Economic Condition Analysis

8/14/2019 Economic Condition Analysis

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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 buyerstend to buy less of the commodity ceteris paribus. Quantity demanded tends to fall asprice 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 relatedgoods, 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 precisedefinition of price elasticity is the percentage change in quantity demanded divided bythe percentage change in price.

Price elasticity of demand ep= percentage change in quantity changes / percentage change in pricePerfectly 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 bypercentage change in price.


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Production and Marginal Products:

Production function: The production function specifies the maximum output that canbe produced with a given quantity of inputs. It is defined for a given state ofengineering and technical knowledge.

Total, Average and Marginal product:

Marginal product: The marginal product of an input is the extra output produced by1 additional unit of that input while other inputs are held constant.

The Law of diminishing return: The law of diminishing returns holds that, we willget less and less extra output when we add additional doses of an output whileholding other inputs fixed.

Returns to scale:

Constant return to scale: CRS denote a case where a change in all inputs leads to aproportional change in output.

Increasing returns to scale (also called economies of scale): IRS arise when anincrease 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 leadsto a less than processes, scaling up eventually reach a point beyond whichinefficiencies set in. These might arise because the costs of management or controlbecome large.

Productivity: Productivity is a concept measuring ratio of total output to a weightedaverage of inputs. Two important variants are labor productivity, which calculates theamount of output per unit of labor and total factor productivity, which measuresoutput 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 centurybecause of technological progress and higher levels of worker education andskill.


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ii. 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; hencelabor productivity and wages have tended to rise even faster than the 1 percent per year during the twentieth century.

iii. 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 lesslabor to cooperate with.iv. Over the twentieth century, labor productivity grew at an average rate of

slightly more than 2 percent per year.


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LECTURE NO: 2

ECONOMIC ANALYSIS OF COSTS

Fixed costs:

FC sometimes called as overhead or sunk cost. They consists of rent for factory oroffice space, contractual payment for equipments, interest payments on debts, salaries oftenured faculty and so forth. These must be paid even if the firm produces no output, andthey do not change if output changes.

Variable costs:

Variable costs are costs which vary as output changes. Examples include materialsrequired to produce output, production workers to staff the assembly lines, power tooperate factories.

Cost concept: TC=FC+VC

Marginal cost:

MC denotes the extra or additional cost of producing 1 extra or additional cost ofproducing 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 unitsproduced. If the last unit costs less than the previous ones, the new AC (i.e.AC includingthe last unit) must be less than the old AC, so AC must be falling. By contrast, if MC isabove AC, the last unit costs more than average cost (AC including the last unit) must behigher than the old AC. Finally, when MC just equal to AC, the last unit costs exactly thesame as the average cost of all previous units. Hence, the new AC; the one including thelast unit, is equal to the old AC; AC curve is flat when AC equals MC.


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Quantity Fixedcost(FC)

Variablecost(VC)

Total cost(TC)

Marginalcost(MC)

Average cost(AC)

AverageFixedcost

(AFC)

Averagevariablecost

(AVC)0 55 0 55

1 55 30 85

2 55 55 110

3 55 75 130

4 55 105 160

5 55 155 210

6 55 225 280

7 55 - 370

8 55 - 480

3025203040*50-

90110

InfinityInfinity Undefined

85 55 30

55 27 27

43 18 1/3 25

40 13 5/4 26

42 11 -

46 2/3 9 1/6 37

52 6/7 7 6/7 45

60 6 7/8 53 1/8

8

7

6

4

2

1

1 2 3 4 5 6 7 8 9 10

Variable and Fixedcost

TC

Cost

Quantity

FC


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80

70

60

50

40

30

20

10

1 2 3 4 5 6 7 8 9 10

MCAC

AFC

AVC

Average & Marginal cost

Quantity


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Lecture No.:3

ANALYSIS OF PERFECTLY COMPETITIVE MARKET

Significant feature of PCM:

1. Under perfect competition, there are many small firms, each producing anidentical 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

Competitive Supply where marginal cost equals price:

Rule for a firm under perfect competition is that, the firm will maximize profits when itproduces at that level where marginal cost equals price:

Marginal cost = Price or MC = P

Quantity Total cost Marginalcost

Averagecost

Price Totalrevenue

Profit

0 55000 - - - - -

1000 85000 27 85 40 40000 - 45000

2000 110000 22 55 40 80000 -300003000 130000 21 43.33 40 120000 -10000

3999 159960.01

4000 160000

38.9839.994040.01

40 40 159960 -0.01

40 40 160000 0

4001 160040.01 40.02 40 40 160040 -0.01

5000 210000 60 42 40 200000 -10000

S

d d

Industry output Firm output

p p

qq


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At the profit maximizing output the firm has zero profits, with total revenues equal totalcosts (these are economic profits and include all opportunity costs, including the ownerslabor and capital). Point B is the zero profit point, the production level at which the firmmakes zero economic profits; at the zero profit point, price equals average cost, sorevenues 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 itsvariable costs.

Suppose, the firm were faced with a market price of Tk.35.00 shown by the horizontal dd line. At that price MC equals price at point C, a point at which the price is actually lessthan the average cost of production.

Reason for producing even though a firm incurring loss: A firm can cover its contractualcommitments even when it produces nothing. In the short run, the firm must pay fixedcosts such a interest to the bank, directors salary and others. The balance of the firmscosts are variable costs, such as costs for raw material, production workers, and fuelwhich would have zero cost at zero production. It will be advantageous to continueoperations, 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 orwhere 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.

Price,AC,MC d

d

d

MCAC

quantity


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Shortcomings of perfectly competitive market:

1. Market failurea. 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, thefirm can raise the price of its product above its marginal cost. Consumers buy lessof such goods than they would under competition, and consumer satisfaction is

reduced. This kind of reduction of consumer satisfaction is typicalof theinefficiencies created by imperfect competition.

b. Externalities: Externalities arise when some of the side effects of production orconsumption are not included in the in market prices.

c. Imperfect information: In perfect competition it is assumed that, buyer and sellerhave complete information regarding the market and the product. But in realworld the information are not always available to everyone.

AVC

AC

MC

M

Shutdownpoint


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IMPERFECT COMPETITION:

Imperfect competition: Imperfect competition prevails in an industry whenever individualsellers 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 animperfect competitor.

Imperfect competition prevails in an industry whenever individual sellers have somemeasure of control over the price of their output.

Imperfect competition does not imply that a firm has absolute control over the price of aproduct.

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.

VARIETIES OF IMPERFECT COMPETITION:

The varieties of imperfect competition can be categorized as follows:

a. Monopoly

b. Oligopoly

c. Monopolistic competition

d d

Firm quantity Firm quantityq

p Firms demand underperfectcompetition

Firms demandunderimperfectcompetitionP

q

d

d

d

d


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TYPES OF MARKET STRUCTURE

Structure Number of producers and

degree of productdifferentiation

Part of economy where

prevalent

Firms degreeof control over

price

Methods of marketing

Perfectcompetition

Manyproducers,identicalproducts

Financialmarket andagriculturalproducts

None Marketexchange or auction

Monopolisticcompetition

Manyproducers,many real orperceived

difference inproduct

Retail trade(pizza, beer,personalcomputer)

Some Advertising andquality rivalry,administeredprices

Oligopoly Few producers,little or nodifference inproduct

Steel,chemicals

Some Advertising andquality rivalry,administeredprices

Monopoly Singleproducer, product withoutclosesubstitutes

Franchise,monopolies(Electricity,water)Microsoft

windows,patented drugs

Considerable Advertising

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 largescale production and decreasing costs.

Costs and market imperfections

2. Barrier to entry.

Legal restrictions

High cost entry

Advertising and product differtiation


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(a) Perfect competition (b) Oligopoly (c) Monopoly

1 2 3 4 10000 12000 100 200 300 100 200 300

MC AC D MC AC D

AC

MC

D

AC

MC

P

Q Q


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LECTURE NO.:4

UNCERTAINTY AND GAME THEORY

Speculation:

Speculation involves buying and selling in order to make profits from fluctuations inprices. The economic function of speculator is to move gods from periods of abundanceto periods of scarcity.

Arbitrage: The simplest case is one in which speculative activity reduces or eliminatesregional price differences by buying and selling the same commodity. This activity iscalled 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 ofarbitrage, the price difference between markets will generally be less than the cost ofmoving the good from one market to the other.

Hedging: One important function of speculative markets is to allow people to shed risksthrough hedging. Hedging consists of reducing the risk involved in owning an asset orcommodity by making a counteracting sale of that asset. Hedging allows businesses toinsulate themselves from the risk of price changes.

The economic impact of Speculations:

1. Market efficiency2. Possibility of even marginal utility.

Risk and uncertainty: Risk is the probability to default. A person is risk averse whenthe displeasure from losing a given amount of income is greater than the pleasure fromgaining the same amount.

Insurance and Risk Spreading:

Market handles risk by risk spreading. This process takes risks that would be large forone 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 ofgambling a reverse.

Capital markets and risk sharing:

Another form of risk sharing takes place in the capital markets because the financialownership of physical capital can be spread among many owners through the vehicle ofcorporate ownership.


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Market failure in information:

While insurance is a useful device for reducing risks, sometimes insurance is notavailable. 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 ofloss.

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 tobuy the insurance.

Social insurance:

When market failures are so severe that the private market cannot provide adequatecoverage, there are may be a role for social insurance, which is mandatory insuranceprovided by the government. Example: Unemployment insurance.

GAME THEORY

Game theory analyzes the way that two or more players choose strategies that jointlyaffect each other. This theory was developed by John Von Neumann (1903-1957) aHungarian-born mathematical genius. Game theory has been used by economists to studythe interaction of oligopolists, union management disputes; countries trade policies,international environmental agreements, reputations, and a host of other situation.

Price setting:

P1

P2

Firm A matching

Firm B undercutting


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BASIC CONCEPTS of Game Theory:

nEwbooks price

Normal price Price war

Normal price A $10

$ 10

B $-100

$-10

Price war C -$ 10

$100

D $-50

$-50

Alternative strategies:

In alternative strategy two firms have the highest joint profits in outcome. Each firmearns $10 when both follow a normal price strategy. At the other extreme is the pricewar, 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. Inoutcome 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 ofmoney because it is selling below cost; nEwbooks is actually better off selling at a normalprice rather than responding.

Dominant Stategy

In considering possible strategies, the simplest case is that, of a dominant strategy. Thissituation arises when one player has a single best strategy no matter what strategy theother 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 declareseconomic 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, nomatter what strategy the other firm follows, each firms best strategy is to have thenormal price. Charging the normal price is a dominant strategy for both firms in thisparticular price war game. When both players have a dominant strategy, we say that,the outcome is a dominant equilibrium.

Amagingprice


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Nash equilibrium: (The rivalry game)

nEwbooks price

High price Normal Price

High price A $200

$ 100

B $150

-$20

Normal price C -$ 30

$150

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 firmshave the highest joint profits in cell A; here they earn a total of $300 when each follows ahigh price strategy. Situation A would surely come about if the firms could collude andset the monopoly price. At the other extreme is the competitive style strategy of thenormal price, where each rival has profits of $10.

In between are two interesting strategies where one firm choose a normal price and one ahigh price strategy. In cell C, for example, nEwbooks follows a high price strategy butAmazing undercuts. Amazing takes most fo the market and has the highest profit of anysituation, while nEwbooks actually losses money. In cell B, Amazing gambles on highpirce, but nEwbooks normal price means a loss for Amazing.

In this game Amazing has a dominant strategy; it will profit more by choosing a normalprice no mater what nEwbooks does. On the other hand, nEwbooks does not have adominant strategy, because nEwbooks would want to play normal if Amazing playsnormal and would want to play high if Amazing plays high.

Now it is safe for nEwbooks for choosing normal price where he could assume highpayoff in relation to the action of Amazing. This is the basic of game theory: you shouldset 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, becauseeach party chooses that strategy which is best for itself without collusion or cooperationand without regard for the welfare of society or any other party.

Oxy steelprice


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Some Important Examples of Game Theory

1. To collude or not to collude:

2. Prisoners Dilemma:

Keins

Confess No confess

A 5 years

5 years

B 10 years

3 months

C 3 months

5 years

D 1 years

1 years

3. The pollution game

U.S. Steel

Normal price Price war

Normal price A $100

$ 100

B $120

$30

Price war C -$30

$120

D $100

$100

The pollution game is an example of a situation in which the invisible hand mechanismof efficient perfect competition breaks down. This is a situation in which the non-cooperative or Nash equilibrium is inefficient.

When the Nash equilibria become dangerously inefficient, governments may step in. Bysetting efficient regulations or emissions charges, or perhaps by establishing efficientproperty 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 highpollution 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.

Smith

Oxy Steel


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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 opportunities2. Sovereign nation3. 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 itspecializes in the production and export of those gods that it can produce at relatively lowcost. Conversely, each country will benefit if it import those goods which it produces atrelatively high cost.

Richardos Analysis of comparative advantage:

Assumptions:

1. Two nations2. Two commodity3. All production cost in terms of labor hour.

Necessary labor for production (labor hour)

In America In Europe

Product1 unit of food 1 3

1 unit of clothing 2 4

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


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However America has comparative advantage in food, while Europe has comparativeadvantage in clothing, because food is relatively inexpensive in America whle clothing isrelatively less expensive in Europe.

From these facts, Richardo proved that both regions will benefit if they specialize in theirareas of comparative advantage that is if America specializes in the production of fodwhile Europe specializes in the production of clothing. In this situation America willexport food to pay European clothing, while Europe will export clothing to pay forAmerican food.

Before trade: When all international trade is illegal or because of a prohibitive tariff, thereal wage of the American worker for an hours work as 1 unit of food or unit ofclothing. The European worker earns only 1/3 unit of food or unit of clothing per hourof work. Clearly, if perfect competition prevails in each isolated region, the prices of foodand 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 asmuch 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. Forsimplicity, further assume that, there are no transportation costs. Then clothing isrelatively more expensive in America (with a price ratio of 2 as compared to 4/3), andfood is relatively more expensive in Europe (with a price ratio of as compared to ).Given these relative price, and with no tariffs or transportation costs, food will soon beshipped from America to Europe and clothing from Europe to America.

As European clothing penetrates the American market, American clothiers will findprices falling and profits shrinking and they will begin to shut down their factories. Bycontrast European farmers will find that the prices of foodstuffs begin to fall whenAmerican products hit the European markets; they will suffer losses, some will gobankrupt, and resources will be withdrawn from farming.

After all the adjustment to international trade have taken place, the prices of clothing andfood must be equalized in Europe and America.


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The Economic Costs of Tariff:

Diagrammatic Analysis:

1. Area B is the tariff revenue collected by the government. It is equal to the amountof 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 areaLEHM 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 surplusloss 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 thegovernment of Tk.200 and a loss to consumers Tk.550. The net social cost isTk.100.

5. Area A is the net loss that comes because domestic production is more costly thanforeign production. When the domestic price rises, businesses are thereby inducedto increase the use of relatively costly domestic capacity. They produce output upto 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 ortariff revenue. This area represents the economic cost incurred when consumersshift their purchases from low cost imports to high cost domestic goods. This isequal to Tk.50.

100 150 250 300

4

6

8

World price plustariff

World PriceL

H

E

J

F

S

D

A C

M


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Economic Condition Analysis