Economic Condition Analysis

Economic Condition Analysis Lecture No.: 1 Topics: Understanding Demand, Supply and Production issues The Demand Curve: The graphical representation of the demand schedule is the demand curve. Law of downward – sloping demand: When the price of a commodity is raised buyers tend to buy less of the commodity ceteris paribus. Quantity demanded tends to fall as price rises for two reasons: Substitution effect and income effect. The Supply Curve: The graphical representation of supply schedule is the supply curve. Forces behind the supply curve: The major elements underlying the supply curve are: Cost of production i.e.prices of inputs and technological advances, prices of related goods, government policy an special influences. ***Equilibrium with supply and demand curves Price Elasticity of Demand: The price elasticity of demand sometimes simply called price elasticity measures how much the quantity demanded of a good changes when its price changes. The precise definition of price elasticity is the percentage change in quantity demanded divided by the percentage change in price. Price elasticity of demand ep= percentage change in quantity changes / percentage change in price Perfectly Elastic Demand ep = 0 Unit elasticity ep = 1 Inelastic demand ep = Infinity Price Elasticity of Supply: Price elasticity of supply is the percentage change in quantity supplied divided by percentage change in price.

Application to major economic issues: 1. 2. 3. 4. 5. 6. 7. 8.

Impact on long run relative decline in farming: Crop restrictions Demand for necessary goods Use of consumer products Tax issues Relative product price Employment and unemployment Energy price control

Production and Marginal Products: Production function: The production function specifies the maximum output that can be produced with a given quantity of inputs. It is defined for a given state of engineering and technical knowledge. Total, Average and Marginal product: Marginal product: The marginal product of an input is the extra output produced by 1 additional unit of that input while other inputs are held constant. The Law of diminishing return: The law of diminishing returns holds that, we will get less and less extra output when we add additional doses of an output while holding other inputs fixed. Returns to scale: Constant return to scale: CRS denote a case where a change in all inputs leads to a proportional change in output. Increasing returns to scale (also called economies of scale): IRS arise when an increase in all inputs leads to a more than proportional increase in the level of output. Decreasing returns to scale: DRS occur when a balanced increase of all inputs leads to a less than processes, scaling up eventually reach a point beyond which inefficiencies set in. These might arise because the costs of management or control become large. Productivity: Productivity is a concept measuring ratio of total output to a weighted average of inputs. Two important variants are labor productivity, which calculates the amount of output per unit of labor and total factor productivity, which measures output per unit of total inputs (typically of capital and labor). Empirical estimates of the aggregate production function: i.

Total factor productivity has been increasing throughout the twentieth century because of technological progress and higher levels of worker education and skill.

ii.

iii. iv.

The capital stock has been growing faster than the number of worker – hours. As a result labor has a growing quantity of capital goods to work with; hence labor productivity and wages have tended to rise even faster than the 1 ½ percent per year during the twentieth century. The rate of return on capital (the rate of profit) might have been expected to encounter diminishing rate of returns because of each capital unit now has less labor to cooperate with. Over the twentieth century, labor productivity grew at an average rate of slightly more than 2 percent per year.

LECTURE NO: 2 ECONOMIC ANALYSIS OF COSTS Fixed costs: FC sometimes called as “overhead” or “sunk cost”. They consists of rent for factory or office space, contractual payment for equipments, interest payments on debts, salaries of tenured faculty and so forth. These must be paid even if the firm produces no output, and they do not change if output changes. Variable costs: Variable costs are costs which vary as output changes. Examples include materials required to produce output, production workers to staff the assembly lines, power to operate factories. Cost concept: TC=FC+VC Marginal cost: MC denotes the extra or additional cost of producing 1 extra or additional cost of producing 1 extra unit of output. Average cost: Average cost is the total cost divided by the total number of units produced. Average cost = Total cost / Quantity Some important rules • • •

When marginal cost is below average cost, it is pulling average cost down When MC is above AC, it is pulling AC up. When MC just equals AC, AC neither rising not falling and is at its maximum. Hence, at the bottom of a U- shaped AC, MC=AC=minimum AC.

This is a critical relationship. It means that a firm searching for the lowest average cost of production should look for the level of output at which marginal costs equal average cost. Because the last unit produced costs less than the average cost of all the previous units produced. If the last unit costs less than the previous ones, the new AC (i.e.AC including the last unit) must be less than the old AC, so AC must be falling. By contrast, if MC is above AC, the last unit costs more than average cost (AC including the last unit) must be higher than the old AC. Finally, when MC just equal to AC, the last unit costs exactly the same as the average cost of all previous units. Hence, the new AC; the one including the last unit, is equal to the old AC; AC curve is flat when AC equals MC.

Quantity Fixed cost (FC)

Variable cost (VC)

Total cost (TC)

0 1 2 3 4 5 6 7 8

0 30 55 75 105 155 225 -

55 85 110 130 160 210 280 370 480

55 55 55 55 55 55 55 55 55

Marginal Average cost Average cost (AC) Fixed (MC) cost (AFC) Infinity 30 Infinity 25 85 55 20 55 27 ½ 30 43 ½ 18 1/3 40* 50 40 13 5/4 42 11 46 2/3 9 1/6 90 52 6/7 7 6/7 110 60 6 7/8

Cost 8

TC

7 6 4

Variable and Fixed cost

2 1

FC 1

2

3

4

5

6

7

8

9

10

Quantity

Average variable cost (AVC) Undefined

30 27 ½ 25 26 ¼ 37 ½ 45 53 1/8

Average & Marginal cost

AC MC 80

AVC

70 60 50 40 30 20 AFC

10

1

2

3

4

5

6

7

8

9

10 Quantity

Lecture No.:3 ANALYSIS OF PERFECTLY COMPETITIVE MARKET Significant feature of PCM: 1. Under perfect competition, there are many small firms, each producing an identical product and each too small to effect the market place. 2. The perfect competitor faces a completely horizontal curve. 3. The extra revenue gained from each extra unit sold is therefore the market price. 4. In perfect competition there is easy entry and easy exit. Demand curve of PCM

p

p D

S d

d

q q Industry output

Firm output

Competitive Supply where marginal cost equals price: Rule for a firm under perfect competition is that, the firm will maximize profits when it produces at that level where marginal cost equals price: Marginal cost = Price or MC = P Quantity Total cost Marginal cost 0 55000 1000 85000 27 2000 110000 22 3000 130000 21 3999 159960.01 38.98 39.99 40 4000 160000 40.01 4001 160040.01 40.02 5000 210000 60

Average cost 85 55 43.33 40 40

Price

Profit

40 40 40 40 40

Total revenue 40000 80000 120000 159960 160000

40 42

40 40

160040 200000

-0.01 -10000

- 45000 -30000 -10000 -0.01 0

AC Price, AC, MC

MC

d’ d d’’

quantity

At the profit maximizing output the firm has zero profits, with total revenues equal total costs (these are economic profits and include all opportunity costs, including the owner’s labor and capital). Point B is the zero profit point, the production level at which the firm makes zero economic profits; at the zero profit point, price equals average cost, so revenues just cover costs. Total cost and the shut down condition: In general, a firm wants to shut down in the short run when it can no longer cover its variable costs. Suppose, the firm were faced with a market price of Tk.35.00 shown by the horizontal d’’ d’’ line. At that price MC equals price at point C, a point at which the price is actually less than the average cost of production. Reason for producing even though a firm incurring loss: A firm can cover its contractual commitments even when it produces nothing. In the short run, the firm must pay fixed costs such a interest to the bank, directors salary and others. The balance of the firm’s costs are variable costs, such as costs for raw material, production workers, and fuel which would have zero cost at zero production. It will be advantageous to continue operations, with P at least as high MC, as long as revenue covers variable costs. Basically, low market price at which revenues just equal variable costs (or, equivalently, at which loses exactly equal fixed costs) is called the shutdown point. Shutdown rule: The shutdown point comes where revenues just cover variable costs or where losses are equal to fixed costs. When the price falls below average variable costs, the firm will maximize profit (minimize its loss) by shutting down.

AC MC AVC M

M’

Shutdown point

Shortcomings of perfectly competitive market: 1. Market failure a. Imperfect competition: When a firm has market power in a particular market (say it has a monopoly because of a patented drug or a local electricity franchise, the firm can raise the price of its product above its marginal cost. Consumers buy less of such goods than they would under competition, and consumer satisfaction is reduced. This kind of reduction of consumer satisfaction is typicalof the inefficiencies created by imperfect competition. b. Externalities: Externalities arise when some of the side effects of production or consumption are not included in the in market prices. c. Imperfect information: In perfect competition it is assumed that, buyer and seller have complete information regarding the market and the product. But in real world the information are not always available to everyone.

IMPERFECT COMPETITION: Imperfect competition: Imperfect competition prevails in an industry whenever individual sellers have some measure of control over the price of their output. If a firm can appreciably affect the market price of its output the firm is classified as an “imperfect competitor”. Imperfect competition prevails in an industry whenever individual sellers have some measure of control over the price of their output. Imperfect competition does not imply that a firm has absolute control over the price of a product. An imperfect competitor has some but not complete discretion over its price. For a perfect competitor, demand is perfectly elastic; for an imperfect competition, demand has a finite elasticity. p

Firms demand under perfect competition

d

P

d‘ d

Firms demand under imperfect competition

d

d d‘ q Firm quantity

q

Firm quantity

VARIETIES OF IMPERFECT COMPETITION: The varieties of imperfect competition can be categorized as follows: a. Monopoly b. Oligopoly c. Monopolistic competition

TYPES OF MARKET STRUCTURE Structure

Perfect competition Monopolistic competition

Oligopoly

Monopoly

Number of producers and degree of product differentiation Many producers, identical products Many producers, many real or perceived difference in product Few producers, little or no difference in product Single producer, product without close substitutes

Part of Firm’s degree Methods economy where of control over marketing prevalent price

of

Financial None market and agricultural products Retail trade Some (pizza, beer, personal computer)

Market exchange auction

Steel, chemicals

Some

Franchise, monopolies (Electricity, water) Microsoft windows, patented drugs

Considerable

Advertising and quality rivalry, administered prices Advertising

or

Advertising and quality rivalry, administered prices

Sources of Market Imperfections: Most cases of imperfect competition can be traced to two principal causes: 1. Industries tend to have fewer sellers when there are significant economies of large scale production and decreasing costs. •

Costs and market imperfections

2. Barrier to entry. • • •

Legal restrictions High cost entry Advertising and product differtiation

(a) Perfect competition

(b) Oligopoly

(c) Monopoly

D MC

AC

MC

AC

D

D

AC MC P

AC MC Q 1234

10000 12000

Q 100

200

300

Q 100

200 300

LECTURE NO.:4

UNCERTAINTY AND GAME THEORY Speculation: Speculation involves buying and selling in order to make profits from fluctuations in prices. The economic function of speculator is to move gods from periods of abundance to periods of scarcity. Arbitrage: The simplest case is one in which speculative activity reduces or eliminates regional price differences by buying and selling the same commodity. This activity is called arbitrage, which is the purchase of a good or asset in one market from immediate resale in another market in order to profit from a price discrepancy. As a result of arbitrage, the price difference between markets will generally be less than the cost of moving the good from one market to the other. Hedging: One important function of speculative markets is to allow people to shed risks through hedging. Hedging consists of reducing the risk involved in owning an asset or commodity by making a counteracting sale of that asset. Hedging allows businesses to insulate themselves from the risk of price changes. The economic impact of Speculations: 1. Market efficiency 2. Possibility of even marginal utility. Risk and uncertainty: Risk is the probability to default. A person is risk averse when the displeasure from losing a given amount of income is greater than the pleasure from gaining the same amount. Insurance and Risk Spreading: Market handles risk by risk spreading. This process takes risks that would be large for one person and spreads them around so that they are they are but small risk for a large number of people. The major for of risk spreading is insurance, which is a kind of gambling a reverse. Capital markets and risk sharing: Another form of risk sharing takes place in the capital markets because the financial ownership of physical capital can be spread among many owners through the vehicle of corporate ownership.

Market failure in information: While insurance is a useful device for reducing risks, sometimes insurance is not available. The reason is that, efficient insurance can thrive only under limited conditions. The conditions for efficient insurance are: 1. There must be large number of insurable events. 2. The events must be statistically independent. 3. There must be sufficient experience regarding such events so that insurance companies can reliably estimate the losses. 4. The insurance must be relatively free from moral hazard. Moral hazard is at work when insurance increases risky behavior and thereby changes the probability of loss. 5. Sometimes private insurance is unavailable because of adverse selection. Adverse selection arises when the people with the highest risk are also the most likely to buy the insurance. Social insurance: When market failures are so severe that the private market cannot provide adequate coverage, there are may be a role for social insurance, which is mandatory insurance provided by the government. Example: Unemployment insurance. GAME THEORY Game theory analyzes the way that two or more players choose strategies that jointly affect each other. This theory was developed by John Von Neumann (1903-1957) a Hungarian-born mathematical genius. Game theory has been used by economists to study the interaction of oligopolists, union management disputes; countries trade policies, international environmental agreements, reputations, and a host of other situation. Price setting:

P1

Firm A matching

Firm B undercutting

P2

BASIC CONCEPTS of Game Theory: nEwbooks price Normal price Normal price

A

Price war $10

$ 10

Amaging price Price war

C $100

B

$-100

$-10 -$ 10

D

$-50

$-50

Alternative strategies: In alternative strategy two firms have the highest joint profits in outcome. Each firm earns $10 when both follow a normal – price strategy. At the other extreme is the price war, where each cuts its price and runs a big loss. In between are two interesting strategies where only one firm engages in the price war. In outcome C for example nEwbooks follows a normal price strategy while Amaging engages in a price war. Amazing takes most of the market but losses a great deal of money because it is selling below cost; nEwbooks is actually better off selling at a normal price rather than responding. Dominant Stategy In considering possible strategies, the simplest case is that, of a dominant strategy. This situation arises when one player has a single best strategy no matter what strategy the other player follows. If nEwbooks conducts business as usual with a normal price, Amazing will get $10 of profit if it plays the normal price and will lose $100 if it declares economic war. Amazing will lose $ 10 if it follows the normal price but will lose even more if it also engages in economic warfare. This also holds for nEwbooks. Therefore, no matter what strategy the other firm follows, each firm’s best strategy is to have the normal price. Charging the normal price is a dominant strategy for both firms in this particular price – war game. When both players have a dominant strategy, we say that, the outcome is a dominant equilibrium.

Nash equilibrium: (The rivalry game) nEwbooks price High price High price

A

Normal Price $200

$ 100

Oxy steel price Normal price

C $150

B

$150

-$20 -$ 30

D

$10

$10

The firm can stay at their normal price equilibrium, which found in the price war game. Or, they can raise their price in the hopes of earning monopoly profits. Our two firms have the highest joint profits in cell A; here they earn a total of $300 when each follows a high price strategy. Situation A would surely come about if the firms could collude and set the monopoly price. At the other extreme is the competitive style strategy of the normal price, where each rival has profits of $10. In between are two interesting strategies where one firm choose a normal price and one a high price strategy. In cell C, for example, nEwbooks follows a high price strategy but Amazing undercuts. Amazing takes most fo the market and has the highest profit of any situation, while nEwbooks actually losses money. In cell B, Amazing gambles on high pirce, but nEwbooks normal price means a loss for Amazing. In this game Amazing has a dominant strategy; it will profit more by choosing a normal price no mater what nEwbooks does. On the other hand, nEwbooks does not have a dominant strategy, because nEwbooks would want to play normal if Amazing plays normal and would want to play high if Amazing plays high. Now it is safe for nEwbooks for choosing normal price where he could assume high payoff in relation to the action of Amazing. This is the basic of game theory: you should set your strategy on the assumption that your opponent will act in his or her best interest. The Nash Equilibrium is also sometimes called the non cooperative equilibrium, because each party chooses that strategy which is best for itself – without collusion or cooperation and without regard for the welfare of society or any other party.

Some Important Examples of Game Theory 1. To collude or not to collude: 2. Prisoners Dilemma: Keins Confess A

5 years

No confess B 10 years

3 months

3 months D 1 years

Smith 5 years C 5 years

1 years

3. The pollution game U.S. Steel Normal price

Oxy Steel

Normal price

A

Price war

$ 100 C $120

Price war $100

B

-$30

$30 D

$120 $100

$100

The pollution game is an example of a situation in which the invisible – hand mechanism of efficient perfect competition breaks down. This is a situation in which the noncooperative or Nash equilibrium is inefficient. When the Nash equilibria become dangerously inefficient, governments may step in. By setting efficient regulations or emissions charges, or perhaps by establishing efficient property rights, government can induce firms to move outcome. A, the “low pollute, low pollute” world. In that, equilibrium the firms make the same profit as in the high pollution world, and the earth is a healthier place to live in. 4. Deadly arms races: In deadly arms race the cooperative agreement could lead to pay off both parties.

LECTURE NO:5 Comparative Advantage and Protectionism International Trade and Domestic Trade: There are three important differences between domestic and international trade: 1. Expanded trading opportunities 2. Sovereign nation 3. Exchange rates Reasons for International Trade: 1. Diversity in natural resources: 2. Difference in tastes: 3. Difference in costs: Comparative Advantage among Nations: The principle of comparative advantage holds that each country will benefit if it specializes in the production and export of those gods that it can produce at relatively low cost. Conversely, each country will benefit if it import those goods which it produces at relatively high cost. Richardo’s Analysis of comparative advantage: Assumptions: 1. Two nations 2. Two commodity 3. All production cost in terms of labor hour. Necessary labor for production (labor – hour) In America In Europe Product 1 unit of food 1 unit of clothing

1 2

3 4

In America, it takes 1 hour of labor to produce a unit of food, while a unit of clothing requires 2 hours of labor. In Europe the cost is 3 hours of labor for food and 4 hours of labor for clothing. We see that, America has absolute advantage in both goods, for it can produce them with greater absolute efficiency than can Europe.

However America has comparative advantage in food, while Europe has comparative advantage in clothing, because food is relatively inexpensive in America whle clothing is relatively less expensive in Europe. From these facts, Richardo proved that both regions will benefit if they specialize in their areas of comparative advantage – that is if America specializes in the production of fod while Europe specializes in the production of clothing. In this situation America will export food to pay European clothing, while Europe will export clothing to pay for American food. Before trade: When all international trade is illegal or because of a prohibitive tariff, the real wage of the American worker for an hour’s work as 1 unit of food or ½ unit of clothing. The European worker earns only 1/3 unit of food or ¼ unit of clothing per hour of work. Clearly, if perfect competition prevails in each isolated region, the prices of food and clothing will be different in the two places because of the difference in production costs. In America, clothing will be 3 times as expensive as food because it takes twice as much labor to produce a unit of clothing as it does to produce a unit of food. In Europe, clothing will be only 4/3 as expensive food. After trade: Now suppose that, all tariffs are repealed and free trade is allowed. For simplicity, further assume that, there are no transportation costs. Then clothing is relatively more expensive in America (with a price ratio of 2 as compared to 4/3), and food is relatively more expensive in Europe (with a price ratio of ¾ as compared to ½). Given these relative price, and with no tariffs or transportation costs, food will soon be shipped from America to Europe and clothing from Europe to America. As European clothing penetrates the American market, American clothiers will find prices falling and profits shrinking and they will begin to shut down their factories. By contrast European farmers will find that the prices of foodstuffs begin to fall when American products hit the European markets; they will suffer losses, some will go bankrupt, and resources will be withdrawn from farming. After all the adjustment to international trade have taken place, the prices of clothing and food must be equalized in Europe and America.

PROTECTIONISM Supply and Demand Analysis of Trade and Tariffs:

Domestic supply

8

Domestic production

Price of clothing in America

Import

World supply

4 Domestic Demand

100

400

Quantity of clothing in America

•

Effect of free trade and Open Trade.

Trade Barriers: • Tariff: A Tariff is tax levied on the imports. = Prohibitive tariff: A tariff which is so high that it chokes off all imports. = Non-Prohibitive tariff: A tariff which injure but not kill the imports •

Quota: A quota is a limit on the quantity of imports.

Difference between Tariff and Quotas: There is no essential difference between tariffs and quotas, some subtle differences do exist. A tariff gives revenue to the government, perhaps allowing other taxes to be reduced and thereby offsetting some of the harm done to consumers in the importing country. A quota on the other hand, puts the profit from the resulting price difference into the pocket of the importers or exporters lucky enough to get a permit or license. Economists therefore termed Tariff less evil than Quotas.

The Economic Costs of Tariff: S

8 M

H

J

A

C

World price plus tariff

6 F

E L

World Price

4

D

100

150

250

300

Diagrammatic Analysis: 1. Area B is the tariff revenue collected by the government. It is equal to the amount of the tariff times the units of imports and totals Tk.200. 2. The tariff raises the price in domestic markets from Tk.4 to Tk.6 and producers increase their output to 150. Hence total profit rise to Tk.250 shown by area LEHM and equal to Tk.200 on old output and Tk.50 for additional 50 units.\ 3. Finally a tariff imposes heavy cost on consumers. The total consumption surplus loss is given by area LMJF and is equal to Tk.550. 4. The overall social impact is, then a gain to producers of Tk.250 a gain to the government of Tk.200 and a loss to consumers Tk.550. The net social cost is Tk.100. 5. Area A is the net loss that comes because domestic production is more costly than foreign production. When the domestic price rises, businesses are thereby induced to increase the use of relatively costly domestic capacity. They produce output up to the point where the marginal cost is Tk.6 per unit instead of Tk.4 per unit under free trade. 6. In addition, there is a net loss to the country from the higher price, shown by area C, This is the loss in consumer surplus cannot be offset by business profits or tariff revenue. This area represents the economic cost incurred when consumers shift their purchases from low cost imports to high cost domestic goods. This is equal to Tk.50.