Inflation
Real GDP
AD0
P0
P1
Y0 Y1
LRAS1
AD1
LRAS0
Inflation
The increase in aggregate demand
is greater than the increase in
potential output. This results in an
increase in the price level from P
0
to P1 (inflation).
Increase in AD
Increase in Potential GDP due to economic growth
.
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Fluctuations in aggregate demand and aggregate supply in the short run explain why short
run real GDP deviates from potential GDP. Figure 7 illustrates an economy in equilibrium
where SRAS0 and AD0 intersect at a point on the LRAS. Assume that the government
increases its expenditure, which shifts demand to AD1. Consequently, the price level rises
to P1 and there is an inflationary gap as real GDP expands to Y1. Notice that the economy
is only in short-run equilibrium, (aggregate demand equals short run aggregate supply) but
not in long run equilibrium. Further, unemployment is below the natural rate.
The increase in price level reduces real wages so workers demand an increase in their money
wages. Producers, who are already operating above capacity, accede to the demand for higher
wages because they are eager to retain workers (as the resources of the economy are already
stretched) and maintain output levels given the high product prices. The increase in money
wages and cost of production reduces SRAS to SRAS1. Eventually, long-run equilibrium is
restored, but at a higher price level, P
2
.
If the increase in aggregate demand is of the same magnitude as the increase in long-run
aggregate supply (potential output), the economy experiences an increase in real GDP without
any inflation.
Business Cycles
Business cycles occur when the economy deviates from full employment. Figure 6a illustrates
a situation where short run equilibrium occurs short of full employment output. When actual
real GDP (Y
A
) is lower than potential GDP (Y
P
), the output gap is known as a deflationary
gap, recessionary gap, or an Okun gap. When short run equilibrium occurs at an output level
above potential output (Figure 6b) the output gap is known as an inflationary gap or
expansionary gap.
Figure 6: Deflationary and Inflationary Gaps
Real GDP
LAS
SAS
AD
YA YP Real GDP
LAS
SAS
AD
YP YA
Deflationary
Gap
Inflationary
Gap
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Fluctuations in
aggregate supply
are discussed
under cost-push
inflation in the
next reading.
Figure 8 illustrates a completely different scenario. A reduction in government expenditure
causes the AD curve to shift to the left to AD1, which reduces prices to P1 and results in a
deflationary gap. The economy is in short-run equilibrium but not in long-run equilibrium
as it operates below its potential GDP. The lower price level equates to an increase in real
wages. Producers, who are working below capacity and suffering from low prices, will try
to reduce money wages. Workers will have to accept lower wages because there are ample
(unemployed) resources in the economy. Lower wages reduce costs of production and shift
the SRAS curve to the right to SRAS1 bringing the economy to a new long run equilibrium
at a lower price level, P2.
Figure 7: LR Adjustment to an Inflationary Gap
Real GDP
LRAS
SRAS0
AD0
Y0 Y1
SRAS1
AD1
P0
P2
P1
Real GDP
LAS
SRAS0
AD0
Y0 Y1
SRAS1
AD1
Deflationary
Gap
P0
P2
P1
Figure 8: LR Adjustment to a Deflationary Gap
Inflationary
Gap
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LOS 23d: Compare and contrast the Keynesian, Classical and Monetarist
schools of macroeconomics. Vol 2, pg 346-349
Aggregate
Demand
Keynesian
Fluctuations in
aggregate demand
and resulting
business cycles are
caused by changing
expectations.
School of Thought
Classical
Fluctuations in
aggregate demand and
aggregate supply are
driven by
technological changes.
Monetarist
Fluctuations in
aggregate demand
and business cycles
are caused by
inappropriate
monetary policy. The
economy is self-
regulating and will
operate at full
employment as long
as money growth is
stable and
predictable.
Aggregate Supply Under the AD/AS
analysis, during a
recession, money
wages fall and bring
the economy to long-
run equilibrium.
Keynesians argue
that wages are
downward sticky. It
is easy to raise
wages, but not as
easy to reduce them
so the rightward shift
in SRAS does not
occur.
Classical economists
argue that wages are
flexible and instantly
adjust to restore LR
equilibrium. The
economy is self-
correcting.
Recessions are
prolonged because
wages are downward
sticky. It is not
possible for the
economy to return to
full employment
from a recession
without any
government
intervention.
Policy Response Keynesians support
government
intervention through
discretionary fiscal
and monetary policy
during business
cycles. Left alone,
the economy will not
automatically move
towards full
employment.
Taxes cause
disincentives and
create inefficiency.
Therefore, they should
be minimized.
Money supply should
be increased at a
steady and
predictable pace.
Also, taxes should be
kept low to minimize
their adverse effects
on potential GDP.
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Money, the Price Level, and Inflation
2009 Elan Guides
LOS 24a: Explain the functions of money. Vol 2, pg 360-362
Money performs the following functions in an economy:
1. Medium of exchange: Money's most important function is as a medium of exchange to
facilitate transactions. Without money, transactions would have to be conducted through
barter, which involves direct exchange of a good or service for another. The barter system
relies on a double coincidence of wants. The likelihood of a double coincidence of wants
is small, which makes the exchange of goods and services rather difficult. Money effectively
eliminates the requirement of a double coincidence of wants by serving as a medium of
exchange that is accepted in all transactions by all parties.
2. Store of value: Money is more liquid than most other stores of value because as a medium
of exchange, it is readily accepted everywhere. Further, money is an easily transported store
of value that is available in a number of convenient denominations. Money holds on to its
value better when inflation is low.
3. Unit of account: Money also functions as a unit of account, providing a common measure
of the value of goods and services being exchanged. Knowing the value of a good in terms
of money helps us quantify the opportunity cost of consuming the good and facilitates efficient
decision-making. For example, if oranges cost $6/dozen and a pair of shoes costs $12 we
know that the opportunity cost of buying the pair of shoes is 2 dozen oranges.
Notes and coins held
by individuals and
businesses are
known as currency.
Notes and coins held
in banks are not
counted as money.
M1 does not include
currency and
checking deposits
owned by the US
government.
LOS 24b: Describe the components of the M1 and M2 measures of money,
and discuss why checks and credit cards are not counted as money.
Vol 2, pg 362-364
M1 and M2 are the two primary official measures of money.
M1 = currency + travelers checks + checking deposits of individuals and businesses.
M2 = M1 + time deposits + saving deposits + money market mutual funds balances.
Checking account balances are included in measures of money because funds in them can
be transferred from one person to another and can be used to make payments. Checks make
this transfer possible but this does not make the check itself money.
MONEY, THE PRICE LEVEL, AND INFLATION
Credit cards are not money either. Credit cards work in exactly the same way as a loan. If
you purchase goods using a credit card, the credit card company will pay the seller today
and you will have an obligation to pay the credit card company when you receive your bill.
This obligation to the credit card company does not represent money. Money only changes
hands between you and the credit card company when you pay your bill.
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LOS 24c: Describe the economic functions of and differentiate among the
various depository institutions, and explain the impact of financial regulation,
deregulation, and innovation. Vol 2, pg 364-369
A company that accepts deposits from households and firms, and lends these funds out to
other households and firms is known as a depository institution. There are three types of
depository institutions:
1. Commercial banks: These are depository institutions that act as intermediaries between
savers and borrowers. Savers make deposits, which are either held by banks as reserves or
used to generate income. Reserves are held to meet regulatory requirements and to service
the cash needs of customers. The rest of the deposits are used to purchase liquid assets such
as Treasury bills, to invest in higher-yielding long-term securities such as U.S. government
and corporate bonds, and for issuing loans. All these sources generate interest income for
banks. Banks earn a spread equal to the difference between the interest earned on loans and
investments, and the interest paid to depositors. However, in pursuit of maximizing the
spread, banks must ensure that they do not take excessive risk.
2. Thrift institutions: These include savings and loan associations (S&Ls), savings banks
and credit unions. An S&L offers checking and savings accounts and makes personal and
commercial loans. A savings bank only offers savings accounts and primarily makes mortgage
loans. A credit union is usually owned by a group of individuals (e.g. workers in a factory).
It accepts savings deposits and uses them to make consumer loans.
3. Money market mutual funds: These are operated by financial institutions that sell shares
in the fund. Investments are made in short term debt instruments such as Treasury bills.
Economic Functions of Depository Institutions
Depository institutions earn a spread between the interest rate they charge borrowers and
the rate they pay on deposits. They perform several economic functions as they:
- Create liquidity by taking funds from deposit accounts and using them to make loans.
- Minimize the cost of raising funds from depositors by spreading the costs over a
large number of borrowers.
- Minimize the cost of monitoring borrowers as they specialize in the business of
lending and are in a more efficient position to monitor the risk profiles of borrowers
than individuals.
- Pool default risks and spread the risks across a large deposit base.
Financial Regulation
Depository institutions face two types of regulation:
1. Deposit Insurance: Deposits are insured up to an amount of $100,000. Insurance is meant
to protect depositors if the institution fails to meet its commitments. However, there is a
trade-off involved. Because institutions know that their depositors are protected to an extent,
they might be more aggressive in the types of loans and investments that they make.
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2009 Elan Guides
2. Balance sheet requirements: To prevent depository institutions from being over-aggressive
with their investments, regulators require them to adhere to the following balance sheet
requirements:
- Equity capital requirements: Owners are required to contribute at least a specified
proportion of the institutions total capital. This serves as a disincentive for making
risky loans, as owners suffer losses if these loans turn bad.
- Reserve requirements: A minimum proportion of deposits must be retained in the
form of cash or other liquid assets.
- Deposit rules: There are restrictions relating to the types of deposits that depository
institutions may accept. For example, for a long time commercial banks could only
accept checking deposits.
- Lending rules: There are also restrictions relating to the types of loans that depository
institutions can make.
Financial Deregulation
During 1980s and 1990s a variety of laws were passed that completely changed the financial
industry in the U.S. Prior to 1980, commercial banks and other depository institutions had
clearly defined businesses, but deregulation allowed nonbank depository institutions to
compete with commercial banks in a broader range of lending activities.
The 1990s saw the introduction of a law that allowed U.S. banks to open branches nationwide.
This encouraged interstate banking and also brought with it a wave of mergers and the entry
of many international banks into the U.S.
Financial Innovation
Financial innovation refers to the development of financial products that lower the cost of
deposits or increase returns from lending. Three main influences on financial innovation are:
1. Economic conditions: Variable-interest mortgages were developed by S&Ls in the 1980s
when the inflation rate was extremely high and they were losing money (as interest rates
rose above the fixed rates that they had issued mortgages at). Economic conditions persuaded
S&Ls to develop a product that transferred some of the risk of rising inflation and interest
rates to mortgage holders.
2. Technology: Technological advances have made banks operations more cost-effective.
Innovations such as credit cards, ATMs and internet banking are also very popular with
customers.
3. Regulation: Financial innovation is also driven by the aim to circumvent regulation. For
example, Regulation Q prevented banks from paying interest on checking accounts. New
types of deposit accounts were developed to get around the regulation.
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LOS 24d: Explain the goals of the U.S. Federal Reserve (Fed) in conducting
monetary policy and how the Fed uses its policy tools to control the quantity
of money, and describe the assets and liabilities on the Feds balance sheet.
Vol 2, pg 369-373
Exhibit 1: The Feds Balance Sheet
Assets (Billions of $)
Gold and foreign exchange 40
U.S. government securities 500
Loans to banks 30
Total assets 570
Liabilities (Billions of $)
Federal reserve notes 550
Banks deposits 20
Total liabilities 570
The Feds Goals
The Federal Reserve is responsible for conducting monetary policy in the U.S. Its goals are
to keep inflation in check, maintain full employment, moderate business cycles and foster
long term economic growth. Success on all these fronts is almost impossible, so a more
realistic goal for the Fed is to fine tune the performance of the economy, and make it work
more efficiently than it would under a completely hands-off approach.
The Feds Policy Tools
The Feds single most important task is to control the amount of money circulating in the
economy. It uses the following tools to accomplish this task:
1. Required reserve ratio: All banks are required to hold a certain proportion of their deposits
in the form of reserves. Reserves are defined as vault cash plus deposits at the Fed. If a
bank has deposits of $100, and if the reserve requirement is 20%, it has to hold a total of
$20 in its account at the Fed and currency in its vaults. If the bank actually holds $30 in the
form of reserves, it has excess reserves of $10, which it can use to make loans.
3. The discount rate is the rate at which the Fed stands ready to lend reserves to banks in
case their reserves fall below required levels. If the discount rate is high, banks would be
wary of their reserves falling below required levels, and not lend money as aggressively as
they would were the discount rate relatively low.
3. Open market operations involve the sale and purchase of government securities. They are
conducted by the Fed to directly influence the level of reserves held by banks. If the Fed
sells securities through an open-market operation, it withdraws the required amount from
the purchasers banks account at the Fed, which directly reduces the banks reserves.
The Feds Balance Sheet
Exhibit 1 provides an example of the Feds balance sheet.
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- Gold and foreign exchange consists of the Feds deposits at other central banks
and special drawing accounts at the IMF.
- U.S. government securities represent the largest proportion of the Feds assets.
- Federal reserve notes consists of currency in circulation and comprise the largest
portion of the Feds liabilities.
- Banks deposits are the reserve deposits of depository institutions.
How Banks Create Money
Before we get into describing the money creation process we must be familiar with the
following terms:
Monetary base: The monetary base is the sum of notes, coins, and banks deposits at the Fed.
It acts as the base that supports the economys money in circulation. When the monetary
base changes, so does the quantity of money circulating in the economy.
Reserves: A banks reserves are defined as vault cash plus deposits at the Fed.
Actual reserves: The amount of reserves held by a bank at a particular point in time.
Required reserve ratio: All banks are required to hold a certain percentage of their deposits
in the form of reserves. A required reserve ratio of 20% when the banks total deposits stand
at $10 million would require the bank to hold a total of at least $2 million in its vaults and
its deposit account at the Fed.
Required reserve ratio = Required reserves / Total deposits
Desired reserve ratio: This is the percentage of total deposits that a bank desires to hold in
the form of reserves. A banks desired reserve ratio cannot be less than the required ratio,
and usually exceeds the required ratio by an amount that the bank considers necessary to run
its day to day business.
Desired reserve ratio = Desired reserves / Total deposits
Excess Reserves are simply actual reserves minus desired reserves. If desired reserves are
not specified, assume that desired reserves equal required reserves.
LOS 24e: Discuss the creation of money, including the role played by excess
reserves, and calculate the amount of loans a bank can generate, given new
deposits. Vol 2, pg 374-380
LOS 24f: Describe the monetary base, and explain the relation among the
monetary base, the money multiplier, and the quantity of money.
Vol 2, pg 374-380
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As a result of Donalds deposit, XYZs deposits and reserves will rise by $400. XYZ will
hold $80 (20% of the increase in deposits) in the form of reserves and loan out the remaining
$320. The client borrowing the $320 will retain $160 in the form of currency, and deposit
$160 back into the banking system. (This amount is in line with the 100% cash drain ratio
assumed). This cycle will continue with dwindling numbers and eventually, the quantity of
money in the economy will increase by a multiple of the initial increase in the monetary
base, which was only $1,000. This multiple is known as the money multiplier (M) and is
calculated as:
Cash drain ratio =
Currency
Deposits
Lets go through an example to see how money is created. Suppose the Fed purchases a
Treasury security worth $1,000 from Warren, who banks with ABC Bank. To pay for this
security, the Fed will increase the balance in ABCs deposit account at the Fed by $1,000,
and ABC will increase the balance in Warrens account by $1,000. The increase in the balance
of ABCs account at the Fed is an increase in its reserves, and the increase in Warrens account
represents an increase in ABCs deposits.
If the required reserve ratio is 20%, BOA must retain $200 of the $1,000 increase in its
deposits in the form of reserves. Assume that it lends its excess reserves ($800) to another
client, Donald. Donald will keep some of the $800 in the form of currency with him (this
drains cash from the banking system), and deposit the rest in either ABC or some other bank.
We shall assume that he deposits the money in XYZ Bank.
The cash drain ratio is the ratio of currency held by individuals to funds deposited in the
banking system. We assume a 100% cash drain ratio in our example. Therefore, Donald will
retain $400 in cash and deposit $400 in XYZ.
In our example, the money multiplier equals (1+1) / (0.2+1) = 1.667
The initial stimulus of a $1,000 increase in the monetary base will eventually increase the
quantity of money in the economy by $1,000 1.667 = $1,667. If the desired reserve ratio
is not equal to the required reserve ratio, we must use the desired ratio in the money multiplier
formula. If the desired ratio is not given, assume that the desired ratio equals the required
ratio.
- If the required reserve ratio increases, the money multiplier will decrease and if the
required reserve ratio decreases, the money multiplier will increase.
- If the cash drain ratio increases, the money multiplier will decrease and if the cash
drain ration decreases, the money multiplier will increase.
M =
total change in quantity of money
=
1 + c

change in monetary base r + c
where:
r = required reserve ratio.
c = currency drain ratio.
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LOS 24g: Explain the factors that influence the demand of money, and describe
the demand for money curve, including the effects of changes in real GDP
and financial innovation. Vol 2, pg 380-382
There are four factors that affect the demand for nominal money (money not adjusted for
changes in price levels).
1. Price level: If the price level increases by 5%, money demand will also increase by 5%.
However, demand for real money, which refers to the purchasing power of money in terms
of goods and services, remains unchanged. Real money demand is calculated by dividing
nominal money demand by the price level.
2. Nominal interest rates: Nominal interest rates represent the opportunity cost of holding
money. The higher the nominal interest rate, the lower the demand for money.
3. Real GDP: At high real GDP levels more people are employed, which results in higher
income in the economy and a higher demand for money.
4. Financial innovation: Financial innovation has allowed people to purchase goods and
services using debit and credit cards. Consumers no longer need to carry cash on them to
make purchases so money demand has fallen.
The Fed purchases $20 million in securities from the open market. What is the maximum
increase in the money supply that can result from this action if the required reserve ratio
is 30%, the desired reserve ratio is 40%, and the cash drain ratio is 80%?
Solution:
We must use the desired reserve ratio to compute the money multiplier.
The money multiplier equals (1 + 0.8) / (0.4 + 0.8) = 1.5
Therefore the largest possible increase in money supply is $30 million. (1.5 $20 million).
Example 1: Money Multiplier
Notice that ABC is not solely responsible for the creation of money in our example. It is the
banking system as a whole that goes through the following cycle and increases quantity of
money:
1. Banks have excess reserves.
2. They lend the excess reserves.
3. Bank deposits increase.
4. Quantity of money increases.
5. Deposits in the banking system increase. Some of the money goes out of the banking
system in the form of cash drain.
6. These deposits in turn create excess reserves which are loaned out.
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You will learn more
about the relationship
between fixed
income security
prices and interest
rates in later
readings. For now
just remember that
prices of fixed
income securities and
interest rates are
inversely related.
LOS 24h: Explain interest rate determination and the short-run and long-
run effects of money on real GDP. Vol 3, pg 383-385
Interest Rate Determination
Interest rates are determined by the demand and supply of money. In the short run, supply
of money (MS) is determined by the Fed, and is completely independent of interest rates.
Therefore the money supply curve is a vertical line at the quantity determined by the Fed.
The demand for money (MD) curve is downward sloping. The point of intersection between
the money demand and supply curves (e) determines short run equilibrium interest rates (ie).
At interest rates above the equilibrium rate (i1), the quantity of money supplied exceeds the
quantity of money demanded. Firms and individuals purchase government securities with
the excess money, which increases demand for these securities. Consequently, the prices of
these securities rise and interest rates fall.
At interest rates below the equilibrium rate (i2), the quantity of money supplied is less than
the quantity of money demanded. Facing a shortage of money, firms and individuals sell
government securities, which increases the supply of these securities. Consequently, their
prices fall and interest rates rise.
The money demand curve shows the relationship between the quantity of real money
demanded and nominal interest rates, holding other factors constant. The money demand
curve is downward sloping. When interest rates increase, the opportunity cost of holding
money increases, which reduces the quantity of money demanded. A fall in interest rates
lowers the opportunity cost of holding money and increases the quantity of money demanded.
- Changes in price levels do not affect the demand for real money.
- Changes in interest rates result in movements along the money demand curve.
- A change in any of the other factors that affect money demand i.e., real GDP and
financial innovation will cause a shift in the money demand curve.
Figure 1: Money Market Equilibrium
Quantity of Real Money
i1
ie
i2
0
MD
MS
Excess
Demand
Excess
Supply
e
In the short run, money
market equilibrium
determines interest rates.
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LOS 24i: Discuss the quantity theory of money and its relation to aggregate
supply and aggregate demand. Vol 2, pg 385-387
In the long run, the loanable funds market determines equilibrium interest rates.
Money market equilibrium, (the intersecting point of money demand and money supply)
which determines interest rates in the short run, only determines the price level in the long
run. This relationship between the money market and the price level is explained by the
quantity theory of money, which asserts that in the long run, any change in the equilibrium
quantity of money only brings about an equal percentage change in the price level.
Under the theory, the equation of exchange is expressed as:
Velocity of
circulation is the
number of times a
unit of currency
changes hands
annually to purchase
goods and services.
If a twenty dollar bill
is used by ten people
over the year, it
would have been
used to buy goods
and services worth
MV or $200.
MV = PY
where:
M = Quantity of money.
V = Velocity of circulation.
P = Price level.
Y = Real GDP.
The quantity of money (M) has no influence on the velocity of circulation (V) or real GDP
(Y).
We can rearrange the equation of exchange to express it as P = M (V/Y).
(V/Y) is independent of M, so a change in M only brings about a proportionate
change in price level (P).
The equation of exchange can also be expressed in terms of growth rates:
Money growth rate + Velocity growth rate = Inflation rate + Real GDP growth rate.
Inflation rate = Money growth rate + Velocity growth rate Real GDP growth rate.
Inflation rate = Money growth rate Real GDP growth rate.
In the long run, since velocity growth rate is not influenced by money growth rate, it is
assumed to be zero. Thus, the formula above is refined to:
Therefore,
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In the long run, Real GDP equals potential GDP, and real GDP growth equals potential GDP
growth. The real GDP growth rate is given, and is independent of changes in money growth
rate. Therefore, a direct link exists between inflation and the money growth rate.
Empirically, the assertion of the quantity theory that inflation rates in the long run are directly
related to the money growth rate does not hold perfectly. However on average, the inflation
rate is correlated with the money growth rate minus real GDP growth rate.
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LOS 25a: Differentiate between inflation and the price level. Vol 2, pg 397
LOS 25b: Describe and distinguish among the factors resulting in demand-
pull and cost-push inflation, and describe the evolution of demand-pull and
cost-push inflationary processes. Vol 2, pg 398-404
The term price level refers to the general level of prices of goods and services in an economy.
Inflation is defined as a persistent increase in the general price level of an economy over a
period of time. When inflation occurs, the purchasing power of money declines as prices of
almost all goods and services increase.
In the long run, in line with the assertions of the quantity theory of money, inflation occurs
when the quantity of money grows faster than real output.
In the short run, there are two sources of inflation:
Demand-pull inflation results from an increase in aggregate demand in an economy. Lets
assume that an economy is operating at long run equilibrium (Point a) where aggregate
demand (AD0) and aggregate supply (SRAS0) intersect on the long run aggregate supply
(LRAS) curve (Figure 1a). An increase in government spending increases aggregate demand
to AD1, and short run equilibrium shifts to Point b where the economy operates above its
potential (Y1), unemployment is below the natural rate, and the price level is higher than
before (P
1
).
With higher price levels, real wages fall. Workers demand higher wages, and employers
accept their demands because they are desperate to retain workers as there are no spare
resources in the economy (it is operating above capacity).
U.S. INFLATION, UNEMPLOYMENT, AND BUSINESS CYCLES
Figure 1: Demand-Pull Inflation
Real GDP
LRAS
SRAS0
Y0
AD1
AD0
Y1
P0
P1
a
b
Real GDP
LRAS
SRAS0
Y0
AD1
AD0
Y1
P2
P1
SRAS1
c
a
b
1a: Initial Effect
1b: Money Wage Adjusts
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When employers raise money wages (Figure 1b), their cost of production rises and supply
falls to SRAS1. Price levels rise further to P2, and real GDP falls until the economy reverts
to its full employment level, and long run equilibrium is restored at Point c.
The events described above only fuel a one-time rise in price levels. For the increase in price
levels to be termed as inflation, it must be persistent. This would be the case if the government
increases its expenditure again after the economy has reached point c. Even though we
know that such a move will be inflationary and will not increase real GDP in the long run,
the government might undertake this step if it believed that the prevailing unemployment
rate were unacceptable and was trying to force unemployment lower. The economy might
already be operating at full capacity, and the undesirably high unemployment rate could be
the economys natural rate of unemployment. The government will keep stimulating AD to
reduce unemployment, but the overheating economy will revert to its potential output every
time, with higher and higher price levels.
Cost-push inflation results from an increase in cost of production. Cost of production can
rise because of an increase in money wage rates, or an increase in the prices of raw materials.
Suppose an economy is operating at long run equilibrium at Point a where aggregate demand
(AD0) and aggregate supply (SRAS0) intersect (Figure 2a). An increase in the price of an
essential raw material increases the cost of production, and reduces supply to SRAS1. Short
run equilibrium occurs at Point b, where the economy operates below capacity (Y1), with
higher price levels P1, and with unemployment higher than the natural rate.
2a: Initial Effect 2b: Money Wage Adjusts
Figure 2: Cost-Push Inflation
Real GDP
LRAS
SRAS0
Y0
AD0
Y1
P0
P1
a
b
SRAS1
Real GDP
LRAS
Y0
AD1
AD0
Y1
P2
P1
c
a
b
SRAS0
SRAS1
P0
In the wake of rising unemployment, the government may try to boost job creation by
stimulating aggregate demand to AD1. This demand stimulus would bring the economy back
to full employment (Y0), but with a further increase in prices to P2. Suppliers of raw materials
will see their purchasing power diminish (as a result of higher prices), and increase raw
material prices again. Once again, the SRAS curve will shift to the left and the government
will try to respond to the deflationary gap by increasing aggregate demand, resulting in a
cost-push inflation spiral.
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The combination of rising price levels and falling real GDP is known as stagflation. In such
a situation, the government is faced with a dilemma. If it responds to the recessionary gap
by stimulating aggregate demand, it ends up inviting another raw material price hike and a
consequent increase in price levels. If it chooses not to do anything, the economy operates
below full employment with under-utilized resources.
A significant difference between demand-pull and cost-push inflation lies in short run state
of the economy. In demand-pull inflation, the economy operates above its potential in an
inflationary gap. In cost-push inflation, the economy operates in a recessionary gap below
full employment output.
LOS 25c: Explain the costs of anticipated inflation. Vol 2, pg 405-406
Expected or anticipated inflation is reflected in all long-term contracts. People accept this
level of inflation, and budget for it. If a 1% increase in price levels is expected in an economy
currently working at full employment, aggregate demand will be expected to move up by
1%. Also, because the 1% increase in prices is expected, wages will also rise by 1%, causing
aggregate supply to fall by 1%. Long run equilibrium will automatically be restored.
Effectively, when inflation is expected, fluctuations in real GDP do not occur. The economy
continues on its long run course, operating at full employment (Figure 3).
Only if the inflation rate and the consequent change in aggregate demand are correctly
forecasted (anticipated) will the economy follow the course illustrated in Figure 3. Forecasts
of inflation that are based on all currently-available, relevant information are known as
rational expectations. These forecasts could well turn out to be wrong, but with the given
information, no other forecast could have predicted inflation rates more accurately.
Figure 3: Expected Inflation
Real GDP
LRAS
SRAS0
Y0
AD1
AD0
P1
SRAS1
AD2
SRAS2
P0
P3
Anticipated increases in
inflation (and aggregate
demand) do not change
real GDP.
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Figure 4: Inflation Not Anticipated
Real GDP
LRAS
SRAS0
Y0
AD1
AD0
Y1
P0
P1
SRAS1
P2
SRAS2
4a: Inflation above expectations
Real GDP
LRAS
Y0
AD1
AD0
Y1
P2
P1
SRAS0
SRAS1
P0
4b: Inflation below expectations
AD2
If aggregate demand grows at a slower rate than aggregate supply (actual inflation falls short
of expected inflation), real GDP settles short of potential GDP (Figure 4b). The economy
will behave similarly to how it adjusts during cost-push inflation, and over time, long run
equilibrium will be restored (by the movement of aggregate demand to AD2) with a higher
price level(P2 vs. P1) and higher output(Y0 vs. Y1)compared to short run equilibrium.
When the inflation forecast based on rational expectations is correct, the economy continues
to operate at full employment. If ,however, actual inflation turns out to be different from
forecasted inflation, an economy will experience business cycles.
Before getting into the analysis that follows please bear in mind that aggregate demand
moves to the right(rises) in line with actual inflation, whereas aggregate supply moves to
the left(falls) in line with expected inflation.
If aggregate demand (AD1) rises more than aggregate supply, (SRAS1) it means that actual
inflation is greater than expected inflation (Figure 4a). Real GDP moves above potential
GDP to Y1 and the economy operates in an inflationary gap. Over time, the economy will
restore long run equilibrium at a higher price level (P2) as inflationary expectations catch
up with actual inflation and aggregate supply catches up with the shift in aggregate demand
by moving to SRAS2. The economy behaves similarly to how it works under demand-pull
inflation.
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LOS 25e: Explain the impact of inflation on unemployment, and describe the
short-run and long-run Phillips curve, including the effect of changes in the
natural rate of unemployment. Vol 3, pg 406-410
The Phillips Curve
The Phillips curve illustrates the relationship between inflation and unemployment. The short
run Phillips curve (SRPC) is downward sloping. The following variables are assumed constant
when deriving the SRPC:
1. The expected inflation rate.
2. The natural rate of unemployment.
Changes in either of the two factors listed above will cause a shift in the SRPC.
To derive the shape of the short run Phillips curve, we start off at Point a with real GDP
at Y0 and price level at P0 (Figure 5a). On Figure 5b, this situation is captured by Point (i)
where unemployment equals the natural rate (UN).
Costs of Inflation:
Anticipated inflation, particularly high anticipated inflation, inflicts the following costs:
Shoe-leather costs: These are the costs of time and effort put in by people to deal with the
effects of inflation, such as holding less cash on hand and making frequent trips to the bank
when in need of cash.
Transactions costs: People spend money more rapidly when they anticipate high inflation
as they expect their purchasing power to diminish in the future. Therefore, they transact more
frequently and incur transaction costs.
Tax consequences: Anticipated inflation reduces the real after-tax returns from saving. This
decreases capital accumulation and hurts long term economic growth.
Increased uncertainty: A high inflation rate increases uncertainty, which makes long-term
planning for investments more difficult. People spend more time forecasting inflation and
worrying about its consequences.
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An increase in aggregate demand to AD1 will bring short run equilibrium to Point b with
higher prices (P
1
) and higher real GDP (Y
1
) . In Figure 5b, this situation is captured by Point
ii with inflation higher than P0 and unemployment lower than UN.
A shift to AD2 will result in short run equilibrium at Point c with lower prices (P2) and
lower real GDP (Y
2
). On Figure 5b, this situation is represented by Point iii where inflation
is lower than P0 and unemployment higher than UN.
Drawing a curve through the three points that we have just derived illustrates the downward
sloping, convex nature of the short run Phillips curve.
The long run Phillips curve (LRPC) illustrates the relationship between inflation and
unemployment in the long run. In the long run, actual inflation always equals expected
inflation, and there are no business cycles because the economy functions at full employment.
Consequently, unemployment does not fluctuate with different price levels and the LRPC
is a vertical line at the natural rate of unemployment.
The short run Phillips curve intersects the long run Phillips curve at the expected rate of
inflation. If the expected rate of inflation changes, the intersecting point of the two curves
changes. Note that only the short run Phillips curve shifts in response to a change in expected
inflation, not the long run Phillips curve.
Figure 5: Phillips Curve
AS0
AD2
P0
AD0
AD1
LRAS
b
a
c
Y0 Real GDP
UN
(iii)
(i)
(ii)
Unemployment
Y1 Y2
Short Run Phillips Curve
P1
P2
At point c:
AD0 has shifted down to AD2,
Prices are lower.
The economy is working below capacity so
unemployment rises above the natural rate.
At point b:
AD0 has shifted up to AD1,
Prices are higher.
The economy is working above capacity so
unemployment falls below the natural rate.
At Point b compared to a:
Price levels are higher than P0,
Unemployment is lower than UN.
At Point c compared to a:
Price levels are lower than P*,
Unemployment is higher than UN.
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A change in the natural rate of unemployment brings about a shift in both the LRPC and
SRPC. The LRPC would be a vertical line at the new natural unemployment rate, and the
new SRPC would intersect the new LRPC at the expected rate of inflation.
LOS 25d: Explain the relation among inflation, nominal interest rates, and
the demand and supply of money. Vol 3, pg 406
The nominal interest rate is the sum of real risk-free interest rate and expected inflation.
Actual or anticipated changes in the inflation rate cause corresponding changes in interest
rates. Lenders know that inflation will erode the value of their money over the term of the
loan so they are less willing to lend at any given interest rate. Inflation therefore, reduces
the supply of financial capital. Borrowers find borrowing money more attractive and seek
more loanable funds in anticipation of higher prices. This increases the demand for financial
capital. The combination of the decrease in supply and increase in demand for financial
capital when inflation is expected to be high results in an increase in nominal interest rates.
According to the quantity theory of money, an increase in the quantity of money (M) translates
into higher price levels (P) unless there is an equal proportionate increase in real output.
Generally over the long run, increases in the growth rate of money lead to higher price levels
and inflation, which translate into an increase in nominal interest rates.
LOS 25f: Explain how economic growth, inflation, and unemployment affect
the business cycle.
Business cycles refer to fluctuations in economic activity as real GDP deviates from potential
GDP. The growth rate of real GDP and the unemployment rate are the key variables used
to determine the phase of the business cycle that an economy is currently going through.
The business cycle has 4 phases:
Contraction (recession) when the unemployment rate is increasing and real GDP
growth is negative.
Recessionary trough as the economy comes out of a recession towards an expansion.
Expansion when the unemployment rate declines and real GDP growth is positive.
Business peak as the expansion slows down and the economy moves towards a
recession.
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The NBER Recession Dating Procedure, October 21, 2003, available from the NBER Website
(www.nber.org/cycles/recessions.html).
1
The United States-based National Bureau of Economic Research (NBER) defines an economic
recession as a significant decline in economic activity spread across the economy, lasting
more than a few months, normally visible in real GDP growth, real personal income,
employment (non-farm payrolls), industrial production, and wholesale-retail sales.
In an expansionary phase, interest rates are low, and there is an increase in production and
prices as the economy operates at, or above its potential GDP. Unemployment is at, or below
the natural rate of unemployment (only structural and frictional unemployment exist).
In a recessionary phase, interest rates are high, there is a decrease in prices and output as
the economy operates below its potential GDP. Unemployment is high (above the natural
rate of unemployment).
LOS 25g: Describe mainstream business cycle theory and real business cycle
(RBC) theory, and distinguish between them, including the role of productivity
changes. Vol 2, pg 410-416
Mainstream Business Cycle Theory (MBC Theory)
This theory asserts that potential GDP grows at a steady rate, while aggregate demand grows
at a fluctuating rate. It assumes that money wage rates are sticky i.e. wages are not easy to
change in response to changing economic conditions, and therefore prolonged inflationary
and recessionary gaps are possible. The following analysis explains mainstream business
cycle theory:
Initially, an economy is at LR equilibrium at Point a where AD0, AS0, and LRAS0 intersect
(Figure 6). An expansion occurs and LRAS increases to LRAS
1
. During the expansion,
demand moves to AD1, and short run supply shifts to SRAS1. Assume that in this expansion,
price levels were expected to rise 5% so money wages were set to reflect this expectation.
The economy has simply moved to a new equilibrium at Point b with higher real GDP (Y1),
and a higher price level, (P
1
) which was already anticipated.
If however, aggregate demand shifts more significantly than anticipated (AD2), real GDP
increases by more (movement from Y0 to Y2) than potential GDP and the economy moves
to point c. Here, the economy will be in an inflationary gap where real GDP growth is
faster, and inflation is higher than expected.
If AD shifts less significantly than anticipated to AD3, Real GDP increases (movement from
Y
0
to Y
3
) by less than potential GDP and the economy will move to point d. Here, the
economy will be in a deflationary gap where real GDP growth is slower and inflation is
lower than expected.
1
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Recall that under the
AD/AS model,
changes in nominal
wages were crucial
in restoring full
employment in
response to a short
run output gap. For
example, in an
economy functioning
in an inflationary
gap, money wages
would rise and shift
the aggregate supply
curve to the left,
bringing the
economy back to
long run equilibrium.
Under the mainstream business cycle theory, economic growth, inflation and business cycles
can arise from a persistent increase in potential GDP, a different rate of change in aggregate
demand than the rate of change in potential GDP, and variations in the pace of aggregate
demand growth.
The mainstream business cycle theory accommodates productivity shocks and says that
shocks like natural disasters can bring about recessions. However, it asserts that productivity
shocks are not the primary source of business cycles. In contrast, the real business cycle
theory regards productivity shocks as the main cause of business cycles. Before analyzing
the real business cycle theory we briefly describe different versions of the mainstream theory.
The Keynesian cycle theory explains fluctuations in aggregate demand through
fluctuations in investment, which is influenced by changes in business confidence
and expectations in the economy.
Fluctuations in aggregate demand under the Monetarist cycle theory are driven by
both investment and consumption expenditure, which are influenced by the growth
rate of the quantity of money.
In the new classical cycle theory, only unexpected fluctuations in aggregate demand
bring business cycles.
Under the new Keynesian cycle theory, both unexpected and currently expected
fluctuations in AD bring fluctuations in real GDP around potential GDP.
Figure 6: Mainstream Business Cycle Theory
AD3
AD1
AD2
LRAS1
LRAS0
a
c
b
d
AD0
SRAS0
Y0
Change in AD
Change in potential output
SRAS1
Real GDP
Y1
Y3 Y2
1. Change in potential output
brings an expansion.
3. Fluctuations in
AD brings business
cycles.
2. A larger change in AD compared to the
change in potential output brings inflation.
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Real Business Cycle Theory (RBC) Theory
This theory attributes the existence of business cycles to fluctuations in productivity. These
fluctuations in productivity are assumed to arise primarily due to the varying pace of
technological change, but may also arise from other sources like natural disasters or climatic
changes.
Regarding technological changes, it is easy to see how rapid changes in technology can
increase productivity and foster economic growth (expansions). But how can rapidly changing
technology be attributed the blame for decreasing productivity and causing recessions?
While technological change eventually does increase productivity, it can make some resources
(including human capital) obsolete, and reduce productivity temporarily in the initial stages.
During this period, more jobs are lost than created, and businesses find it hard to remain
profitable- two defining characteristics of a recession.
Two outcomes from changes in productivity get expansions and contractions underway. Lets
study how they work in an expansion:
1. Investment demand changes: In an expansion, firms see that the economy is growing at
a good pace and forecast a healthy demand for their products. Therefore, they hire more
workers and aggressively acquire more capital goods to boost production. As a result of the
increase in demand for capital, real interest rates rise to ri1 (Figure 7a), and because of the
increase in demand for labor, real wages also rise.
2. Labor market changes: According to RBC theory, people have a limited quantity of labor
to supply, and decide when to work after undertaking a cost-benefit analysis. They compare
the return from working in the current period to the return from working in the next period.
Suppose you are a laborer with one hour of labor to offer anytime over the next year.
Obviously, since you are willing to work for only one hour, you will work when real wages
are at their highest level. If real wages are currently $10, and one year from now you could
work for $10.5, would you necessarily supply that one hour of labor one year from now and
not today?
The answer becomes clear when we examine the role of real interest rates in your decision
framework. If the current real interest rate is 6% and you were to work today, you would
earn $10, invest them for one year, and have $10.6 in a year. Were you to work after one
year, you would earn a wage of $10.5. By working today and investing your wage, you are
better off by $0.1 ($10.6 - $10.5). However, if real interest rates were merely 3%, you would
work one year later because you would be better off by $0.2 ($10.5 - $10.3).
Therefore, the when-to-work decision depends on real interest rates. The lower the real
interest rate, the lower the incentive to work and lower the quantity of labor supplied in the
current period. Many economists believe this inter-temporal substitution effect to be rather
insignificant, but RBC economists attach a great deal of importance to this effect.
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Going back to our example, in the wake of increasing real interest rates in an expansion, the
supply of labor increases to LS1. The effect of the increase in business optimism on the
demand for labor is greater than the effect of real interest rates on the supply of labor. The
demand for labor curve shifts to LD1, and as a result, the real wage rate rises to rw
1
.
Notice the key ripple effect in the real business cycle theory. The quantity of labor employed
initially increases to Q1 as demand for labor shifts to the right, and then, as supply of labor
increases, the quantity of labor employed increases further to Qe1. The rapid decrease in
unemployment indicates that an expansion is underway in the economy.
The existence of the word real in naming this theory is not a coincidence. The theory is
different from other propositions in that it asserts that real changes, not simply monetary
changes, cause business cycles. If only the quantity of money were to change, AD would
shift, but with no change in productivity or potential output, this stimulus would only translate
into higher price levels. The important supply curve in RBC theory is the long run aggregate
supply curve, and changes in supply are only driven by productivity shocks, which then
stimulate business cycles and changes in real output. Under RBC theory, if only aggregate
demand changes, the economy adjusts via rising prices.
Figure 7: Real Business Cycle Theory
Brighter economic prospects increase labor demand,
while higher real interest rates increase labor supply.
The increase in labor demand increases the quantity
of labor employed to Q1, and the increase in labor
supply increases employment levels to Qe1. This
is known as the ripple effect (on employment).
e1
Qe0 Qe1 Q1
LS0
e0
LS1
LD0
LD1
Brighter economic prospects increase
demand for loanable funds. As a result,
real interest rates rise.
LFS0
ri0
ri1
LFD0
LFD1
7a: Loanable Funds Market 7b: Labor Market
Loanable Funds Labor
rw0
rw1
Real
interest
rates rise
Wage
rates
increase
3. Higher real interest
rates increase supply
of labor.
Note: Magnitude of
shift in labor demand
is greater than that of
shift in labor supply.
2. Brighter economic
prospects increase
demand for labor.
1. Higher demand for
capital increases real
interest rates.
Differences between RBC Theory and MBC Theory
MBC theory states that potential GDP increases at a stable rate. Business cycles are caused
by AD increasing at fluctuating rates, and by fluctuations of real GDP around potential GDP.
RBC theory states that potential GDP grows at fluctuating rates due to the different pace of
technological change over time. It is these fluctuations of potential GDP that it defines as
business cycles.
Criticisms of RBC theory:
1. The money wage rate is sticky, and is not as easily changeable as the RBC theory
asserts.
2. Inter-temporal substitution is weak.
3. Productivity shocks are as likely to be caused by changes in aggregate demand as
they are to be caused by technological changes.
Defense of the RBC theory:
1. Inter-temporal substitution is consistent with a lot of microeconomic evidence.
2. This single theory explains both business cycles and economic growth.
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FISCAL POLICY
Fiscal policy refers to the use of government spending and taxation policies in order to meet
macroeconomic objectives. Changes in the level and composition of taxes and government
spending impact the Federal budget. Fiscal policy refers to the overall effect of the budget
- A balanced budget is when government spending equals tax revenue (G = T).
- A budget deficit involves a net excess of government spending over tax revenue
(G > T). A budget deficit is associated with expansionary fiscal policy.
- A budget surplus occurs when government spending is less than tax revenue
(G < T). A budget surplus is associated with contractionary fiscal policy.
Government spending or government expenditure, which can be financed by taxes or
government borrowing, is classified into three main types:
- Government purchases of goods and services for current use are classified as
government consumption.
- Government purchases of goods and services intended to create future benefits,
such as infrastructure investment or research spending, are classified as government
investment.
- Government expenditures that are not purchases of goods and services, and instead
just represent transfers of money (such as social security payments) are called
transfer payments.
LOS 26a: Explain supply side effects on employment, potential GDP, and
aggregate supply, including the income tax and taxes on expenditure, and
describe the Laffer curve and its relation to supply side economics.
Vol 2, pg 434-438
Fiscal policies, especially taxation policies have an impact on long run aggregate supply
(potential output). These effects are known as supply-side effects.
Lets first study the effect of income taxes on the market for labor, and potential GDP.
In the absence of any taxes, labor demand and labor supply (LD
0
and LS
0
) intersect at Point
a to determine equilibrium wage rate, w
0
, and quantity of labor q
0
(Figure 1a). Translating
this quantity on to Figure 1b, we determine the potential GDP of the economy, given that
q
0
units of labor are employed, as PGDP
0.
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Once income taxes are levied, the labor supply curve shifts to the left because now it would
take a higher wage for workers to supply the same amount of labor. Workers look at after-
tax wages when deciding how many units of labor to supply. The reduction in labor supply
to LS
1
increases the equilibrium wage rate to w
BT
, but reduces the after-tax wage rate to w
AT
and decreases the quantity of labor employed to q
1
. Translating the new quantity of labor
to Figure 1b shows us that the new potential output for the economy will be lower at PGDP
1
A tax cut on the other hand, would result in an increase in supply of labor, an increase in
the equilibrium quantity of labor employed, and boost the economys potential GDP.
The difference between before-tax and after-tax wages is called the tax wedge. Income taxes
are not the only taxes that create a tax wedge. Taxes on consumption expenditure also create
a tax wedge. The incentive to supply labor depends on the goods and services that a unit of
labor supplied can purchase. Taxes on consumption increase the prices of goods and services,
effectively reducing real wage rates, and shift the labor supply curve to the left. If the income
tax rate is 20% and consumption is taxed at 5%, the tax wedge equals 25%.
Figure 1: The Effects Of Income Taxes On Employment And Potential GDP
Quantity of Labor
q0
q0 q1
q1
PGDP1
PGDP0
w0
wAT
LS0
LD0
LS1
a
Quantity of Labor
w
BT
Tax wedge
Step 2a: Before-
tax wages
increase.
Step 2b: After-
tax wages
decrease.
Step 4: Potential
GDP falls.
Step 1: Labor supply
falls because of the
income tax.
Step 3a: Quantity of
labor employed
decreases.
Step 3b: There is a
decrease in quantity
of labor employed.
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Differences in tax wedges across countries create different levels of disincentives to provide
labor, and explain differences in the potential GDP of countries.
The Laffer Curve
The Laffer curve (Figure 2) illustrates the relationship between tax rates and tax revenues.
At the two extreme tax rates, 0% and 100%, the government collects no tax revenues- at 0%
it is obvious that there will be no taxes collected, and at 100% no one will bother working
because every dollar earned will be taken away by the government.
As tax rates increase from zero, tax collections rise, but start falling beyond a certain point
(T*). Beyond T*, high tax rates start creating a significant disincentive to work, and the
effect of higher tax rates is offset by lower total dollars earned.
Most economies are believed to be on the upward sloping part of the Laffer curve. If they
increase tax rates, tax collections would rise, and if they reduce tax rates, tax revenues would
fall.
Supply-siders gained popularity during the time of President Reagan in the U.S. They asserted
that tax cuts would increase employment and output. From our analysis in Figure 1 we can
see the wisdom in that theory. However, they mistakenly also asserted that tax cuts would
increase tax revenues and help counter a budget deficit. This would be true if the U.S. were
on the downward sloping part of the Laffer curve. Unfortunately, the US was on the upward
sloping side of the curve, and even though President Reagans tax cuts increased employment
and output, they did not increase tax revenues, and the budget deficit only worsened.
Figure 2: The Laffer Curve
Tax Rate 0% 100% T*
Upward Sloping Region
- Increases in tax rates lead to
an increase in tax revenue.
- Decreases in tax rates lead to
a decrease in tax revenue.
Downward Sloping Region
- Increases in tax rates lead to
a decrease in tax revenue.
- Decreases in tax rates lead to
an increase in tax revenue.
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Economists now widely accept that tax cuts provide powerful incentives to increase output,
but if they are not accompanied by cuts in government spending, the budget deficit can soar.
So far we have studied the impact of taxes on employment and the level of potential GDP.
Now we will look at the effects of the budgetary position on economic growth, or the rate
of change in potential GDP.
LOS 26b: Discuss the sources of investment finance, and the influence of fiscal
policy on capital markets, including the crowding-out effect. Vol 3, pg 438-443
There are three main sources of investment finance in an economy:
1. Borrowing from the rest of the world.
2. Private savings: Given their disposable income, consumers spend a portion and save
the rest. Savings contribute to the supply of loanable funds.
3. Government savings: If there is a budget surplus, the government contributes to the
supply of loanable funds as it has excess money. A budget deficit on the other hand,
reduces the supply of loanable funds.
Fiscal policy directly affects the market for savings and investment in two ways:
1. Taxes on capital income affect the incentive to save and influence the supply of
loanable funds.
2. The budgetary status dictates whether the government contributes to, or withdraws
from the supply of loanable funds in the economy.
Taxes and Savings
A tax on interest income weakens the incentive to save and creates a wedge between the
before-tax and after-tax interest rate earned by investors. The effects of taxes on savings can
be more serious than the effects of taxes on labor for two reasons:
1. A tax on labor only reduces the level of potential output. A tax on capital income
reduces the quantity of savings and investment and slows the growth rate of potential
GDP. This creates an ever-increasing gap between what potential GDP actually is
and what it could have been. This gap is known as the Lucas wedge.
2. Inflation plays a crucial role in evaluating real after-tax returns. The higher the
inflation rate, the higher the true tax on interest income. We illustrate this with an
example.
Example 1: Effects of Taxes on After-Tax Real Returns
Consider two scenarios - One with a nominal interest rate of 16% and the other with a
nominal interest rate of 6%. The following table calculates the after-tax real return in the
two scenarios.
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Scenario 1
Nominal interest rate = 16%
Inflation = 14%
Real interest rate = 2%
Tax rate = 30%
After-tax nominal return = 11.2%
After-tax real return = -2.8%
Scenario 2
Nominal interest rate = 6%
Inflation = 4%
Real interest rate = 2%
Tax rate = 30%
After-tax nominal return = 4.2%
After-tax real return = 0.2%
The real return in both scenarios is 2%; (16% - 14%) in Scenario 1, and (6% - 4% in
Scenario 2). If there were no taxes, investors would earn the same return in both cases.
However, if tax rates were 30%, the after-tax real return would be higher under Scenario
2 (0.2%) compared to Scenario 1 (-2.8%). This is because taxes are paid on nominal
incomes, not inflation-adjusted real incomes.
Taxes reduce nominal after-tax returns from saving, and significantly reduce real after-tax
returns in an inflationary environment. They hinder capital accumulation and consequently
decelerate long-term economic growth.
Effect of Income Taxes on Private Savings and Investment
When there are no taxes, loanable funds supply (LFS0) and demand (LFD0) intersect at Point
a to determine real interest rates ri
0
, and quantity of loanable funds, Q
LF0
(Figure 3). When
the government levies a tax on capital income, the supply of loanable funds falls to LFS
1
because investors look at after-tax real interest rates when deciding how much to save.
Demand for loanable funds remains unchanged.
Demand for loanable
funds is dependent
on the productivity
of capital and the real
interest rate.
Figure 3: Effect Of Income Taxes On Private Savings And Investment
LFS1
LFS0
LFD0
ri0
riBT
QLF1 QLF0
a
b
Tax wedge
Quantity of Savings and Investment
riAT
Step 1: Taxes on capital
income reduce supply
of loanable funds.
Step 3: Equilibrium
quantity of loanable
funds (investment
savings) falls.
Step 2a: Real
interest rates rise.
Step 2b: After-tax
real interest rates fall.
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Real interest rates rise from ri
0
to ri
BT
, but after-tax real interest rates fall to ri
AT
, Further, the
equilibrium quantity of loanable funds in the market falls to Q
LF1
. The effects of taxes on
private savings and investment are likely to be significant. In turn, the impact on growth rate
potential GDP can be even more pronounced because savings are directly related to the level
of investment and investment directly affects the rate of growth of potential GDP.
Government Savings and the Crowding-Out Effect
When there is a balanced budget, the government has no impact on the supply of loanable
funds, and all the funds available for supply are from private sources. The private supply
of loanable funds (PSLF) curve intersects with the loanable funds demand (LFD
0
) curve to
determine equilibrium real interest rates (ri
0
) and quantity (Q
0
) at Point a.
If however, the budget goes into a deficit, dissaving by the government reduces the supply
of loanable funds to LFS
1
, increasing interest rates to ri
1
and decreasing the equilibrium
quantity of loanable funds and investment to Q
1
. The equilibrium quantity of loanable funds
does not decrease by the full amount of the budget deficit because the increase in real interest
rates increases the quantity supplied of private saving (movement along PSLF curve).
This tendency of budget deficits to reduce investment in an economy is known as the
crowding-out effect. A budget surplus on the other hand, increases the supply of loanable
funds, reduces real interest rates, and increases the amount of investment in an economy.
In our analysis, we assumed that the increase in private savings (in response to an increase
in real interest rates) was a movement along the same PSLF curve. Ricardo-Barro equivalence
states that in response to budget deficits, the supply of private savings increases in an economy,
forcing the supply of loanable funds curve back to its original position.
LFS1
PSLF
LFD0
ri0
ri
1
Q1 Q0
a
b
Savings and Investment
Figure 4: The Crowding Out Effect
Step 2: Real
interest rates
rise
Amount of
budget deficit
Step1: A budget deficit reduces the
supply of loanable funds.
Step 4: Budget deficits crowd out
investment and slow down the
growth rate of real GDP.
Step 3: Equilibrium quantity of investment falls to Q1. However, the
reduction in investment is not as much as the deficit.
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This theory assumes that taxpayers are rational and understand that current budget deficits
signal higher taxes in the future. In order to prepare for lower disposable incomes in the
future, consumers start saving more, which increases the private supply of loanable funds.
The decrease in loanable funds supply due to government borrowing to finance deficits is
offset completely by an increase in private saving, leaving loanable funds supply unchanged.
This outcome is rather extreme. Taxpayers probably do save more if they expect taxes to
rise in the future, but not significantly enough to finance the entire budget deficit.
Conclusion: A budget deficit crowds out private investment, reducing the growth rate
of real GDP.
LOS 26c: Discuss the generational effects of fiscal policy, including generational
accounting and generational imbalance. Vol 3, pg 443-446
Income taxes and social security taxes are paid by individuals who are currently working.
These people will be given social security and Medicare benefits once they retire. Commitments
that the government owes to citizens after they retire must be discounted to the current period
to determine whether taxes collected today will be sufficient to pay for their benefits later
on. Generational accounting and present values are used by economists to evaluate the
governments ability to meet its social security obligations.
Currently the U.S. government is in a difficult situation. The baby boom generation is nearing
retirement, and social security and Medicare payments are set to rise. To finance these
payments, the U.S. government will have to either raise taxes on those currently working
i.e., the children of baby boomers, or reduce its own expenditure. Either scenario is
discomforting and illustrates the generational effects of fiscal policy. To pay for the retirement
benefits of baby boomers, the subsequent generation will suffer. There is a generational
imbalance in the division of the fiscal burden between the retiring baby boomers and generation
currently working and paying most of the taxes.
Another problem that the U.S. potentially faces is its international debt burden. The rest of
the world has been a significant source of investment finance for the US, and when these
loans need to be paid back, the U.S. must ensure that it has a trade surplus to offset a
ballooning capital account deficit.
LOS 26d:. Discuss the use of fiscal policy to stabilize the economy, including
the effects of the government expenditure multiplier, the tax multiplier, and
the balanced budget multiplier Vol 3, pg 447-450
Fiscal Policy and Aggregate Demand - Business Cycle Stabilization
We have already seen the effects of fiscal policy on aggregate supply. Fiscal policy also has
a direct effect on aggregate demand, and this feature is used by governments to deal with
business cycles.
Discretionary fiscal actions are enacted by the government, and involve changing tax laws
or the level of government spending. Basically, these actions are up to the governments
discretion as opposed to automatic stabilizers, which act on their own to bring the economy
towards full employment. We will describe automatic stabilizers later in this reading.
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Suppose the government were to spend $100 on wages to construct a bridge. These funds
would be used by construction workers to acquire the goods and services they need, which
in turn would provide income to other participants in the economy. A wave of government
spending not only increases the government expenditure component (G) of aggregate demand,
but also increases private consumption expenditure (C). The eventual increase in AD is worth
much more than just $100 because of the government expenditure multiplier.
There is also a tax multiplier at work in an economy. If taxes are reduced, disposable incomes
rise, and consumption expenditure increases by a multiple of the dollar amount of the tax
cut.
It is important to remember that the government expenditure multiplier is stronger than the
tax multiplier. For example, if government spending increases by $100 (which increases
aggregate demand), and taxes are raised by $100 (which reduces aggregate demand) even
though the budgetary position would remain unchanged, the expansionary effect of the
expenditure multiplier would outweigh the contractionary effect of the tax multiplier, and
aggregate demand will increase. The balanced budget multiplier is positive. An increase in
government spending combined with an equal dollar increase in taxes leads to a higher real
GDP.
Lets see how discretionary fiscal policy is used to stabilize the economy. Suppose an economy
is in short run equilibrium in a recessionary gap where the intersection of its AD
0
and SRAS
0
curves occurs at Point a, which is well short of potential GDP (Figure 5). Faced with rising
unemployment, the government decides to increase its spending to stimulate aggregate
demand. The government only needs to increase its expenditure by the total value of the
output gap divided by the government expenditure multiplier. For example, if the government
believes that the multiplier stands at 4, and the recessionary gap stands at $2 billion, the
initial fiscal stimulus must be worth $2 billion/4 = $500 million only. The remaining $1.5
billion will be generated in the economy through the multiplier effect and the economy will
eventually reach long run equilibrium at Point b.
Figure 5: Use Of Expansionary Fiscal Policy To Counter A Recession
LRAS0
SRAS0
AD*
AD0
AD1
a
b
Real GDP
Step 3:
Multiplier effect
Step 2: Initial
fiscal stimulus:
Increase in
government
expenditure or
tax cut.
Step 4: Long run
equilibrium
established at
potential output.
Step 1: Economy currently in short run equilibrium but in a recessionary
gap.
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If the economy were overheating in an inflationary gap, the government would want to reduce
aggregate demand to cool it down. It could do so by either reducing its expenditure, or by
raising taxes. Either way, the initial decrease in expenditure or increase in taxes would only
be a fraction of the actual inflationary gap. The multiplier effect would magnify the
contractionary effects of the governments steps and bring the economy back to full
employment.
LOS 26e: Explain the limitations of discretionary fiscal policy, and differentiate
between discretionary fiscal policy and automatic stabilizers. Vol 3, pg 450-454
Limitations of Discretionary Fiscal Policy
The effectiveness of discretionary fiscal policy is severely limited by three types of time
lags:
1. Recognition lag: This refers to the time that it takes the government to figure out
that the economy is not functioning at potential output. A lot of data including
unemployment rates, jobless claims, GDP growth, and inflation numbers must be
analyzed before the state of the economy can be determined.
2. Law-making lag: Fiscal actions must be approved by Congress, and before approval,
there are numerous committee meetings and debates because members have different
ideas regarding the most appropriate course of action. The government might have
recognized the need for action, but its implementation may be delayed in getting the
necessary approvals.
3. Impact lag: This refers to the time it takes for a fiscal stimulus to flow through the
economy and generate the changes in consumption patterns that are desired.
Automatic stabilizers work in the absence of explicit action by the government to bring the
economy towards full employment. There are two automatic stabilizers embedded in fiscal
policy.
1. Induced taxes: Revenue from income taxes rises in an expansion and falls in a
recession. In a recession, when tax revenues fall due to lower total incomes, the
budget moves towards a deficit, which is exactly the budgetary position that is
required to deal with the demand shortfall. In an expansion, tax revenues rise and
take the budget towards a surplus, which is the budgetary stance required to cool
down the economy.
2. Needs-tested spending: These are government programs that pay benefits to qualified
individuals and businesses (e.g. unemployment benefits). In a recession (expansion),
the unemployment rate exceeds (is less than) the natural rate, and the amount of
unemployment benefits paid out by the government increases (decreases). This
increase (decrease) in government spending leads the budget towards a deficit
(surplus), and stimulates (reduces) aggregate demand.
Empirical evidence suggests that automatic stabilizers play a significant role in mitigating
deviations from potential output. They reduce the severity of both expansions and recessions.
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Cyclical and Structural Fiscal Balances
The fiscal balance can be broken down into two components:
1. The structural balance is a persistent surplus or deficit. Explicit government action
is required to eliminate this balance. The structural balance is the deficit or surplus
that would occur even if the economy were functioning at full employment.
2. The cyclical balance is temporary and only arises when the economy is not operating
at its potential output. It vanishes once full employment is restored. The cyclical
balance equals the actual fiscal balance minus the structural balance.
Figure 6 illustrates these two types of balances. In Figure 6a, the light green curve represents
government outlays (e.g. unemployment benefits) which are negatively related to the level
of real GDP. The grey line represents government tax revenues, which are positively related
to real GDP. The economys potential GDP is assumed at $10 trillion where outlays equal
revenues so there is a balanced budget.
- At GDP levels short of potential GDP, outlays exceed revenues, and there is a cyclical
deficit.
- At GDP levels higher than potential output, revenues exceed outlays and there is a
cyclical surplus.
Cyclical budget balances occur when the economy deviates from potential output.
In Figure 6b we examine three different scenarios and evaluate the nature of the fiscal balance.
- If potential output and actual GDP equal $9 trillion, and outlays exceed revenues,
the government has a structural deficit.
- If potential output and actual GDP equal $10 trillion, and outlays equal revenues,
the government has a structural balance of zero.
- If potential output and actual GDP equal $11 trillion, and outlays are less than
revenues, the government has a structural surplus.
Structural budget balances exist even when the economy is working at full employment.
They do not vary when the economy deviates from potential output. Over the last few years,
the U.S. has run a persistent structural deficit.
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Figure 6: Cyclical And Structural Balances
If actual and potential GDP = Y*1
- There is a budget deficit.
- It cannot be cyclical because the economy is at full employment level.
- Therefore, it is a structural deficit.
- There is a budget surplus.
- It cannot be cyclical because the economy is at full employment level.
- Therefore, it is a structural surplus.
- The budget is balanced.
- Cyclical and structural balances equal zero.
Y*0 Y*2 Y*1
Tax Revenues
Government Outlays
Structural
deficit
Structural
surplus
9 10 11 Real GDP
10
Tax Revenues
Government Outlays
Potential
GDP
Real GDP
Y Y Y*
Cyclical Deficit:
Revenues are
lower than outlays.
Economy in
deflationary gap
Economy in
inflationary gap
Cyclical Surplus
Revenues exceed outlays.
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MONETARY POLICY
Monetary policy refers to a central banks use of money supply to attain its macroeconomic
objectives.
LOS 27a: Discuss the goals of U.S. monetary policy and the Feds means for
achieving the goals, including how the Fed operationalizes those goals.
Vol 2, pg 462-465
There are three goals of Monetary policy:
1. Maximum employment: This goal requires achieving a healthy, sustainable growth
rate of potential GDP, and keeping actual real GDP close to potential GDP (which
keeps unemployment close to the natural rate).
2. Stable prices: This goal requires keeping inflation low.
3. Moderate long term interest rates: This requires keeping nominal long-term interest
rates close to real long-term interest rates.
Price stability is the key goal because it creates the ideal environment for firms and households
to make well informed savings and investment decisions that stimulate economic activity,
create jobs and bring economic growth. The nominal interest rate equals the real interest rate
plus the inflation rate so price stability will ensure that the two remain close to each other.
In the long run, these goals are in harmony and reinforce each other, but in the short run they
might be in conflict. For example, during cost-push inflation, the Fed faces a tradeoff between
inflation and unemployment.
Means for Achieving These Goals
The Federal Reserve Act of 2000 instructs the Fed to maintain long-run growth of the
monetary and credit aggregates commensurate with the economys long-run potential to
increase production. This sounds a lot like the assertions of the quantity theory of money
where the quantity of money equates to monetary and credit aggregates and the growth
rate of potential GDP equates to the economys long-run potential to increase production.
Recall that under the quantity theory of money: Mg + Vg = Pg +Yg
In the long run, quantity of money must grow at the same rate as the growth rate of real GDP.
Remember that velocity is assumed constant so Vg is zero, and the aim is to keep price levels
stable (Pg = 0).
By increasing the quantity of money at the rate of growth in potential output, the Fed can
expect to have a negligible impact on price levels, and maintain full employment.
Operationalizing Stable Prices
Keeping prices stable sounds like a good idea, but it is a very subjective goal. The Fed makes
it more specific by focusing on Core CPI, and the current Fed Chairman, Ben Bernake, has
suggested that a core inflation rate between 1 and 2 percent meets his definition of stable
prices.
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Operationalizing Maximum Employment
The Fed looks at a the huge amount of data (e.g. labor force participation rates, unemployment
rates, housing and stock market performance) to gauge the condition of the economy. It
attaches special importance to the output gap- the deviation of real GDP from potential GDP
and tries to minimize it to generate maximum employment.
LOS 27b: Describe how the Fed conducts monetary policy, and explain the
Feds decision-making strategy including an instrument rule, a targeting rule,
open-market operations, and the market for reserves. Vol 3, pg 466-472
Conduct of Monetary Policy
Two monetary policy instruments are available to the Fed. It can either set the price of money
and leave the market to determine equilibrium quantity, or it can set the quantity of money
and let the market determine price. It obviously cannot set both.
The Fed has chosen the interest rate as its preferred monetary policy instrument. It targets
the Fed Funds Rate (FFR) which is the interest rate at which banks lend overnight loans to
each other. The Fed allows exchange rates and the quantity of money to find their own
equilibrium.
There are two decision-making strategies that the Fed may use in setting the FFR:
1. The instrument rule sets the FFR at a level based on the current state of the economy.
Under this rule, the Fed mechanically calculates the FFR based on current estimates
of the inflation rate and the output gap. The Taylor rule is the best known example
of an instrument rule. It computes FFR as the equilibrium real interest rate (which
Taylor says is 2%) plus amounts based on inflation and the output gap.
According to the Taylor rule:
Prevailing
level of
inflation in
the economy.
FFR = 2 + Inflation + 0.5 (Inflation 2) + 0.5 (output gap)
Fed Funds
Rate.
Implicit
target rate of
inflation.
The difference
between actual
and potential
GDP.
Weight
attached
to output gap.
Weight attached
to deviation of
inflation from the
implicit target rate.
Real
interest rate.
2. The targeting rule determines the FFR at the level that makes the forecast of the
ultimate policy goal (usually price level) equal to its target (CPI between 1% and
2%). This requires the Fed to gather a large amount of information about the economy
and its prospects, how it responds to shocks and policy changes, and then decide on
the best level for FFR.
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The Mechanics behind hitting the FFR Target: Open Market Operations
Once the Fed has decided on its desired FFR, it instructs the New York Fed to conduct open-
market operations that directly influence the reserves of banks.
In an open-market purchase, the Fed buys securities from banks. The assets ownership is
transferred to the Fed, and in return the Fed increases the balance in banks reserve accounts.
This increase in the monetary base coupled with the multiplier effect increases money supply.
The Feds assets and liabilities increase, while there is no change in a banks total assets (it
sold securities in exchange for an increase in reserves).
Fed Funds Market
The higher the FFR, the larger the quantity of overnight loans supplied, and the lower the
quantity of overnight loans demanded in the Fed Funds market. The demand and supply of
overnight lending determine equilibrium FFR.
Reserves Market
Reserves are held to meet reserve requirements and to meet withdrawal requests from
depositors. There is an opportunity cost of holding reserves in the form of interest income
that would have been earned if they were lent out in the overnight market. The higher the
FFR, the higher the opportunity cost of holding reserves. At high FFR, banks prefer to hold
on to less reserves and instead lend them out in the overnight market. At lower FFR, banks
retain a larger quantity of reserves. Therefore, the reserve demand curve is downward sloping.
Figure 1 illustrates the market for reserves. Reserve demand RD
0
is downward sloping, while
Reserve supply (RS0) is vertical at the quantity determined by the Fed. If the Fed wants to
reduce FFR, it will increase reserve supply through an open-market purchase to RS1, and if
it wants to increase FFR, it will reduce reserve supply through an open-market sale to RS2.
Figure 1: Hitting The Fed Funds Rate Target
RS2 RS1 RS0
RD0
FFR2
FFR0
FFR1
Reserves
Initially Fed sets FFR to FFR0 by
setting reserve supply to RS0.
If the Fed subsequently wants to reduce
FFR it will increase reserve supply
through an open market purchase to
RS1.
If the Fed wants to increase FFR it will
decrease reserve supply to RS2 through
an open market sale.
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LOS 27c: Discuss monetary policys transmission mechanism (chain of events)
between changing the federal funds rate and achieving the ultimate monetary
policy goal when fighting either inflation or recession, and explain loose links
and time lags in the adjustment process. Vol 3, pg 472-482
When the Fed changes the FFR, it has an impact on numerous economic variables in an
economy. Lets examine the chain of events that flow through an economy as a result of an
increase in FFR.
As soon as the supply of reserves is decreased through an open-market sale of securities, the
FFR rises (the overnight rate). The impact on other short terms rates is almost immediate
because there is powerful substitution effect that keeps the FFR and short term rates close
to each other. An overnight loan to another bank is a close substitute for an investment in
short term securities like T-bills.
If the rate on T-bills were to be significantly higher than FFR, demand for T-Bills would rise,
increasing the price of T-Bills and reducing yields or interest rates. If short term rates were
lower than FFR, institutions would offload their holdings of short term instruments, which
would increase short term yields and bring them closer to FFR. When the returns offered in
the two markets are close to each other, there is no reason for a bank to switch between
making an overnight loan and buying T-bills, and both markets are in equilibrium. Therefore,
an increase in FFR is immediately followed by an equal increase in short term interest rates.
Long term bond rates are higher than short term rates, and fluctuate less than the short term
rates. Long term bonds offer a higher return because long term investments are more risky
and less liquid. To generate a demand for these instruments the returns offered must be higher
than returns offered on short term securities.
Long terms bond rates are also less volatile than short term rates because they are influenced
by current short term rates and by expectations about future short term rates. An individual
can either invest in a long term instrument, or continuously roll over bonds with short tenures.
If the long term rate exceeds the average of short term rates, people would just lend long-
term and borrow short-term. On the other hand, if the long term rate were less than the
average of short term rates, people would just borrow long-term and invest in short-term
bonds.
These market forces keep the long term interest rate close to the average of expected future
short term rates plus a premium for the extra risk. The average of future short term rates is
less volatile than individual expected future short term rates.
An increase in FFR immediately causes an increase in long term rates, but the magnitude
of the change is different as it depends on the outlook for future short term rates.
Exchange rates respond to interest rate differentials in the near term. An increase in FFR
would increase the differential between dollar denominated bonds and other bonds, which
would make dollar assets dearer, and increase the value of the dollar. However, one must
recognize that interest rates and monetary policy are not the only factors that influence
exchange rates.
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The Ripple Effects of a Change in FFR
An increase in FFR decreases the quantity of money and bank loans because of two reasons:
1. An increase in FFR is brought about by an open-market sale, which reduces banks
reserves at the Fed. This decrease in reserves reduces the quantity of deposits and
bank loans that the banking system can create (lowers money supply).
2. An increase in FFR increases the opportunity cost of holding money for households
and firms. A rise in interest rates reduces the quantity of money demanded (movement
along the money demand curve).
With there being lower quantities of money in circulation in the economy, and with loans
harder and more expensive to get, consumers and firms spend less, resulting in a reduction
in consumption (C) and investment (I) expenditure.
Changes in the FFR also have repercussions on the loanable funds market and real long-term
interest rates. When the FFR increases, there is a decrease in the supply of bank loans (due
to lower excess reserves in the banking system) that fuels an increase in real interest rates.
The increase in real interest rates in turn reduces consumption expenditure because the
opportunity cost of not saving increases. Investments in new projects become more expensive
to finance so investment expenditure also falls. Further, the appreciating currency makes
imports cheaper, exports less competitive and therefore, reduces net exports of the economy.
These three changes result in a reduction in aggregate demand, which decreases real GDP
and price levels.
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Comprehensive Illustration- Fed fights recession
If inflation is low and the economy is operating below potential GDP, the Fed will move to
stimulate aggregate demand. It will conduct an open-market purchase of securities which
will increase the supply of reserves. This increase in supply of reserves to RS1 will bring
FFR down to FFR1 (Figure 2a).
With higher reserves, banks are able to give out more loans so the supply of money increases
(MS
1
). The increase in money supply reduces short term interest rates, which in turn translate
into an increase in quantity of money demanded (Figure 2b).
Figure 2: Fed Fights Recession
MS1 MS0
MD0
i0
i1
Quantity of money
demanded
increases.
LRAS
SRAS0
AD*
AD0
AD1
Contribution
increase in C, I,
and (X-M)
Multiplier
Effect
LFS1
LFS0
LFD0
ri0
ri1
RS1 RS0
RD0
FFR0
FFR1
Interest rates fall
Quantity of Money Quantity of Reserves
Quantity of Loanable Funds Real GDP
Step 1: An open-
market purchase
increases the supply of
reserves and decreases
FFR.
Step 2: An
increase in
reserves increases
the monetary base
and increases
supply of money.
Step 3: Supply of
loanable funds increases.
Real interest rates fall.
Step 4: Decrease in real interest rates stimulates
aggregate demand. Multiplier effect brings
demand to AD1.
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The increase in supply of bank loans contributes to the increase in the supply of loanable
funds to LFS1, forcing long term real interest rates lower (ri1). However, the reduction in
long term real interest rates is smaller than the reduction in short term rates (Figure 2c).
Because of lower real interest rates, consumption and investment expenditures increase, as
do net exports. Therefore, aggregate demand increases to AD
*
. Over time, the multiplier
effect comes in and boosts aggregate demand to AD1, where the economy reaches long run
equilibrium at potential GDP. (Figure 2d).
So far, our analysis has suggested that the eventual impact of monetary policy on aggregate
demand is fairly straightforward and predictable. However, this is not usually the case.
Loose links in the chain:
1. The real long term interest rate that influences spending and aggregate demand is
only loosely linked to the FFR.
2. The link between nominal interest rates and real interest rates depends on inflation.
3. Many factors other than real interest rates also affect the components of aggregate
demand. Further, these factors are difficult to predict.
Time lags:
1. Empirical evidence suggests that changes in FFR have had the desired effect on
aggregate demand with a one year lag.
2. The FFR change takes an even longer period of time to have an effect on inflation.
LOS 27d: Describe alternative monetary policy strategies, and explain why
they have been rejected by the Fed. Vol 3, pg 483-487
Monetary base instrument rule: Also known as the McCallum rule, this rule targets the
growth rate in the monetary base. It is based on the first derivative of the quantity theory
of money. Specifically, it suggests setting the growth rate in the monetary base equal to a
target inflation rate plus the long term real GDP growth rate minus the medium term growth
rate of the velocity of circulation. It asserts that setting the growth rate in the monetary base
at this level will keep inflation close to its target and the economy close to full employment.
The McCallum rule holds an advantage over the Taylor rule in that the output gap and long
term real interest rates do not need to be estimated. However, the McCallum rule relies on
the demand for money and the monetary base being relatively stable. It is not used because
the Fed believes that shifts in the demand for the monetary base would bring large variations
in interest rates, causing large fluctuation in aggregate demand and severe business cycles.
The money targeting rule: Also known as the k-percent rule, this rule is also based on
the quantity theory of money and was first suggested by Milton Friedman. He asserted that
the velocity of circulation was stable over time so he recommended that the growth rate of
money supply be equal to the growth rate of potential GDP. Money targeting works when
demand for money is stable and predictable and the velocity of circulation does not change.
In these sophisticated times however, technological innovation in the banking system has
given rise to large fluctuations in the demand for money, which severely dent the effectiveness
of money targeting in regulating business cycles.
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Exchange rate targeting rule: Under this rule, the Fed intervenes in the foreign exchange
market. The Fed can choose to fix the exchange rate against a basket of currencies, but then
it would be left with no control over U.S. monetary policy and inflation. This is because
purchasing power parity moves prices in two countries towards each other after adjusting
for the exchange rate. If a calculator costs $50 in the US, and the exchange rate is 100 yen/$,
the calculator should sell for 5,000 yen in Japan. If purchasing power parity did not prevail,
it would be possible to earn a profit by buying in the cheaper country and selling in the other.
Therefore, under a fixed exchange rate regime, the prices of goods and services would rise
in the U.S. at the same rate as they do in other countries. The U.S. would have no control
over its own inflation rate, and could potentially end up importing inflation from countries
that it has fixed the dollar against.
The Fed can also pursue a crawling peg exchange rate where the exchange rate is periodically
adjusted to reflect the difference between the desired and actual inflation rate.
The main disadvantage of a crawling peg is that the real exchange rate may change in
unpredictable ways. The real exchange rate is the relative price of the GDP basket in the
U.S. versus the relative price of the GDP basket of other countries. GDPs of various economies
are structurally different (e.g. U.S. GDP has a higher proportion of technology products than
the GDP of other countries). Identifying and adjusting for differences in the GDP basket and
offsetting unpredictable changes in the real exchange rate are very difficult.
Inflation rate targeting rule: Under this strategy, the central bank makes a public commitment
to achieving an explicit inflation target, and to explaining how its actions will achieve that
target. Inflation targets are specified in terms of a CPI inflation rate. The argument here is
that inflationary expectations must be managed, and when everyone is aware that the central
bank will move to contain inflation within an acceptable band, spending and investing
decisions will be made wisely.
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AN OVERVIEW OF CENTRAL BANKS
LOS 28a: Identify the functions of a central bank. Vol 2, pg 497
A central bank has the following functions in an economy:
- Setting monetary policy.
- Controlling money supply.
- Regulating the banking system.
- Issuing currency (the U.S is an exception as the U.S Treasury issues currency in the
U.S.
- Managing economic and financial market conditions.
- Determining how the economy behaves.
LOS 28b: Discuss the monetary policy and the tools utilized by central banks
to carry out monetary policy. Vol 2, pg 497-500
How Monetary Policy Works
A central bank uses the interest rates to influence the overall level of consumption and
investment expenditure. When interest rates are reduced, saving becomes less attractive, and
borrowing more attractive. Low interest rates also tend to boost prices of financial assets
such a real estate and equities. Higher house prices enable homeowners to extend their
mortgages to finance higher consumption, while higher share prices raise household wealth
and encourage individuals to spend.
Interest rate changes also have an effect on the exchange rate. A lowering of interest rates
results in a depreciation of the domestic currency in the near term, which in turn increases
the competitiveness of the economys exports and makes imports more expensive. However,
bear in mind that the impact of interest rates on exchange rates is very unpredictable.
Finally, we must point out that there is a significant time lag between a monetary stimulus
and its desired impact on economic variables. It is believed that it takes about one year for
an interest rate change to have an effect on output, and that it takes up to two years for an
interest rate change to have an effect on inflation. Therefore, interest rates have to be set on
forecasts of what inflation might be in the future, not what it is currently.
In the U.S the three policy tools of the Fed are:
- Bank reserve requirements.
- The discount rate.
- Open market operations.
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An Overview of Central Banks
2009 Elan Guides
U.S. monetary policy focuses on promoting economic growth and achieving full employment
while containing inflation. The Feds mandate states directly that monetary policy should
aim to have the U.S. economy operate at full capacity.
The primary objective of most major central banks is to contain inflation, Under inflation
targeting, the bank sets an explicit target for inflation along with a time period over which
any deviation from the target must be eliminated. The Fed has been under pressure to embrace
inflation targeting as a way to make policy more transparent, and the current Fed Chairman,
Ben Bernake, has been known to be a leading proponent of inflation targeting. To date
however, the Fed has maintained a dual mandate of full employment and stable prices.

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