© The McGraw-Hill Companies, 2002 Week 7 Issues in Microeconomics

©The McGraw-Hill Companies, 2002

Week 7Issues in

Microeconomics


The labour market

3©The McGraw-Hill Companies, 2002

Demand for factors in the long run

• The optimum mix of capital and labour depends on the relative prices of these factors– This helps to explain why more labour-intensive means

of production are used in some countries where labour is relatively abundant.

• A change in the price of one factor will have both output and substitution effects

• A rise in the wage rate leads to – substitution towards more capital-intensive techniques

– but also leads to lower total output


The demand for labour in the short run

• Under perfect competition, with diminishing marginal productivity:

• the firm maximizes profit when the marginal cost of employing an extra worker equals the MVPL...

The marginal value product of labour is the revenue obtained by selling the output producedby an extra worker

W0

MVPL

Employment

Wag

e, M

VP

L


The demand for labour in the short run

W0

MVPL

Employment

Wag

e, M

VP

L

L*

Employment is L*.

This decision is consistent with the MR = SMC rule formaximizing profit underperfect competition.

Below L*, extra employmentadds more to revenue thanto labour costs.Above L*, the reverse is so.

…this occurs at Ewhere wage = MVPL.

E


The supply of labour

• The LABOUR FORCE:– all individuals in work or seeking employment

• Labour supply– for an individual, the decision on how many

hours to offer to work depends on the real wage

– an individual’s attitude towards leisure and income determines if more or less hours of work are supplied at a higher real wage rate.


Labour supply in aggregate

• If we consider the economy as a whole, or an industry

• a higher real wage rate also encourages a higher participation rate

• so labour supply is likely to be upward-sloping


Labour market equilibrium for an industry

• The industry supply curve SLSL slopes up

– higher wages are needed to attract workers into the industry

• For a given output demand curve, industry demand for labour slopes down

• Equilibrium is W0, L0.Quantityof labour

Wag

e DL

DLSL

SL

W0

L0


A shift in product demand

Quantityof labour

Wag

e DL

DLSL

SL

W0

L0

Beginning in equilibrium,

a fall in demand for theproduct also shifts the derived demand for labourto D'L

D'L

D'L

The new equilibrium is at W1, L1.

L1

W1


A change in wages in another industry

Quantityof labour

Wag

e DL

DLSL

SL

W0

L0

Again starting in equilibrium,

An increase in wages in another industry attracts labour,

so industry supply shifts to the left –

S'L

S'LThe new equilibrium is at W2, L2.

L2

W2


The information economy



Welfare indicators by country group

0

500

1000

1500

£bn

2003

Business use of the internet 2003

Business to businessBusiness to consumer

0

2

4

6

£bn

1997

Business use of the internet 1997

Business to businessBusiness to consumer


e-products

• An e-product:– can be digitally encoded then transmitted

rapidly, accurately and cheaplye.g. music, films, books, sport …

• Fixed costs of producing e-products are huge …

• … but marginal costs of distribution are tiny

• implying vast economies of scale


Network externalitiesSuppose D1 represents the demand curve for a product exhibiting network externalities

£

Quantity

D1

P1

Q1

With price at P1, demand is limited.

If price is reduced to P2, morepeople find the network attractiveso not only is there a move alongthe demand curve, but there is a shift in demand.

P2

D2

Q2

Long-run demand is moreelastic (DD).

D

D


Information: the supply side

• Given substantial economies of scale, we expect monopoly suppliers of information products:

• Dominant firm with competitive fringee.g. Microsoft

• Niche market monopolies


Pricing information products

• Strategies for pricing information products:– two-part tariff

• an annual charge to cover fixed costs, and a small price per unit related to marginal costs

– versioning• the deliberate creation of different qualities to

facilitate price discrimination

– bundling• the joint supply of more than one product to reduce

the need for price discrimination


Competition vs. collaboration

• A strategic alliance is a blend of co-operation and competition, in which a group of suppliers provide a range of products that partly complement one another– e.g. Microsoft and Intel– airline alliances: One World, Star


Understanding the e-economy

• 1 The information revolution is changing our lives– but few of its activities or market

tactics are unprecedented• 2 The revolution in technology has

not required a corresponding revolution in economic theory


Government spending and Revenue


Government spending

0

10

20

30

40

50

60

% o

f na

tiona

l inc

ome

1880 1929 1960 2001

The scale of government activity has grown steadily in industrial countries since 1880

JapanUSAGermanyUKFranceSweden


Private and public goods• A private good

– if consumed by one person, cannot be consumed by another person.

e.g. dental treatment

• A public good– even if consumed by one person, can still be

consumed by other people.e.g. street lighting

The strong externalities associated with public goods, meanthat government intervention may be justified to ensure appropriate provision.


Merit goods and bads• Merit goods (bads)

– goods (bads) that society thinks everyone ought to have (ought not to have) regardless of whether they are wanted by each individual.e.g. Education, health services, cigarettes

– The government may spend money on compulsory education or compulsory vaccination because it recognizes that otherwise individuals act in a way they will subsequently regret.


Varieties of taxes• Direct taxes

– taxes on earnings from labour, rents, dividends and interest.e.g. income tax, corporation tax

• Indirect taxes– taxes levied on expenditures on goods

and servicese.g. VAT, duty on alcohol

• Wealth taxes– capital transfer tax, tax on property


Employers pay the bluearea, and workers the green.

A tax on wages

Hours worked

Wa

ge

L

W

DD

SS

With no tax, the labourmarket is in equilibrium at wage W, hours L.

The orange area is a welfare loss for society.

L'

SS'

W'

W''

With a tax, labour supplyis effectively at SS',workers receive W'',but firms pay W', thedifference being the tax.


The incidence of a tax

• Who pays a tax depends upon the elasticity of demand and supply for the product.

• This also affects the size of distortion caused by the imposition of a tax.


The Laffer curveshows how much tax revenue is raised at each possible tax rate. Beyond t*, higher tax rates reduce revenue because of disincentive effects.

t* 100%Tax rate

Tax

rev

enu e


Industrial policy and competition policy


Industrial policy andCompetition Policy

• Competition policy– aims to enhance economic efficiency

by promoting or safeguarding competition between firms

• Industrial policy – aims to offset externalities that affect

production decisions by firms


Industrial policy

• Inventions and the patent system– designed to provide a sufficient incentive

for invention without suppressing competition for ever

• Research and Development (R&D)– the social return on risky projects may

exceed the private return• Dynamic change

– coping with sunset and sunrise industries


Consumer surplus

Consider the demand curve Dand suppose price is at P withquantity demanded being Q.

P represents the value placedon the good by the marginalconsumer

so D can be seen torepresent marginal social benefit

D

Q

P

Quantity

Pric

e

A

E

With all consumers paying the same price P for the good, the triangle APE represents consumer surplus – benefit received by consumers in excess of the amount they need to pay.


– as shown by the rectangle.

Producer surplus

D

LAC = LMC

Quantity

Pri

ce

Q

P

Producer surplus is theexcess of total revenueover total costs


Consumer surplus isthe area of the biggreen triangle.

The social cost of monopoly:

comparing perfect competition and monopoly

For simplicity, suppose asindustry with horizontallong-run average and marginal costs.

Under perfect competition,long-run equilibrium wouldbe with industry outputQc selling at price Pc.

D

LAC = LMC

Qc

Pc

Quantity

Pri

ce


and the red triangle showsthe welfare loss – the social cost of monopoly

The monopoly receivesproducer surplus (profit)of the blue rectangle.

Consumer surplus is nowthe smaller green triangle.

The social cost of monopoly:

comparing perfect competition and monopoly

D

LAC = LMC

Qc

Pc

Quantity

Pri

ce

MR

Qm

Pm

If taken over by a monopolist, profitmaximization is at the lower output Qm and higher price Pm.


Perfect competition and monopoly under differing cost

conditionsSuppose that monopolyenjoys lower costconditions than underperfect competition

Qc

Pc

LRSSpc

Under perfect competitionequilibrium is at Pc, Qc.

LAC = LMC

MR

Pm

Qm

Compared with Pm, Qm

under monopolyD

Quantity

Pri

ce


Welfare implications

• In comparing the two situations, the loss of consumer surplus under monopoly (the red triangle)

• must be balanced against the gains from efficiency (the blue rectangle)


Counting the cost of monopoly

• The size of the social cost of monopoly is difficult to evaluate– in part it depends upon the elasticity of demand

– which influences the size of the ‘red triangle’ of welfare loss

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© The McGraw-Hill Companies, 2002 Week 7 Issues in Microeconomics