SELECTED ISSUES IN MICROECONOMICS (CONTINUEDâ€¦â€¦â€¦â€¦â€¦)

<< SELECTED ISSUES IN MICROECONOMICS:WELFARE ECONOMICS

INTRODUCTION TO MACROECONOMICS:Price Level and its Effects: >>

Introduction to Economics ECO401

Lesson 7.2

SELECTED ISSUES IN MICROECONOMICS (CONTINUED...............)

Supply and Demand Curve for Labor:

The labour supply curve may bend backwards above a certain wage rate as the income effect

of higher income dominates the substitution effect of higher wages.

The wage rate is the marginal cost of labour to the firm and is directly proportional to the hours

worked.

The demand curve for labour can be derived from the intersection of the wage rate lines

(horizontal parallel lines) and the marginal revenue product of labour (a downward sloping

concave function) given by MRPL = MPPL x MRi, where subscript "L" stands for labour and

subscript "i" stands for the good which the labourer helps produce.

The Value of Marginal Product of Labor (VMPL):

The value of marginal productivity of labor can be represented by the following formula:

The value of marginal product of labour (VMPL) = MPPL x Pi.

It is equal to MRPL when P = MC (as in perfect competition), but otherwise VMPL > MRPL.

One important difference between labour and land, capital is that the latter two can be

purchased but labour can only be rented.

A rent is a periodic payment as a reward for hiring the factor of production for that period,

where the purchase price of capital is the "value" of owning that capital for its entire life.

The Net Present Value (NPV) and Discounting:

Decisions about purchasing capital or land are often made on the basis of the net present

value (NPV) associated with the decision. The NPV of an asset is the discounted value of the

net returns that the asset generates over a period of time plus the discounted value of its

disposal value at the end of the period minus the initial purchase cost.

Discounting is the process of converting a stream of future incomes and expenses into a

present value. The discount rate is the rate at which the future incomes are discounted.

THE ECONOMICS OF INFORMATION PRODUCTS

The economics of information products or (internet products) involves studying how economic

principles apply to the production, distribution and consumption of these products.

The internet has reduced the marginal cost of distributing information to zero, as once a

product is launched on the web, any number of potential customers can access/view it without

any additional cost to the producer of the information.

Since the average cost of information product is falling over the entire range of output the

market structure most consistent with such a product is (natural) monopoly.

Experience goods are goods that people must get a flavor of before they can consider buying

them.

Introduction to Economics ECO401

END OF UNIT 7 - EXERCISES

WELFARE ECONOMICS AND EXTERNALITIES

If monopoly power existed in an industry, would production be above or below the

socially efficient level (assuming no externalities)? Which would be greater, MSB or P?

A firm with monopoly power produces where MR = MC. But this is below the socially efficient

level of output which obtains where P = MC.

Assuming no externalities, and perfect competition show that social efficiency is

achieved in the factor markets, where: MSBf = MRPf = Pf = MDUf = MSCf (where MRP is

the marginal product of a factor, MDU is the marginal disutility of supplying it and f is

any factor).

The MRPf is the marginal benefit to the employer from employing a factor. Profits will be

maximised where MRP = Pf. The MDUf is the marginal cost to the factor supplier from

supplying a factor. The factor supplier's `surplus' will be maximised where Pf = MDUf. Under

perfect competition, since MRPf = Pf for each producer, and Pf = MDUf for each factor supplier,

then, since the market price for the factor (Pf) is the same for all firms and factor suppliers,

then MRPf = MDUf for all firms and factor suppliers. In the absence of externalities in the factor

market, MSBf = MRPf, and MDUf = MSCf. Thus: MSBf = MRPf = Pf = MDUf = MSCf , i.e. MSBf

= MSCf

Note: The concepts in this question will not be tested in the exam.

Trace through the effects in both factor and goods markets of the following:

a) An increase in the productivity of a particular type of labour.

b) An increase in the supply of a particular factor.

The following charts illustrate the effects:

(a)

1. Labour demand

→

MRPl↑ (i.e. MSBl↑)

employment of labour↑

W↑

MRPl > W

2. Labour supply

W↑ → W > MDUl (i.e. W > MSCl) → supply of labour↑

→

MDUl↑

(movement up along MDUl and hence MSCl curve) .

These adjustments would continue until MSBl = MSCl.

3. Producer supply

→

MRPl↑

MC↓

production↑

P↓

P > MC (i.e. P > MSC)

4. Consumer demand

P↓ → MU > P → consumption↑ → MU↓ (movement down along MU and

hence MSB curve)

These adjustments would continue until MSB = MSC (in goods markets).

(b)

1. Factor supply

Sf↑ (i.e. MSCf↓) → Sf > Df

→

Pf↓

2. Factor demand

Introduction to Economics ECO401

Pf↓ → MRPf > Pf → employment of factor↑ (movement down along MRPf

and hence MSBf curve)

These adjustments would continue until MSBf = MSCf.

3. Producer supply

→

Pf↓

MC↓

production↑

P↓

P > MC (i.e. P > MSC)

4. Consumer demand

P↓ → MU > P → consumption↑ → MU↓ (movement down along MU and

hence MSB curve)

These adjustments would continue until MSB = MSC (in goods markets).

Note: The concepts in this question will not be tested in the exam.

If MUX/MUY were greater than PX/PY, how would consumers behave? What would bring

consumption back to equilibrium where MUX/MUY = PX/PY?

Consumers would buy relatively more of X and relatively less of Y. But as they did this,

MUX/MUY would fall (because of diminishing marginal utility) until MUX/MUY = PX/PY.

Note: The concepts in this question will not be tested in the exam.

If MCX/MCY were greater than PX/PY how would firms behave?

What would bring

production back into equilibrium where MCX/MCY = PX/PY?

Firms would produce relatively more of good Y and relatively less of good X. But as they did

this, MCX/MCY would fall (because of the law of diminishing returns and hence increasing

marginal costs as production increases) until MCX/MCY = PX/PY.

What are marginal external costs?

The different between marginal social cost and marginal private costs is marginal external cost.

In other words, it is the marginal cost of the externality to society.

Is it likely that the MSB curve will be parallel to the MU curve? Explain your reasoning.

No. It is likely that the marginal external costs of consumption will increase as more is

consumed, and thus the curves will get further apart (making the MSB curve steeper than the

MU = MB curve). For example, the marginal pollution costs of cars gets progressively greater as

more and more cars come onto the roads and the environment becomes less and less able to

absorb the additional quantities of pollutants.

Give other examples of each of the four types of externality.

a) External costs of production (MSC > MC): The pollution of rivers and streams by slurry

and nitrate run-off from farms; road congestion near a factory.

b) External benefits of production (MSC < MC): Beneficial spin-offs from the development of

new products (for example, the various space programmes in the USA, the USSR and

Europe have contributed to advances in medicine, materials technology, etc.); where the

opening of a new environmentally friendly factory results in less output from factories that

pollute.

Introduction to Economics ECO401

c) External costs of consumption (MSB < MB): The effect of CFC aerosols on the ozone

layer; the unpleasant sight of kites stuck in trees and wires.

d) External benefits of consumption (MSB > MB): People decorating the outside of their

houses or making their gardens look attractive benefits neighbours and passers-by; car

owners getting their cars properly serviced so as to reduce the smoke emitted and the

pollution associated with it.

Some roads could be regarded as a public good, but some could be provided by the

market. Which types of road could be provided by the market? Why? Would it be a

good idea?

Roads where there are relatively few access points and where therefore it would be practical to

charge tolls. Charges could be regarded as a useful means of restricting use of the roads in

question, or, by charging more at peak times, of encouraging people to travel at off-peak times.

Such as system, however, could be regarded as unfair by those using the toll roads, and might

merely divert congestion onto the non-toll roads.

Which of the following have the property of non-rivalry: (a) a can of drink; (b) public

transport; (c) a commercial radio broadcast; (d) the sight of flowers in a public park?

(a) No. (b) No (passengers take up seats). (c) Yes. (d) Yes (unless I get in your way!).

Give some other examples of public goods. Does the provider of these goods (the

government or local authority) charge for their use? If so is the method of charging based

on the amount of the good that people use? Is it a good method of charging? Could you

suggest a better method?

Two examples are: national defence; urban roads. In both cases the user is not directly

charged. The funding comes from taxation. In the case of roads, part of the funding comes from

road users generally (in the form of taxes on petrol and road fund licences) and part from

general or local taxation. Only in the case of petrol tax is the charging related to the amount that

people use the public good. It encourages people to use the roads less, and thus takes into

account the marginal cost (i.e. repairs and maintenance) of road provision. In this sense,

however, roads are not a pure public good because using them does create a small amount of

wear and tear on them (although a significant portion of road maintenance costs are due simply

to deterioration through time).

If the marginal cost of provision is zero (as is the case with a pure public good) then charging

people according to how much they use it will not cause an efficient allocation of resources: with

a zero marginal cost, the price should be zero. Charging people according to how much they

use it, however, could be regarded as fair according to the benefit principle but not according

to the principle of vertical equity.

Name some goods or services provided by the government or local authorities that are

not public goods.

Education, health, libraries, parks. Only limited people can use these facilities.

If health care is provided free, the demand is likely to be high. How is this high demand

dealt with? Is this a good way of dealing with it?

It is dealt with by a system of queuing. Emergency cases are usually dealt with immediately, or

at least very quickly, but non-emergency cases may have to wait weeks, months or even years

for treatment.

Many people would argue that for reasons of equity, and the special nature of health, it is better

to solve the problem of waiting lists by diverting more resources into health care, rather than by

using a system of charging people. Except where there are initially idle resources or

Introduction to Economics ECO401

inefficiencies, this approach will result in a lower provision of other publicly provided goods or

services, or higher taxes.

How would you attempt to value time that you yourself save (a) getting to work; (b) going

on holiday; (c) going out in the evening?

The approach is to ask what the opportunity cost to you of that time is. What else could you

have done with the time and what, as a result, would you have been prepared to pay to save

time? Thus in the case of (b), if you have a long holiday and the travel is seen as an enjoyable

part of it, then there may be no time cost to you, or it may even be seen as a benefit; whereas if

you only have a week off work and want to get to the sun as quickly as possible, then you will

want to minimise travel time and thus may be prepared to pay quite a lot more to fly rather than

go over land.

Imagine that a public project yields a return of 13 per cent (after taking into account all

social costs and benefits), whereas a 15 per cent private return could typically be earned

in the private sector. How would you justify diverting resources from the private sector

to this project?

If it could be argued that this particular project yielded longer-term benefits, and that the market

rate of discount is too high in the sense that it gives undue weight to present benefits and costs

over future benefits and costs than is socially desirable, then there would be some justification.

The justification for a lower social rate of discount is that the market only reflects the wishes of

the current generation, whereas governments ought to take a longer-term perspective.

An alternative justification may be in terms of the distribution of costs and benefits. If the project

was an effective means of targeting help to the poor (say a new hospital in an area where there

is a lot of poverty) then the government may want to apply a lower rate of discount.

Assume that a project has an initial construction cost of Rs10 000, takes a year to come

into operation and then has a life of 3 years. Assume that it yields Rs5000 per year in

each of these 3 years. Is the NPV positive at (a) a 10 per cent discount rate; (b) a 15 per

cent discount rate?

(a) NPV = Rs.10 000 + Rs.5000/1.1 + Rs.5000/1.21 + Rs.5000/1.331

= Rs.10 000 + Rs.4545 + Rs.4132 + Rs.3757

= +Rs.2434

The NPV is therefore positive at a 10 per cent discount rate.

(b) NPV = Rs.10 000 + Rs.5000/1.15 + Rs.5000/1.3225 + Rs.5000/1.5209

= Rs.10 000 + Rs.4348 + Rs.3781 + Rs.3288

= +Rs.1417

The NPV is therefore still positive at a 15 per cent discount rate.

Why is this type of costbenefit analysis (CBA) simpler to conduct that ones assessing

the desirability of a new road or airport?

There are specific scenarios, with very precise assumptions. The main purpose was not to

demonstrate the positive NPV (which depends on the assumptions about the value of the

environmental benefits of reducing emissions), but to compare the relative advantages of the

alternative scenarios.

With a CBA of a new road or airport, there have to be assumptions, not only about the

environmental impact, but about the value of time saved or additional time incurred by

travellers, about the value of lives saved or lost and about the costs to local people disturbed

by the road or airport. Thus the measurement of externalities is likely to be more problematic

than in the case of lowering the sulphur content of road fuel.

How do merit goods differ from public goods?

They could be provided by the market (albeit with too little consumed). The problem of non-

excludability does not apply.

Note: The concepts in this question will not be tested in the exam.

Introduction to Economics ECO401

Summarize the economic policies of the major political parties. (If it is near an election

you could refer to their manifestos.) How far can an economist go in assessing these

policies?

You will need to look at the current policies.

Economists in their role as economists cannot challenge fundamental normative issues such

as whether it is desirable to have a much more substantial redistribution of income from the

rich to the poor. They can, however, examine whether the factual claims of the parties are

correct, and whether the policies they advocate will bring the effects they claim.

Note: The concepts in this question will not be tested in the exam.

Give some examples of how correcting problems in one part of the economy will create

problems elsewhere.

Two examples are:

· A local authority reduces street parking in the centre of a town in order to reduce

congestion on the streets, but succeeds in encouraging commuters and shoppers to

park outside the town centre in residential areas, thus reducing the quality of life for

those living in those areas.

· The government taxes the consumption of electricity in order to encourage people to

become more fuel efficient and thus to reduce power station emissions. Some people

respond by switching to burning coal, with the result that emissions from this source

increase.

THE MARKET FOR FACTORS OF PRODUCTION

Why might the labour supply curve be backward bending?

Because after a point the income effect of the higher wage dominates the substitution effect.

Note that when we talk of substitution, it is substitution between work and leisure. The labourer

must decide how to utilize his time, i.e. how much hours to spend working and how much to

spend relaxing. If the wage rate (which also represents the worker's income) becomes very high,

given that leisure is a normal good, the demand for relaxation increases. This is the income

effect and it is positive for leisure and negative for hours worked. However, as the wage rate

increases, the opportunity cost of relaxing increases and prompts the worker to work more. This

is the substitution effect and is negative for leisure and positive for hours worked. The labour

supply curve becomes backward bending when the income effect of higher wages dominates

the substitution effect.

What is the distinction between MRPL and VMPL? When is this distinction important?

Labour's marginal revenue product (MRPL) = MR * MPPL

Labour's value of marginal product (VMPL) = P * MPPL

The two terms mean the same when the product market is perfectly competitive, because then:

MR = MC = P. However, when the product market is not perfectly competitive, for e.g., if it is a

monopoly, then P > MR at the profit maximizing output, and therefore VMPL > MRPL. The

important implication of this is that a monopolist would pay labourers less than the "value of the

output that their labour helps produce", i.e. the VMPL. To that effect this can be viewed as

exploitation of labour.

Do any of the following contradict marginal productivity theory:

a) Nationally negotiated wage rates;

b) Discrimination;

Even if marginal productivity theory were not relevant in these cases, the theory would still be

accurate in the sense that if firms wanted to maximise profits then they should employ workers

to the point where MCL = MRPL.

But do any of the above four cases necessarily contradict marginal productivity theory?

Introduction to Economics ECO401

a) No, not necessarily. Firms may find it convenient (in terms of the costs of negotiating

and the avoidance of disputes) to pay nationally agreed wage rates. They then could

employ workers up to the point where their MRP was equal to this wage rate (which,

given that the firm was a `wage taker' would be equal to the MCL).

b) Yes. Discrimination would lead to firms employing those workers against whom they

were discriminating below the level where their MRP was equal to their MCL.

Which of the following are stocks and which are flows?

a) Unemployment.

b) Redundancies (job lay-offs).

c) Profits.

d) A firm's stock market valuation (share price).

e) The value of property after a period of inflation.

Stocks: (a), (d) and (e). They are measurements at a point in time.

Flows: (b) and (c). They are measurements over a period of time. (Note that (e) would only be

a flow if it were measuring the rise in the value of property over a period of time.)

What is the present value of a machine that lasts three years, earns Rs.100m in year 1,

Rs.200m in year 2 and Rs.200m in year 3, and then has a scrap value of Rs.100m?

Assume that the rate of discount is 5 per cent. If the machine costs Rs.500m, is the

investment worthwhile? Would it be worthwhile if the rate of discount were 10 per cent?

Using the formula given in the lectures:

PV = Rs.100/1.05 + Rs.200/(1.05)² + Rs.300/(1.05)³

= Rs.95.24 + Rs.181.41 + Rs.259.15

= Rs.535.80

Thus the investment is profitable at a discount rate of 5 per cent given that the machine costs

Rs.500.

If the rate of discount is 10 per cent, then the present value this time is given by:

PV = Rs.100/1.1 + Rs.200/(1.1)² + Rs.300/(1.1)³

= Rs.90.91 + Rs.165.29 + Rs.225.40

= Rs.481.59

With a 10 per cent discount rate, therefore, the investment would not be profitable.

What market price would a piece of land sell for if it earned Rs.10,000 rent per year, and if

the rate of interest were 5 per cent?

According to the formula, market price of land = [annual rental value (in Rs.) / interest rate (in %

p.a.)]

Rs.10,000/0.05 = Rs.200,000.

What does this tell us about the relationship between the price of an asset (like land) and

the rate of interest?

The higher the rate of interest, the lower the market price of the asset. The asset would have to

be cheaper (i.e. yield a higher rate of return) to persuade the purchaser to sacrifice the

alternative of earning the market rate of interest.

INFORMATION ECONOMICS

There are many dimensions to information economics. The first of these was touched upon in

the lectures on background on demand under "demand under uncertainty." We touched

Introduction to Economics ECO401

concepts like moral hazard and adverse selection. Below we touch upon some of the remaining

aspects that were not covered there. PART A contains questions related to the economics of

information products on the web that were covered in the lecture, while PART B contains other

"general" information economics issues.

PART A:

What has the internet done to the cost of distributing information?

It has virtually brought down this cost to zero. Distributors can place information on their

websites and consumers can access it or download it from there without any additional cost to

the distributor. There are however still the initial costs of preparing the information in a format

that can be placed on the web, and also the costs of maintaining the website and marketing the

website to interested consumers of that information. However, in terms of the marginal cost of

distributing information to one more consumer, that cost has now been brought down to virtually

zero by the internet.

What are experience goods?

These are goods whose value can be ascertained by the consumer only after experiencing or

consuming it. For example if a university wanted to deliver an online course in say, finance, it

might allow potential students to take part of the course free and then if they are satisfied they

could proceed with a charge for the remaining or whole of the course. The same principle

applies to buying software on the web. You are often given a free trial version before you asked

to commit to buy the software.

How is it possible for companies like MSN or yahoo to provide free e-mail or chatting

facilities or "web space" to internet users the world over?

Everything has a cost. Providing free web space or e-mail account to millions of users also must

have a cost. Now if the users are not paying this cost, someone else should. This someone else

is the ever-growing pool of businesses (travel companies, financial advisors, supermarkets,

fashion outlets you name it) who wish to advertise their products to millions of potential

customers worldwide. Yahoo and MSN, because they have such a large captive clientele can

serve as the ideal vehicle media for their advertisements. Thus you will see that whenever you

log on to the yahoo page there is some advert that appears without you asking. This is to ensure

that "all" users do actually see the advert, so that "some of them" buy the product being

advertised.

PART B

(YOU WILL NOT BE TESTED ON THIS IN THE EXAM)

Assume that you wanted the following information. In which cases could you (i) buy

perfect information, (ii) buy imperfect information, (iii) be able to obtain information

without paying for it, (iv) not be able to obtain information?

a) Which washing machine is the most reliable?

b) Which of two jobs that are vacant is the most satisfying?

c) Which builder will repair my roof most cheaply?

d) Which builder will make the best job of repairing my roof?

e) Which builder is best value for money?

f) How big a mortgage would it be wise for me to take out?

g) What course of higher education should I follow?

h) What brand of washing powder washes whiter?

In which cases are there non-monetary costs to you of finding out the information? How

can you know whether the information you acquire is accurate or not?

Introduction to Economics ECO401

(a) (i) or (ii);

(b) (iii) (by asking people currently doing the job) or (iv);

(d) (iii) (albeit imperfect, by inspecting other work that the different builders have done) or (iv);

(e) As (d);

(f) (iii);

(g) (iii);

(h) (i) or (ii) (as in (a)) or (iii) by experimenting.

All could involve the non-monetary costs of the time involved in finding out.

If th

If the information is purely factual (as in (c) above), and you can trust the source of your

information, there is no problem. If you cannot trust the source, or if the information is subjective

(such as other people's experiences in (b) above), then you will only have imperfect information

of the costs and/or benefits until you actually experience them.

Make a list of pieces of information a firm might want to know, and consider whether it

could buy the information and how reliable that information might be.

· Some examples include:

The position and elasticity of the demand curve: Market research can provide some information,

but it is very unreliable, especially in an oligopolistic environment, where the actions of rival are

unpredictable.

· Next year's wages bill:

The information cannot be purchased, but it could use its own past experiences to predict (albeit

imperfectly) the outcome of wage negotiations.

· The costs of alternative inputs:

This information is probably available free from suppliers.

· Ways of saving taxes:

Employing accountants can help the firm save money here.

What type of information can be a public good? (Clue: do not confuse a public good with

something merely provided by the government, which could also be provided by the

private sector.)

An example of information that is nearer to being a public good, is information that is simple

enough not to require being presented as a set of tables or as a report. It can be told from one

person to another: as such it would be difficult to enforce copyright. An example would be the

current rate of inflation or the size of the balance of trade deficit or surplus.

Table of Contents: