Why do markets sometimes fail? Describe one cause of market failure, and explain what might be done about it.
- Externalities, Information Assymmetry, etc.
- No. See Quantity Theory.
- Protectionism.
- Brexit.
- Trade deficits/war.
Explain a supply and demand curve, consumer and producer surplus, and what the analysis of supply and demand predicts about the consequences for total surplus of letting prices be determined in a free market.
A supply curve shows the quantities that firms would be willing to sell at each possible price, holding other things constant – such as the state of technology, wage rates and the cost of intermediate inputs. A demand curve shows the quantities that consumers would be willing to buy at each possible price, again holding other things constant – in this case, income levels and the prices of other goods are among the most important other variables. At the intersection of supply and demand, a market price could be set at a level such that all the output that firms would like to sell at that price can be sold to a consumer willing and able to buy it.
The demand curve can also be seen as graphing the amounts that consumers are willing to pay for each extra unit bought, starting at the highest levels when just a few units are consumed, and falling as more is bought. The marginal consumer is, by definition, paying exactly the maximum amount that they would be willing to pay for their marginal unit, but consumers would be willing to pay more for every other unit that they purchase. The difference between the amount they are willing to pay and the amount they have to pay is known as consumer surplus.
Similarly, the supply curve can be seen as graphing the amounts that firms need to receive in order to supply each additional unit of the good – if the market is perfectly competitive, this is just equal to their marginal cost. The marginal unit sold goes for its marginal cost, but the infra-marginal units typically have lower marginal costs than this. The difference between the market price and the marginal cost of these units is known as producer surplus. It is not the same as profit, because it doesn’t take account of fixed costs – if producer surplus was lower than fixed costs, the firm would be making a loss and would want to exit the market in the long term.
The diagrams show these two interpretations of the supply and demand curve. It should be clear that the total shaded area is maximised if the quantity sold is where supply and demand curves meet – selling less implies that there are consumers willing to pay more than the amount firms need to receive to make them willing to sell the good; while selling more than this implies that firms are having to receive more than consumers would be willing to pay for the good.
A competitive market should therefore get to the best outcome, provided that the supply and demand curves truly represent the cost of production and the value gained from consumption. If there are externalities, for example, this will not be true, and the market may produce too much (with negative externalities such as pollution) or too little (with positive externalities such as vaccinations) of the good.
Explain the own-price, cross-price and income elasticities of demand. Give an example of how these concepts help you think about what happens when firms vary the prices they set.
Economists and firms can use the concept of elasticity to assess the responsiveness of demand to the forces that affect it, most notably prices and incomes. An elasticity of demand is defined as the percentage change in the quantity demanded, divided by the percentage change in the other factor (price, or income). A relationship is said to be inelastic if the absolute percentage change in the driving factor (such as price) is larger than the absolute percentage change in the dependent variable (demand); it is elastic if the absolute percentage change in the dependent variable (demand) is greater than the absolute percentage change in the driving factor (price).
To be specific, the own-price elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in the good’s own price, moving along the demand curve. It will be negative, since the demand curve slopes down, and can be elastic (more negative than -1) or inelastic (less negative than -1). An inelastic demand curve tends to look “steep”, and an elastic demand curve tends to look “shallow”, but the elasticity of demand does not depend on the slope of the curve alone, but on the slope, relative to the price and quantity we are looking at. The same slope can give elastic demand for small quantities and high prices at the top of a demand curve, and inelastic demand for larger quantities and lower prices at the bottom of the demand curve.
A firm will only want to set a price such that its demand is elastic (in own-price terms) – this is the demand curve for the firm’s own products (such as Mars Bars) rather than for the industry as a whole (chocolate snacks). This is because the marginal revenue is related to own-price elasticity:
MR = d(PQ)/dQ = P + dP/dQ x Q = P + Q ÷ (dQ/dP) = P (1 + Q/P ÷ dQ/dP)
= P (1 + 1/elasticity)
Remembering that elasticity is negative, marginal revenue can only be positive if the elasticity is more negative than minus one. If demand is very elastic, then a small reduction in price leads to a large increase in quantity demanded, and the firm’s marginal revenue will be very close to its price – this makes price cuts attractive. If demand is not very elastic, then marginal revenue will be small, and price cuts bring in few extra sales to offset the lower revenue per unit. With inelastic demand, cutting prices leads to a reduction in revenues, and the firm would do better to raise prices instead.
The cross-price elasticity of demand can be positive or negative. Complements, goods that are typically consumed together (cars and fuel), have negative cross-price elasticities, since a rise in the price of one makes consumption of the other less attractive. Substitutes, goods that are alternatives (petrol and diesel) have positive cross-price elasticities, since a rise in the price of one makes the other more attractive. If cross-price elasticities are small, firms can probably ignore them for practical purposes, but if they are larger, then these effects should be considered. A firm may be able to boost demand for its product by cutting the price of its complement (printers are relatively cheap compared to the cost of making them; toner cartridges are relatively expensive). If a rival firm cuts the price of a substitute, our firm may need to do the same in order to defend its share of the overall market – this is how price wars start.
Income elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in income, and can again be positive (for so-called normal goods) or negative (for so-called inferior goods). The income elasticity of demand is more useful for telling a firm how its demand is likely to change over time as economic circumstances change, than in response to a change in the firm’s own prices – most goods do not take up a sufficiently large part of a consumer’s income for a change in the good’s price to have an important effect on the consumer’s real income.
Explain how and why different concepts of costs vary with output in what Economists call the long and short run.
Economists typically divide costs into Fixed Costs and Variable Costs, and time into the Short Run and the Long Run. Strictly speaking, the definitions can be circular, as Fixed Costs are defined to be those costs that cannot be changed in the Short Run, and the Short Run is the period over which some costs cannot be changed (or, conversely, the Long Run is the period within which all costs can be changed and none are fixed). What that really means, however, is that the context matters, and that you have to think when applying these concepts – what is the relevant length of time for the company that we are studying to be making its decision over, and what costs should it be taking as fixed within that timescale? Total Costs are the sum of Fixed and Variable Costs, and Average Fixed Costs, Average Variable Costs and Average Total Costs are obtained by dividing the relevant amounts be the level of output.
It is best to illustrate these concepts with a specific example, and I will use an electricity generating company. Thinking about the timescale of a few days, many costs will be fixed – workers will have contracts that cannot be changed that quickly, for example, although it might be possible to adjust the amount of overtime they do, and a firm with more than one product may be able to vary the amount of labour that it puts into each one. The fuel that the company uses will be a variable cost, however – if it is not burned now, it could be stored for later, or sold to another user, or (if the fuel is delivered and burned almost simultaneously, like gas) the firm need not buy fuel if it is not producing. The firm will also need to do more maintenance, the more it uses its power stations, and so the cost of this extra maintenance (over and above the work that needs to be done each year, even if the station is not used at all) should be counted as a variable cost.
Looking at the timescale of a few months, the firm can adjust the number of employees, and it could even decide to close a power station and no longer pay insurance or fees for connecting it to the network. Over that longer timescale, more costs have become variable, and fewer costs are fixed. The firm would still be committed to pay interest on any loans used to build the station, however – those costs are effectively fixed throughout the station’s expected economic lifetime. The firm could only avoid those costs if it sold the station to another company, which does sometimes happen, but usually takes months or even years to negotiate. In any case, if the reason for wanting to sell the station is that it is not making enough money, the buyer is unlikely to want to pay a good price.
If we think about expanding production, in the short run, the firm can only do so by taking on more (or fewer) variable costs. In the long run, it can adjust the amount of capital equipment it has, and because it has more options, it can usually produce a given amount of output more cheaply than with the capital equipment it started with. This means that the firm may well have a set of average total cost curves that look like the following diagram
In the Long Run, Average Total Costs are minimised at the bottom of the dotted line; this is also the minimum of the SRAC2 line; the set of short-run possibilities with the capital equipment “2”. (Not necessarily 2 units of equipment, just the second set shown in the figure.) For higher and lower levels of output, it is best to adjust the amount of capital – note that the SRAC curve rises above the LRAC, implying that some other amount of capital equipment would give lower total costs for the same level of output – but in the short run, it is not possible to make that adjustment… On SRAC3, it is also quite possible to see that the bottom of that curve implies a level of costs which is higher than the LRAC for the same level of output – the bottom of the SRAC curve may imply that capital equipment “3” is being used as efficiently as possible, but it’s actually better to use a different amount of capital equipment, again not at the bottom of its own SRAC curve, to produce the output.
Average Variable Costs (which are the same as Average Total Costs in the long run) are what the firm needs to compare with the market price to decide whether production is worthwhile, but to choose the best level of output, the firm needs to think about Marginal Cost, and that is the change in cost from producing slightly more, or slightly less, output.
Note that this answer has not included anything on economies of scale, and saying something about those (since they affect how costs change with output, but only in the long run when all costs are variable) could be part of a good answer – the point I want to make is that there will often be more than one way of answering a question, and I do not start with a fixed list of points that I “need” to see when marking one.
Economies of scale mean that a large firm can have lower average costs than a small firm. This gives the larger firms an advantage and so industries with strong economies of scale are unlikely to have many small firms in them. The extreme case is a natural monopoly, when it is most efficient to only have one firm in the industry.
In the monopoly model, there is a single firm, protected by barriers to entry. It therefore faces the market demand curve, and has a marginal revenue curve which is below the demand curve (except at the vertical intercept). The firm will produce where marginal revenue equals marginal cost, assuming that it is a profit-maximiser. There will be a deadweight loss because the firm is setting price above marginal cost, and could have sold more units to consumers who would have valued them more than the cost of producing them. The firm will be able to make super-normal profits in the long term (in general) and these will not be competed away by entry. While it is hard to show in the standard diagrams, there is a risk that the firm will become inefficient and its actual costs will be higher than they need to be, because the managers are not under pressure from competitors.
A monopoly will set a price such that marginal revenue equals marginal cost, when marginal revenue is less than price. This means that it could have produced a bit more and still sold each unit for a price greater than its marginal cost of production. The difference between price and marginal cost is the deadweight loss on each of those units. Students should draw the standard diagram of this. They might also point out that a monopoly might be able to get economies of scale and thus produce at lower cost than a more competitive market structure; this would offset the static deadweight loss we observe.
Students should be able to understand the factors that affect elasticity of demand, so correct answers would include (among others):
(1) Expenditure: goods that form a small part of our overall expenditure tend to have inelastic demand.
(2) Convenience: greater convenience of a good helps to keep demand inelastic.
(3) Necessity: if you have to buy a product out of necessity it will tend to make it inelastic.
(4) Habit (or addiction): will make demand inelastic e.g. tobacco. Firms use advertising and branding to create brand loyalty and thus more inelastic demand.
(5) Lack of substitute products: this will tend to make the product inelastic.
(6) Durability: goods that are durable and do not need to be replaced often tend to have inelastic demand.
False. The law of diminishing returns and economies of scale can relate to different time periods, but they are also different ideas. The law of diminishing returns states that as more of a variable factor of production is added to a fixed factor of production, we will find that returns to the variable factor will diminish at some point. Economies of scale are realised when long-run average costs decline as output increases.
An increase in demand will have a bigger impact on the equilibrium price, the more elastic the supply is.
False. Following a change in demand, price changes are greater if supply is inelastic, while output changes are greater if supply is elastic.
Hence, with elastic supply, rising demand leads to price increases, to which suppliers respond by supplying larger quantities.
The long run is that period of time where all factors of production are variable. A typical long run average cost curve is a U-shaped curve that is itself an envelope of short-run average cost curves. It has a region where we observe increasing returns to scale, one with constant returns to scale, and one with decreasing returns to scale. The short run is a period where at least one factor of production is fixed.
The short run costs curves and the long run costs curves are derived from similar functional relationships for costs for producing a given product.
Each cost curve assumes given prices for all inputs. In the long run, all inputs can be varied, but in the short run some inputs are fixed.
When constructing the long-run average costs curve, students should be aware that the long run average cost curve is an envelope of short run average costs curves or a frontier curve, illustrating how costs change as fixed inputs change.
The long run average costs curve is drawn as the tangency points of a series of short run average cost curves and shows all the lowest long run average costs at any given level of output.
Yes. In the short run, a firm will produce at the point where the market price is equal to the average variable costs. In other words, in the short run, the firm will keep producing as long as all variable costs are recovered. Even if fixed costs are not being recovered in the short run, the firm will keep operating in the hope of better market and demand conditions eventually so that fixed costs can also be recovered in due course. If variable costs are not recovered the firm will shut down. In the long-run, the break-even point indicates the output at which all costs are recovered or where price equals average total costs. In the long run, the shut down point is indicated by the output at which price is equal to the average total costs. All costs must be recovered, otherwise the firm must shut down.
Economies of scale (or increasing returns to scale) arise when long run average costs fall as output increases or if the costs per unit of output decrease as output (and scale of production) expand. Hence, when a firm experiences economies of scale from its use of its factors of production, as it produces more output, it will be using smaller and smaller amounts of factor inputs per unit of output. Other things being equal this means that it will be producing at a lower unit cost.
List some reasons why a firm may have economies of scale and provide examples of an industry where these might occur.
Specialisation and division of labour: car industry.
Indivisibilities: airlines, airports (runways, not terminals).
Geometric relationships: Oil, chemicals, and brewing.
Byproducts: Zoo and manure.
Multistage production: Cardboard manufacturing.
One-time costs: Large R & D costs in the pharmaceutical industry.
When firms grow beyond a certain size, cost per unit of outputmay start to increase resulting in diseconomies of scale. There are several reasons for diseconomies of scale.
Management problems of co-ordination may increase as the firm becomes larger and more complex, and the lines of communication become longer.
There may also be lack of personal involvement by management due to the large overall firm size, so the firm becomes more poorly managed.
Workers may also feel alienated if their jobs are repetitive (which occurs when firms take advantage of specialisation to a large degree). Poor motivation may lead to shoddy work.
Furthermore, industrial relations may deteriorate.
As a result of these factors, more complex interrelationships between different categories of worker or factors of production may arise, which in turn increases costs per unit.
Production processes and complex interdependencies of mass production can lead to greater disruption if there are hold-ups in any part of the firm.
Remember that whether firms experience economies or diseconomies of scale will depend on the conditions applying in each individual firm.
A reduction in a firms wage bill will generally result in a lower marginal cost and a lower profit maximizing level of output.
False. A falling marginal cost schedule will lead to a higher profit maximising level of output.
False. In the short run, firms in perfect competition may make supernormal profits. This will attract entrants, leading to a lower equilibrium price and a reduction in profits to level of normal profits.
True. Zero economic profits or normal profits are not the same as zero accounting profits. Normal profit is the level of profit required to keep the firm in business and this is likely to be greater than zero accounting profit.
Consider the market for COMPUTER OPERATING SYSTEMS. Is this market better described by perfect competition, imperfect competition, or monopoly? List the perfectly competitive or monopoly characteristics of this market.
Imperfect Competition. Microsoft, through Windows, dominates the computer operating systems market. The cost of switching to alternative platforms, real or perceived, such as learning to use different word processing software or becoming familiar with a different operating system act as an effective entry barrier for other competitors and rival products. Network costs are also at play people end up using a dominant software platform if most other people also use it because doing so promotes interoperability. Recently other systems like macOS have also become significant players.
Consider the market for CINEMAS. Is this market better described by perfect competition, imperfect competition, or monopoly? List the perfectly competitive or monopoly characteristics of this market.
Perfect Competition or Imperfect Competition. Cinemas are quite competitive depending on the location. Many multiplexes serve overlapping geographic areas and provide relatively homogenous product offerings leading to low prices. Planning approval for new multiplexes may, however, act as an entry barrier. In London, close to perfectly competitive; in smaller places, imperfectly competitive.
Consider the market for CAR INSURANCE. Is this market better described by perfect competition, imperfect competition, or monopoly? List the perfectly competitive or monopoly characteristics of this market.
Perfect Competition. Many suppliers are present, relatively homogenous cover is provided, good information is available through the quote process and low prices may be obtained through search (though not always). Many insurance companies underwrite belowcost (i.e. total claims exceed premiums earned), so the industry is highly competitive.
Consider the market for IN-FLIGHT DRINKS. Is this market better described by perfect competition, imperfect competition, or monopoly? List the perfectly competitive or monopoly characteristics of this market.
Monopoly. When in-flights drinks are charged for they are often very expensive. This stems from a lack of competition at 35,000ft. Only one person has a trolley full of drinks, you can take it or leave it.
Consider themarket for CITY CENTER CAR PARKS. Is this market better described by perfect competition, imperfect competition, or monopoly? List the perfectly competitive or monopoly characteristics of this market.
Imperfect Competition or Monopoly. Prime land is expensive and planning permission may be difficult to obtain. The local council may be a significant competitor and parking lots may be very limited in prime locations, leading to a restricted supply. This leads to reduced competition and high prices. It might count as imperfect competition or as monopoly.
Firms may make announcements that they are going to occupy part of the product space by launching a new model, in the hope that their rivals will be scared away. This threat needs to be credible.
Think of a real-life situation (not already discussed in lecture) in which people face a prisoners dilemma.
For instance, a football game in which everyone has seats, but ends up standing to get a better view. They’d all be more comfortable if they sat down, but any person gets a better view standing than sitting, whatever the others are doing. Once everyone is standing, however, the view is no better than if everyone was sitting.
Illustrate, using a diagram, how congestion charging in London has attempted to reduce negative externalities.
Commuters driving into London typically ignore the social cost of their decisions such as congestion and possible extra pollution, as a result of which marginal private cost is lower than marginal social cost (which also account for congestion and pollution). Imposing a congestion charge (tax) increases the marginal private cost of motoring in London, leading to a reduction in the amount of congestion and the marginal social cost.
Smoking, Computer viruses, Pollution.
Examples include Vaccinations, Education, Research and development.
For each example of positive and negative externalities in the preceding questions, highlight how taxes or subsidies are being, or could be, used to deal with the problem of externalities.
Smoking. Tax on cigarettes. Taxes would increase prices and with higher prices, some demand would fall.
Computer viruses. Usually sent by email which is free or downloaded without consent or knowledge from suspect websites. Malicious software attempts to target peoples email address books in order to send unsolicited messages, viruses and spam at a very low cost by using automated software to send millions of spam messages. The low costs of email transmission and the lack of price incentive in email market needs to be addressed. Fines and criminal prosecutions can be imposed on senders of viruses and spam. Taxes can be levied on internet services providers to fund policing efforts aimed at combating online piracy, spam and malicious software (including computer viruses).
Pollution. Rising car tax for vehicles which emit greater pollution. This provides incentives for producing cleaner carswith lower emissions.
Vaccinations. Low take up of vaccinations for children (such as the MMR in the UK) leads to loss of positive externalities because vaccinated children are less safe from contracting a disease if some children are not vaccinated. Epidemics can result in extreme cases because vaccinations reduce vulnerability to specific diseases and vaccination programmes need wide scale adoption to be effective. The provision of subsidies can improve take up of vaccines.
Education. Some provision of grants and cheap loans represents a subsidy, but top up fees represent a tax.
Research and development. Generates positive externalities through additions of knowledge and by facilitating innovation e.g. through better anti-cancer drugs. Sometimes tax breaks for R & D are provided to firms, which equates to a subsidy.