Factor Markets

When discussing factor markets we are talking about the market for factors of production. Recall the circular flow of income (there is a post on it somewhere) - firms are demanders of factors of production and households are suppliers. Firms pay money to households in exchange for their factors of production - wages for labour, for example.

We'll be looking at perfectly competitive factor markets. Everyone in this market is a price taker, whether it be the firms, the workers or whoever. Freedom of entry and exit exists. It costs nothing for a person to leave the labour force and nor does it cost anything for someone to join it. We assume that the factors are homogenous. Everyone/everything in the market has the same level of skill and motivation. Finally, there is perfect knowledge. Workers know everything about the firm and firms know everything about the workers, for example.

Let us zoom in on the labour market more specifically. A perfectly competitive labour market looks as follows:

On the left we have the market as a whole. The wage rate is determined by the interaction of demand for workers and the supply of workers.  With this wage rate, we can look at an individual firm on the right. At wage rate W the firm would be willing to employ Q hours worth of labour.

We need to somehow ascertain how much labour would be supplied by people in the labour market. This figure is dependent on many factors. From the point of view of the worker, working involves disutility's such as sacrificing leisure time and it being tedious/boring.  The more they work the larger the disutility. The marginal disutility of work (MDU) will increase as people work more. Due to this, we see an upwards sloping supply curve of labour. To encourage people to work more hours, higher wages need to be paid in order to compensate for the higher disutility.

In general, an individual's supply of labour will look like this. The higher the wage rate, the more hours worked. However, there is a case where the shape of the individuals supply of labour actually bends backwards. This is the case when an individual feels that after a certain point they can afford to work less and have more leisure time. It looks like this:

Once wage reaches W the individual feels that they are earning enough and can afford to cut back on the amount they work should wages rise further.

The amount of labour a firm demands rests on the assumptions that firms are trying t maxisimise profits. The theory is known as the marginal productivity theory. We look at the marginal revenue product of labour in this piece of analysis (MRPL). We know that to maximise profits, marginal costs must equal marginal revenue, so therefore the firm will employ labour up until the point wages (the marginal cost) equal the marginal revenue product of labour. It looks like this:

The firm will hire Q hours worth of labour in order to maximise their profits. What about the demand curve for a firm as a whole? Well, because whatever the wage the firm will be producing where wages equal MRPL, this means that the demand curve for the firm is the MRPL curve. From the peak of the curve to the right is the demand for labour for a firm trying to maximise its profits.

There are some firms that are known as monopsomists. These firms are wage setters, not wage takers. They are a firm with monopoly power on factors of production in an area - say a single employer in a village. They have the power to restrict the amount of labour they employ to keep wage rates down. The firm faces an upwards sloping supply curve for labour, to employ more workers they need to pay a higher wage rate. This supply curve shows us what wage must be paid to attract a certain amount of labour. The wage is also the average cost of employing labour, therefore the supply curve is the AC curve. The marginal cost of labour will be above the average costs because to attract more employees the wage rate must be raised. The profit maximising point for the firm would be where MCL = MRPL with a wage of W1. If we were in a perfectly competitive market the wage rate would have been at W2 with a higher amount of labour employed. The monopsomist forces the wage rate down by restricting how many workers it employs.

Monopoly, Monopolistic Competition and Oligopoly

Before we look specifically at any of the three market structures in the title we should take a closer look at revenue as this will be important in the analysis. When price varies with output, which it does in all market structures bar perfect competition, the demand curve is downwards sloping. Average revenue equals (total revenue) / (quantity). This is the same as (price x quantity) / quantity. Cancel out the two quantities and we're left with average revenue being equal to price - hence it is equal to the demand curve.

So, the average revenue curve is sloping downwards because it is equal to price. Why the position and shape of the marginal revenue curve then? Well, as we know, marginal revenue is equal to the change in total revenue divided by the change in quantity. If we substitute in price x quantity for total revenue we are left with: 

If we use the product rule to differentiate this (Google this or find a text book, I'm not going to explain the pure math behind it) we're left with marginal revenue being equal to: 

The change in price over the change in quantity will give us a negative figure, so what we're left with is Price + something negative. Due to the "+ something negative" it will be falling below the AR curve, hence its position on the diagram above.

The total revenue curve interacts nicely with the marginal revenue curve we can see above. The total revenue curve increases at a decreasing rate. Why? Well, because to sell more the firm has to lower its price. Due to this, there will come a point when total revenue is maximised. This will coincide with the quantity at which marginal revenue is equal to 0. That quantity will be the revenue maximising quantity for the firm.

Now that we've understood the concept of revenue, let us hone in on the specific market structures. We'll start with monopoly. In a monopoly we have one firm that dominates the market. How do they do this? It is largely due to the barriers to entry into the market. They could be any of the following:

·         Economies of scale.

·         Legal restrictions.

·         Aggressive tactics.

·         Product differentiation.

...the list does go on. These all make it very difficult for new firms to break into the market and pose any sort of competition/threat to the existing monopoly firm. Graphically, a monopoly looks as follows:

They produce at the point MC = MR because this is where profits are maximised. At this point there is a difference between average costs and average revenue, revenue exceeds costs which means that the monopoly is making a supernormal profit. All pretty obvious thus far. Monopoly is probably the easiest of the market structures to master, all there is to remember is that supernormal profits are made in the long and in the short run. To the consumer a monopoly may seem to be a disadvantage - higher prices and lower output compared to perfect competition. This is true, but it does have its advantages. Firstly, supernormal profits fuel innovation which can lead to better, cheaper products in the long run. Secondly, if the economies of scale are big enough then through a monopoly some markets can exist that wouldn't be possible if monopolies weren't allowed. This is in the case of a natural monopoly.

Natural monopolies are markets that have very high, fixed  start-up costs. So high that it becomes unprofitable if more than one firm try and provide the good/service. An example would be the London Underground - massive start up costs in laying the foundations of the network. So, if there were two firms in the market a loss would always be made and therefore production wouldn't occur at all. See this diagram below.

If there was two firms trying to run versions of the Underground simultaneously then neither would be able to stay afloat only serving half of the market each - whereas one firm serving the whole market means it is affordable. With two firms, the demand curve above with slope down at twice the rate meaning it is always below the long run average costs curve, meaning a loss will be made. The scale of production that comes with a natural monopoly means that costs can be lower and therefore the market price can be something consumers will be willing to pay.

That's the low down on monopolies. Now to move onto monopolistic competition. Do not get the two confused - similar names yet totally different market structures. In a monopolistic market firms sell a different variety or different brand of the same product. There are many firms that all act independently of each other with freedom of entry and exit into the market. There is symmetry in the market - new firms entering the market effect all old firms equally.

1 = Firm demand. 2= Firm demand after new competitor enters.

Each firm has a share of the whole industry, but can only influence the price minimally, hence the inelastic demand curve for the firm. Every time a new firm enters the industry all existing firms will see their demand decrease and the influence they have on industry price fall. Every new firm that enters moves the market closer to perfect competition.

A firms profit in the short run looks strikingly similar to that of a monopoly. Supernormal profits are available. However, emphasis on 'short term'. Over the longer term more firms enter and prices are forced down. The quantity each firm supplies is also forced down and supernormal profits are quashed. Firms will keep entering until average costs equal average revenue, at this point no more supernormal profit is available. We haven't entered perfect competition because the demand curve/average revenue curve is sloping downwards meaning price is not constant across all firms.

On the left we have the firm in the short run. Supernormal profit is made. The new firm enters and we move to the situation on the right hand side. The firms individual demand has fallen, and thus its average revenue and marginal revenue have fallen too. This means that the amount of profit that is made has fallen. These firms will keep entering and this will keep happening until supernormal profit is wiped out completely.

The model is all well and good taken at face value - but it does have its limitations. In reality there is imperfect information about profits and demand, it doesn't take into account the effect non-price competition has and in reality it is difficult to identify an industry demand curve. Bar all of these problems it does give us a fairly accurate representation of a monopolistically competitive market. One problem with this market type is because of the downwards sloping demand curve - production will not take place at the lowest long run average cost. Therefore monopolistic competition isn't as efficient as perfect competition.

The final type of market structure to analyse is that of an oligopoly market. Oligopoly is when there are a few large, major players in an industry. 3 or 4, for instance. There are significant barriers to entry and firms are very interdependent. The firms have to look at the incentives to compete with the other dominant firms and the incentives to collude with these firms to determine their plan of action.

Now, to determine the total production of an oligopoly market we have to run through a little story. We start with an industry with one firm acting as a monopoly. The firms demand function is as follows: P = 200 - Q and its marginal costs are 0.From this, we can see that if quantity was 0 then price would be 200 and if price was 0 then the quantity would be 200. We can use this to draw an initial demand curve.

We derive the marginal revenue curve by differentiating total revenue. Total revenue = (200-Q) x Q, and that differentiated leaves us with: MR = 200-2Q. Profit is maximised at MC=MR, and MC = 0, so therefore the firm will produce 100 of the good. Half the market is supplied.

Now, the next part of the story is for a competitor to enter the market. Firm B spots that there is unfulfilled demand, 100 of it, and decides to enter the market. The demand curve for Firm B is going to be: P = 100 -Q. With that as the demand curve, and using the method in the paragraph above, firm B works out it's marginal revenue curve to be: MR = 100 - 2Q. The new market now looks like this:

Firm A is still supplying 100 of the market and now Firm B has entered and is supplying an additional 50 to the market. 150 of the market demand is satisfied.

But, the next day Firm A reacts to this new firm. They have to readjust and now see their demand function as: P = 200 - Q - 50, or P = 150 - Q.

Both Firm A's demand and MR curves have swung in, and now it finds itself supplying only 75 to the market compared to the 100 it was supplying previously. The new entrant has brought down Firm A's production. 125 of the market is now supplied.

Firm B has to react to this change from Firm A. It sees Firm A's new supply of 75 and recalculates its demand function to be: P=200 - Q - 75, or P = 125 - Q. From this it gets its marginal revenue to be: MR = 125 - 2Q. At this marginal revenue Firm B will now increase its production to 62.5. 137.5 of the market demand is now satisfied. You may have noticed some repetition here. The market will keep going back and forth between the two until an equilibrium is achieved. Firm B's production increases whilst Firm A's falls. So when will equilibrium occur? It will be the point when one firm reacts to another firms level of supply and achieves the same level of supply. In the example above this is when 66.66 is produced by each firm, leaving the 133.33 of the market demand being satisfied.

What we have described above is typical when the number of firms in an industry is small - it is known as Cournot competition, competing over market share. As we see above, with 2 firms in the market each firm supplies 1/3 of the total demand in equilibrium meaning 2/3 of demand is satisfied. With 3 firms in the industry, each firm will supply 1/4 of the total demand in equilibrium meaning 3/4 of demand is satisfied. Each additional firm added means more of the total demand is satisfied and therefore the market is moving closer to perfect competition.

What can we say about profits under Cournot competition? Well with the total demand function being P = 200-2(Q) we can calculate price to be 66.66 by substituting in the equilibrium quantity we derived earlier. We assumed costs are nothing, therefore total revenue in the industry will equal 2(66.66 x 66.66) = 8887.7. Sounds like a nice figure. However, what would it be under a monopoly? We saw Price and quantity equal to 100 when there was just one firm, so total revenue will be 100x100 = 10,000. Higher than in the oligopoly. This tells us that firms would be better off if they got together and agreed to limit the market - this is known as collusion.

Collusion can happen in many ways, one of these being price leadership by the dominant firm. In this scenario, the dominant firm makes an assumption that all the smaller firms in the industry will act like a firm in a perfectly competitive market once it has set the price and chosen its output.

The dominant firm has to decide the price it is going to charge. The price has to be between the range of P1 and P2 above. Any higher than P1 and there will be excess supply, any less than P2 and they won't be able to afford to supply anything. So, the demand curve for the dominant firm runs from P1 down to the point on the market demand curve that coincides with P2. So, the leader can choose a price, say P. Then, with a price decided the dominant firm has to decide how much it will produce at this point and therefore how much of the market is left for the other smaller firms.

So, Price P was decided by the leading firm. Therefore, at this price the dominant firm will supply QL to the market (Where P = Dominant firm demand). The following firms will supply QF to the market (Where P = S) and the total supplied to the market will be QT. QT should be QL + QF. That is one form of collusion between firms - a very subtle one and therefore very difficult to prove.

A few rules of thumb are used when it comes to tacit collusion - using an average cost mark-up when it comes to pricing, for example. Something like P = (1 + 0.1)AC would do the trick. Firms would agree on a certain rate of profit and then enforce this pricing mark up to achieve that. They also use benchmark pricing, £9.99 or £14.99 for example.

As far as collusion and the law goes it's a tricky one. It is illegal but it can be incredibly difficult to prove that it is actually going on. It is entirely up to the authorities to decide the difference between prices being set competitively and firms agreeing prices. Unless it is really bad or really obvious it rarely gets proved.

Phew, that is it. Cheers for reading guys. Same script - comment if you need any additional help or you spot mistakes, all feedback is welcome!

Sam.

Perfect Competition

Perfect competition is a very unrealistic market structure. We'll discuss the characteristics of it later, but for now we have to understand that it is a theoretical concept. If the world was perfect then in most cases we'd have markets operating 'perfectly'. The world isn't perfect and therefore actually seeing perfect competition in reality is a long shot. The major assumption we make is that firms are price takers. By this we mean that each firm alone has no influence over the market price because of their relative size. They take the price they can get as given and perceive it to be constant. Therefore the demand curve for a firm in perfect competition is horizontal - the can sell as much as they want but only at the market set price. Any higher and they wouldn't sell a thing, any lower and they'd make a loss in the long run.

Here we have a typical perfect competition scenario in the short run. On the left is the market where the market price is determined by the supply and demand for the good. The firm, on the right, takes the market price as given and as their price. Average revenue and marginal revenue is the same as the demand curve because we are looking at a constant price for the good. Production takes place at the point where MC = MR, anywhere before this point and more profit can be made, anywhere after this point and profit falls. If you look at the diagram, at the point MC = MR, the average cost is below the average revenue. This means profit is available, which is shown by the yellow area. In the short run the supernormal profit will be (AR-AC) x Qe.

Now, above I've just said that AR and MR are the same as demand because price is constant. You want proof I hear? Sure thing. Average revenue = Total revenue / Quantity. Total revenue is actually price x quantity. Therefore average revenue can be re-written as (price x quantity) / quantity. Quantity cancels out leaving price ~ average revenue = price. Marginal revenue = the change in total revenue / the change in quantity. Substituting in what total revenue actually is we have the change in (price x quantity) / change in quantity. The change in quantity cancels out leaving price ~ marginal revenue = price. Boom!

But, we have only discussed the short run. These supernormal profits don't go unnoticed - they attract new firms into the industry. Supply now shifts out.

The price falls due to the increase in supply. On the right diagram we can see that it's fallen to the point where MC = MR = AC. This means that supernormal profit is no longer being made, it has been competed away. At this point no more firms will enter the industry because there won't be the pull of supernormal profits. Therefore, in the long run there is no supernormal profit to be made in a perfectly competitive market.

It seems risky to the normal person, producing right on the point of breaking even. This is true to a certain extent. Shocks to the system could cause demand to fall, what would happen to the firm then?

Here we have the case of a fall in demand in the market causing a fall in price. The firm was initially producing where MC = MR = AC, but now the fall in price means that if they produce at MC = MR they will actually be making a super-normal loss. This point would be below average costs and therefore the enclosed area on the right hand diagram would be loss. Would they carry on producing? Surprisingly, yes, in this case the firm would. To understand this we have to look at the breakdown of the costs. In the short run we know capital is fixed and labour is variable. Therefore the average variable cost for the firm in a simple world would be labour costs / quantity. As long as the average revenue (demand curve) is greater than the average variable costs then the firm will continue producing. This means they can cover the costs of labour and make some contribution to the fixed costs. If they couldn't cover the average variable costs it would be better for the firm to stop producing, lay off all the workers and only lose the fixed costs.

Some other things we can state is that the short run supply curve for a firm in a perfectly competitive market is the marginal cost curve until the point where price equals average variable cost. As we said above, below that point the firm will stop supplying the market. In the long run the firms supply curve is horizontal at the minimum average cost.

All we need to do now is sum up whether perfect competition is a good thing. It definitely has its advantages, they are as follows:

·         It's efficient - production occurs at the lowest average cost which is the most efficient point.

·         Competition - competition in an industry forces firms to be more efficient.

·         Price is influenced by demand - the market is essentially run by consumers, it responds to their behaviour.

·         No supernormal profits in the long run.

It really has few disadvantages though. You could state the fact that it isn't realistic as a disadvantage, I guess. In real life it would be rare to find a market with freedom of entry/exit, identical products, price taking firms, etc. One point that could be made about the lack of super-normal profit is the lack of innovation. Innovation tends to be fueled by profit, without profit there is little room for firms to innovate. Innovation is one thing that can lead to a more efficient market, so in perfect competition once the efficient point is reached it will not be made any more efficient. Comprende?

Sam.

Principles of Economics - Perfect Competition

Perfect Competition is a market structure that follows these assumptions:

• Firms are price takers - each firm has no impact on the price in the market, they take the price the market forces set.
• Freedom of entry into the market - there are low barriers to entry so anyone could potentially set up in this market.
• Firms produce identical products - the taxi market for example, each taxi firm offers an identical product.
• Producers and consumers have perfect knowledge - both producers and consumers know everything there is to be known about the market.

However, few, if any, industries are actually perfectly competitive.

In the short run, the number of firms is fixed. In the long run, if supernormal profits are being made then new firms will enter the industry. If losses are being made, firms will leave the industry. 

Short run equilibrium of the firm:

This is what the market looks like in the short run in perfect competition. The price is Pe, and is set by the demand and supply forces. It is horizontal because firms are price takers. Due to price being constant, the red dotted line is also the average revenue, the marginal revenue and the demand for the firm as they're all the same. Qe is the amount produced by the firm because this is the amount at which profits are maximised (MC = MR). There is slight profit being made because the average revenue is higher than the average cost at the production point.

This is where the long run can be introduced. In the long run, firms see these profits being made and enter the industry. These means the industry supply increases, shifting the supply curve to the right on the left hand diagram above. Price falls, which means each firms demand falls until the point it is equal to the average cost. At this point, firms break even and make no profit. Firms will stop entering the industry now.

As far as the public interest goes with perfect competition, it has its benefits and drawbacks. The benefits are as follows:

• Firms produce at the least cost output.
• Firms that are inefficient will be forced out.
• Prices are minimised.
• Consumers determine what and how much is produced.

The drawbacks are:

• There us very little incentive to invest in new technology.
• Goods are all the same, lack of variety for consumers.

That ties up this post about perfect competition. Thank you for reading, keep checking back and sharing. Have a good day!

Sam.

Common Agricultural Policy Part 2 - Declining Farm Incomes

The next thing the CAP aims to eradicate is declining farm incomes. These are mainly caused by two things: low income elasticity of demand and/or increases in supply. As usual, we'll display this diagrammatically. Lets suppose we have a fairly inelastic demand curve and at the same time farm efficiency has improved, we can expect the market to now look as follows:

We can see that prices have fallen from P1 to P2 and quantity has risen from Q1 to Q2. However, we can also see that this has caused a fall in income of area a and an additional income of area b for the farmers. Area a is clearly larger than area b, meaning the farmers income as a whole has fallen. The way for farmers to gain is for demand to shift out by a larger amount, as even a small shift in demand would leave farm incomes still falling. 

What the farmers need is a more elastic demand curve for any increases in supply efficiency to actually increase farmers income. However, demand for grown crops is generally more inelastic because it's a necessity and therefore a change in price really doesn't affect demand all that much. This is why the government needs to intervene with the CAP because else there would be no incentive for farmers to make their production mechanisms more efficient as they'd effectively be losing money due to it.

Now we have covered both reasons as to why the CAP is necessary; fluctuating crop prices and declining farm incomes. We will next cover how the EU uses it's policies to correct these issues. Stay tuned!

Sam.

Common Agricultural Policy Part 1 - Price Fluctuations

The Common Agricultural Policy is a massive deal in Europe and the European Union. It's a very expensive policy that started out back in 1962 as a simple price support policy. It has two key objectives: to stabilise prices and to provide income support for social reasons. If you look at the distribution of farms across Europe, it is clear to see why this is needed. The biggest 7% of farmers own roughly half the land, whilst the smallest 50% of farmers own only 7% of land. This is a massive inequality and could lead to monopoly powers, outlandish prices and other such problems if it went unregulated.

We'll first look at a few of the characteristics of the agricultural industry. There are many producers, all are price takes. There are also many consumers, all of which are also price takers. There is generally freedom of entry and exit into the industry. It's about as close to perfect competition as you could get in a realistic scenario. Governments need to intervene for many reasons:

• To reduce price fluctuations.
• Raise farm incomes.
• Protect rural communities.
• To encourage greater self-sufficiency.

Firstly, I'm going to focus on the price fluctuations. In the short term they are caused by instability and the fluctuations in the harvest (good or bad!). Let's assume that the demand for a crop were to rise one year, which would cause a shift to the right of the demand curve. Supply in the short term obviously cannot react to this because supply is fixed each year depending on what is planted. This demand rise will cause a rise from price P1 to P2. This is all shown on the diagram below.

The farmers observe this rise in price and then next year they increase their supply to the market. At P2 the farmers decide that Q2 is the correct quantity to supply to the market. However, at this amount supplied, demand is outstripped and therefore price must fall to P3. The year after, at price P3 a different amount is supplied by the farmers, but at this supply more is demanded and therefore price rises again. This will continue, as shown on the diagram below we can see that the market is slowly spiralling towards a point of equilibrium at which both consumers and producers would be happy. 

We call this concept a stable cobweb. This price fluctuations and changes are supply are making the market more and more stable as over time the fluctuations get smaller until equilibrium is finally met. In this case, the government wouldn't need to intervene in the agricultural industry. However, there is the opposite case. An unstable cobweb could appear. The case of this occurs when the supply of the crop is very elastic. Diagramatically, the supply curve will be much flatter. The same instance as above will occur, demand increases causing a price rise as supply is fixed. In the second term supply is increased due to this new price, but there is oversupply and price has to fall... and so on and so forth. Except, when the supply curve is elastic this doesn't spiral towards equilibrium, it spirals away from it as can be seen in the diagram below.

This shows one of the cases in which the government would need to intervene in the agricultural industry, hence the Common Agricultural Policy. The price fluctuations in this unstable cobweb would keep getting worse and worse if left to market forces. 

Next we'll move on too supply side shocks. This is when supply is affected, either for good or for bad, and therefore the supply of the crop isn't as expected. Once again, diagrams are an easier way of showing this. The first case will be a bad harvest, where supply of the crop is less than what was expected. The diagram below shows this. Supply of the crop has fallen from the expected level of Qe to the actual level of Qa. The area labelled 'b' is income that the farmer has lost, the area labelled 'c' is income gained from this supply side shock. The expected income for the farmer was area 'ab', but the actual income of the farmer is now area 'ac'. If area c is greater than area b then the farmer has gained, otherwise the farmer has lost out due to the bad harvest. Generally, the more inelastic demand is, the greater are 'c' is and therefore the more likely the farmer will benefit. 

I'll quickly go through the other supply side shock as well. As you can guess, this is when there is a better harvest than expected. This causes a shift to the right of actual supply from Qe to Qa. A fall in price is seen from Pe to Pa and once again the farmers income may be affected. Area 'c' is the income gain, area 'b' is the income loss and area 'a' is the income that has stayed constant. If area 'b' is bigger than area 'c' then the farmer has lost out. 

What we have achieved in this blog post is the causes of the fluctuations in prices of harvested goods. This is one of the things the Common Agricultural Policy aims to stop, as stable prices is an aim. In the next post we'll look at what is causing the decline of farmers income and then we'll move on to look at how the government intervenes in this policy to correct these issues.

Stay tuned guys, enjoy!

Sam.

Principles of Economics: Revenue (Microeconomics)

* Sorry about the delay with this post, I've had a busy week and have just got round to writing this up. But I'll have another one up tomorrow as well to make up for it. *

Right, today's post will be relating to revenue and more specifically a firms revenue. We'll start with a few of the basic bits of terminology that I'll be using throughout this post. Firstly, total revenue. This is fairly self-explanatory but I'll give a definition anyway. Total revenue is a firms total earnings in a period of time from the sale of a particular amount of goods, the formula is better known as price x quantity. Average revenue next and this is the amount a firm earns for each unit sold, the formula for this is (total revenue) / (quantity) which you may have noticed just equals price. Marginal revenue is the final term, this refers to the extra revenue gained from selling one more unit of a good. The formula for marginal revenue is (change in total revenue) / (change in quantity).

We'll first look at the revenue curves for a small firm. We'll be assuming this firm is in a perfectly competitive market (Will do a blog post on this later today/tomorrow). Basically, this means that the firms are generally too small to have any effect on the price of the good they are selling. If they raise their price no-one will buy from them, if they lower their price they will find an overwhelming demand and probably be charging less than the cost to produce the good. That being said, the market forces determine the price the firm has to charge.

As you can see here, the demand and supply have met in the market and this has created a price for the good. The firm, shown on the left has a demand curve of this price because consumers will only buy from the firm at this price. No matter the quantity, the price will remain the same. Another note on this, D = AR = MR because the price is constant. The average revenue and marginal revenue will always be the same because we are working with a constant price.  We can model the total revenue of a firm as well. This is simple, first we create a table with the quantity supplied, price and total revenue. We then plot this table. Simple.

Simple as that for a total revenue curve for a small firm. However, when it comes to larger firms and the price of the good does vary with output we are struck with a different scenario. The average revenue curve is still equal to the price and will be the demand curve, but this time it will be downward sloping as with the normal characteristic of demand. The marginal revenue curve will also be downward sloping, but at a faster rate than the average revenue curve and will more than likely reach negative values. This is due to the diminishing marginal rate of production, the marginal revenue falls with each additional good you produce up to a point where producing another good will generate no additional revenue and may even decrease revenue. Before the quantity where marginal revenue equals zero, the average revenue is elastic because an increase in quantity will lead to a rise in revenue. After this point, it's inelastic because a rise in quantity leads to a fall in total revenue. 

And all that's left to add to this is the shape of the total revenue curve when the price varies with output. I should note, this happens in larger firms when they can effect the market price. The total revenue curve would be somewhat hill shaped. It would slope up, reach a peak at some unknown point and then slop down again afterwards. You may be thinking "Ok, great... Why?"! Well, this will come in useful in the next posts when we look at profit maximisation of a firm. 

Thank you for reading again, keep watching for the next few posts which will relate and link to this one. Have a good day!

Sam. 

Preferential Trading Arrangements

Preferential trading arrangements refer to such things as trade blocs. Trade restrictions are held with the rest of the world but lower restrictions or none with member states. There are three types of preferential trading arrangement:

• Free Trade Area - This is when member states remove tariffs and quotas with one another. However, restrictions on trade with non-member states are kept individual to each nation.
• Customs Union - This is the same as above, but in addition there are common external restrictions on trade with non-member states. 
• Common Markets - This takes it one step further and the members operate as a single market. This means as well as the features of the above arrangements there is also a common taxation system, common laws regarding production, employment and trade, free movement of labour and capital and no special treatment by governments to their own domestic industries. Additionally to this, we sometimes see fixed exchange rates between members and common macroeconomic policies. 

Next we move on to trade creation and trade diversion, which come as a result of preferential trading arrangements. First, trade creation. This is when consumption shifts from a high-cost producer to a low-cost producer as a result of of joining the customs union. Normally this is due to obtaining the goods cheaper from other members of the union. As with most things, this can be modeled on a diagram! 

Trade Creation Diagram

This is it, the trade creation diagram. Let's explain it a bit. SDom and DDom are the domestic supply and demand of a good. Before the EU, the country had to pay at the 'PEU + tariff' price so domestic production was at Q2 and domestic demand was at Q1. The imports here were the difference between Q1 and Q2. With the joining of the EU, the price was now the PEU price, lower than before. This meant domestic supply had fallen to Q4 and domestic demand had risen to Q3. So the new imports level is the difference between Q3 and Q4, which is higher than before. Thus, trade has been created. 

Trade diversion works in very much the opposite way. This is when consumption shifts from a lower cost producer outside the customs union to a higher cost producer inside it. There is a net loss in world efficiency now the higher cost producer is being used. 

Trade Diversion Diagram

This is the trade diversion diagram. The country was initially paying price P1 for the good, meaning they consumed at Q1 and produced at Q2. Price falls to P2 because of the joining of the EU. We can see here, that consumer surplus has improved. The original consumer surplus at price P1 has now increased to include the areas 1, 2, 3 and 4 on the diagram. We also notice a loss of producer surplus by area 1 which will be the fall in profits. No tariffs are paid out anymore, so the areas 3 and 5 are lost to the government in terms of revenue. This leaves an overall net gain of areas 1 + 2 + 3 + 4 - 1 - 3 - 5 = 2 + 4 - 5. Here we can decide whether the trade diversion has been beneficial or detrimental. If the size of area 5 which we have lost is greater than the size of areas 2 plus 4 which we've gained then there is a net loss, otherwise we've achieved a net gain. 

If there are high external tariffs or a small cost difference between goods produced inside and outside of the union then a customs union is likely to lead to trade diversion.

In the long term, a customs union could have advantages and disadvantages, I'll name a few of both:

• Advantages:
• Increased market size - allows firms to potentially exploit economies of scale to lower costs.
• Better terms of trade with world markets because of the power of the customs union.
• Increased competition which will stimulate efficiency and bring costs down.
• Disadvantages:
• Resources may flow to the geographical centre for the lower transport costs leaving depressed regions on the edge of the union.
• Mergers will be encouraged which will boost monopoly powers.
• Diseconomies of scale.
• The administration costs of maintaining the union.

The basics of preferential trading arrangements in one blog post, tadaaa! Thank you for reading, keep sharing and following the blog! Thanks guys, have a good day.

Sam.

Principles of Economics: Supply (Microeconomics)

*Disclaimer: I'm fully aware of the fact that I've already written a post on supply. However, I've decided to cover it again now I know more on the subject and can give a better coverage.* 

Okay, I'll dive straight into this one with the main principle of supply: 'When the price of a good rises, the quantity supplied will also rise'. Now, it's all well and good just stating that, however we need to know the reasons why this happens. Let's look at three of them:

• Beyond a certain level of production for the producer costs are likely to rise at a quicker rate than previously. This could be due to having to pay overtime to staff members or increased maintenance costs for machinery. Either way, the quantity supplied by producers will only rise if the price rises so that it becomes efficient for them to raise their costs.
• A more basic reason now: The higher the price of the good, the more profitable it is for the firm. In general terms this theory holds true. Most firms have an aim of profit maximisation, so therefore they'll increase supply when the price rises to maximise profits.  Both of these two points are short term reasons as to why supply rises when price increases.
• A long term reason is because when price rises in an industry new firms are encouraged to join the market with the hope of profit. This increase in firms will increase the supply to the market. 

Here we have a very basic graphical presentation of the supply curve. A supply curve shows us the supply schedule. Supply schedule refers to the amount producers are able to and willing to produce at different prices at a set point in time, it is normally shown in a table and can then be presented in a graph like the one above. The supply curve will generally slope upwards from left to right, to show that the higher the price the higher the supply will be. Obviously, price elasticity of supply plays a part in the steepness of the slope but I'll get on to that point in a few blog post times, I'm keeping it very basic here. 

As with demand, there are many factors apart from just price that affect the supply of a good to the market. These are the main ones:

• Production cost - Higher costs mean less profits means less supply and vice versa. This can be because of a change in the input prices (wages, raw materials), government policy (subsidies, taxation), organisation changes or technology changes.
• Nature - This can include the weather, disease, natural disaster. Basically things that are out of human control.
• Aims of the producer - The supply of a firm aiming to maximise profit will be different to a firm aiming for sales maximisation. Therefore different producer aims will cause varying levels of supply. 
• Expectations - If prices are expected to rise, producers will hold onto stock in anticipation of this rise meaning supply will fall. This works the opposite way for if prices are expected to fall.
• Number of suppliers - Simply put, more producers means more supply, less producers means less supply. 
• Profitability of alternatives - If a substitute in supply is more profitable, supply for the good in question may fall. Alternatively, if a substitute in supply is less profitable, the good in questions supply may rise as the producer re-diverts resources. 
• Profitability of goods in joint supply - Goods that are produced together mean if the profitability of the joint good rises then the supply of the good in question may also rise. Works the opposite way too.

As with demand, there can either be a movement along the supply curve or a shift in the supply curve. 

A change in price will mean a movement along the supply curve. So, the supply curve will stay at the initial place of 'Supply 1' on the diagram and the point supplied will just move up or down that curve. If any of the other determinants of supply stated above change then we can expect a shift in supply. A shift to the right, 'Supply 1' to 'Supply 2' on the diagram, shows an increase in supply. A shift to the left, 'Supply 1' to 'Supply 3' on the diagram, shows a decrease in supply. A movement along the curve is known as a change in the quantity supplied whereas a shift in the supply curve is known as a change in supply.

There we have it, a recap on the basics of supply. Next to come in terms of principles of economics will be marginal utility theory, so stay tuned for that! Thanks for reading and have a good day.

Sam. 

Protectionism (Macroeconomics)

Protectionism refers to the protection of a domestic industry from foreign competition. There are many types of protectionism which i'll run through later on in this post. The free movement of goods and services is restricted between countries and economic blocs to try and protect a countries own industries from the powers of competition from abroad. The main types of protectionism are as follows:

• Tariffs
• Quotas
• Voluntary Export Restraints
• Foreign Exchange Restraints
• Embargoes
• Red Tape

Tariffs is very much self-explanatory. A tariff, or tax, on a good being imported into the country from abroad.  The effect of the tariff will be moving the supply curve of the good backwards by the value of the tariff. A tariff will protect domestic firms, especially new firms, by making it more expensive for goods to be imported and therefore raising the price, allowing home-grown firms to compete more. It's useful when it comes to goods from the likes of China and India. These countries have such low costs of production that they can afford to sell the goods at prices much lower than those of domestic firms in the United Kingdom. Therefore, these tariffs add to the production cost meaning that imported goods will cost more and allow domestic firms to compete more. 

A quota is also a fairly self-explanatory form of protectionism. It is a limit on the supply of a good or service into a country from abroad. An example would be a quota restriction on the import of t-shirts from China. The government may create this quota in the form of a number of goods, i.e 20,000 t-shirts per year, or they could do it by value, i.e £4 million worth of t-shirts per year. Supply of the good will fall which will in turn help domestic industries once again to compete as well as potentially raise the price of the goods. A problem with quotas, however, is that it can cause international disputes such as the one between China and the EU about the importing of Chinese textiles. More can be read about that by clicking here.

Voluntary export restraints are an agreement between one country and another to limit their exports to each other of certain goods. This is normally made between countries who are on good terms with one another or who are in the same economic bloc. Foreign exchange restrictions are a type of protectionism that doesn't appear much. This is when a government seeks to reduce imports by limiting the amount of foreign exchange made available to those within the country who wish to buy imported products. Basically, the supply of foreign money to buy these imports will be limited so not as may goods can be purchased from abroad. 

The final two now: embargoes are a ban on the import or export of products to/from a particular country. For example, a ban on weapons to a country with poor human rights records. Red tape is the idea of making importing difficult by creating lots of paperwork and procedures to delay and therefore discourage the imports. 

There is, of course, an argument for going ahead with protectionism. Firstly and potentially most importantly, it gives the government the ability to control imports which can therefore improve the trade balance. If the trade balance is in the red the government can use any form of protectionism in an attempt to curb spending on imports and improve the trade balance. Protectionism is very beneficial to declining domestic industries as well as the new industries. Both these industries aren't at the stage to be totally competitive and therefore could easily be wiped out from cheap imports. However, protecting them by limiting imports or raising the price allows these firms to get a proper foot in the market, expand and grow enough to be able to compete with the cheaper imported goods and services. Finally, it's also a method for generating revenue for the government if the protectionism comes in the form of a tariff. This tariff placed by the government goes straight in their pocket and can therefore help to eradicate budget deficits as well as improve investment power. 

With all advantages does come disadvantages, and the case of protectionism is no exception. Consumers will experience a welfare loss due to higher prices and the loss of consumer surplus. It can also be regressive for low income families as the protection will effect everyone equally, therefore those with less money will feel it the most. Raw materials may well become more expensive. This is far from beneficial for domestic industries as production costs will rise and therefore profits will be squeezed. Retaliation is another big thing that could crop up as a direct result. Putting a form of protectionism on imports from a certain country could cause that country to do the same back, which will restrict the exporting potential of the country and could worsen the balance of trade.  Finally, maybe a minor disadvantage, but there is the administration and implementation costs of the protections to take into account.

That pretty much sums up protectionism for you. Decide or yourselves whether you think they're beneficial or not, but at the end of the day forms of protectionism will always be used. Thanks for reading guys, stay tuned and share the blog if you find it useful!

Exchange Rates (Macroeconomics)

Exchange rates are something that affects all of us, be it directly or indirectly. Exchange rates are basically the value of a currency compared to that of another currency. They fluctuate a lot, which leads to price changes.

I'll be using the Sterling (£) in my examples throughout. Firstly, let's look at what determines the value of a currency. The value of the £ is determined by the free market, so therefore the powers of demand and supply dictate the value of the £. The majority of the demand for the £ will come from trading partners demanding the U.K's exports and therefore needing the £ to buy them. The majority of the supply of the £ comes from us demanding foreign imports, and needing to sell the £ to get foreign currency to buy the imports.

An increase in the demand for the £ will increase the value compared to other currencies. This is often referred to as a "strengthening of the £" or an "appreciation". Obviously, a fall in demand for the £ will have the opposite effect. An increase in the supply of the £ will decrease the value compared to other currencies. This is often known as a "weakening of the £" or a "depreciation". A decrease in supply will have the opposite effect, raising the value.

Another key factor that influences the demand and supply of the £ is interest rates. If interest rates in the U.K. are high, then we will see a high demand for the £ as people will make a better return off of it in U.K. banks. This will increase the value of the currency. A decrease in interest rates will see money flow out of the U.K. in search of a better return on their investment and therefore demand and the value of the £ will fall.

There are two different exchange rate mechanisms. The first one is the floating mechanism. This is when the value of the currency is determined by the free market - the powers of demand and supply. The advantage of this mechanism is that theoretically the exchange rate should automatically adjust which will eliminate any imbalances withing the Balance of Payments. The other is the fixed mechanism. This is when the exchange rate is fixed and determined by the government or central bank of a country. The bonus to this is that it gives more stability to the value of the currency but runs the risk of goods becoming to un-competitive if it's too high or the market can be flooded if it's too low.

That's the lot for exchange rates, thanks. Also, any requests for what to come next? Post it in comments and ill see what i can do. Thanks for reading, follow the blog if you enjoy!

Government Intervention - Subsidies (Microeconomics)

Subsidies work in sort of the opposite way to taxation. They are direct payments from the government to firms and businesses, or in some cases consumers. The aim of a subsidy is to reduce the overall cost of producing the good/service so that more can be made and sold at a cheaper price. These subsidies are normally given to produces of goods with positive externalities, so that the market failure can be fixed by increasing the production and consumption.

Lets have some examples of subsidies:

• The government may give subsidise local bus companies so they can run bus routes in rural areas without making a loss. This fixes the market failure of under-production of public transport. This is an example of a subsidy to the producers.
• The government also give subsidies to the over 60's so they can pay for fuel during the Winter. This means they can now afford to pay for the fuel to keep them warm, fixing the under-consumption there.

In both of these cases, if they were left to the free-market there would be under-consumption. In a way, a subsidy works in the opposite way to an indirect tax. It increases the supply of the good so that the price decreases and thus the quantity demanded increases.

That's about all for basic subsidies to correct market failure. Thanks.

Price Elasticity of Supply (Microeconomics)

This will be the last elasticity post for a while, i promise...

Right, so price elasticity of supply is sometimes referred to as PES. It measures the responsiveness of supply to a change in price. Basically, it indicates the amount a supplier is willing to to provide to a market after a change in price. The aim of a supplier is to maximise profits, so therefore the price elasticity of a supply should always be positive (If the price of a good increase so should supply, and vice versa.)

The formula for PES goes like this:

PES = % Change in quantity supplied ÷ % Change in price

As stated previously, the result will almost always be positive as it's highly unlikely that if price falls then suppliers will supply more of a good to the market. The figures gained from the formula are once again important:

• Greater than 1. If the result is over 1 then it tells us that the goods price elasticity of supply is elastic. So a price rise will lead to a more than responsive rise in supply.
• Between 0 and 1. If the result is between 0 and 1 then the goods price elasticity of supply is inelastic. This means a price rise will lead to a less than responsive rise in supply.
• Exactly 1. If the result is 1 then the goods price elasticity of supply is unitary. A change in price leads to an exactly proportional change in supply.

There are three main determinants of the price elasticity of supply of a good. The first is time period. If it takes a lot of time to adjust the supply of a good then it's likely the goods PES will be inelastic. An example of this would be Christmas trees with the long growing period. The next determinant is availability of factors of production. If there is no spare resources or labour to increase production then the PES is likely to be inelastic, and vice versa. Finally, availability of stocks of a product. If a supplier has plenty of goods stored away that can be added to the market should price change then the PES will likely be elastic. If there is no way of storing, or isnt any stored, PES will likely be inelastic. 

An example as usual. The price of shampoo increases by 22% over a period of time, over the same period suppliers supply 15% more shampoo to the market.

PES = 15% ÷ 22% = 0.68

This tells us that the PES of the shampoo is inelastic, suggesting that maybe it takes a long time to produce, there was no extra stored away or there is no spare factors of production. 

That's all for price elasticity of supply. 

Demand and Supply (Microeconomics)

This post will broken down into demand, supply and then demand with supply. Lets go...

Firstly, demand. Demand is the willingness and ability to buy a good at any given price. It is shown by a demand curve on a supply and demand diagram, and it shows the relationship between quantity demanded and price. There are two types of demand, effective demand and notional demand. Effective demand is the willingness and ability to buy a good, whereas notional demand is the desire for a good. The relationship between price and demand is inverse... so the lower the price - the higher the demand. There are many factors that determine the demand of a good, they are:

• Tastes or preferences - If a good is currently 'in', or the taste for a product increases then demand will increase. If it's out of fashion or the taste for it decreases then demand will decrease.
• The number of consumers - Simply put, more consumers will generally increase demand... less consumers will decrease demand.
• The income of consumers - If income increase then demand for superior goods such as Bentleys or TVs increases and vice versa. For inferior goods, such as tesco value food, as income increases demand decreases as consumers move to better quality goods. 
• Price of related goods - Using phones as an example, if Nokia phones are really expensive then demand for Samsung phones may increase. Opposite will happen if Nokia phones and really cheap. 

Now onto supply. Supply is the quantity of a product that producers are willing to provide at different market prices over a period of time. The relationship between price and supply is fairly obvious, the higher the price - the more producers are willing to supply to the market (higher supply). The determinants of supply are:

• Production costs - If production costs rise you'd expect a fall in supply, if they fall you'd expect a rise in supply. If its cheaper to make a good, then more will be produced.
• Size and nature of industry - In a competitive industry, any changes in cost will effect supply, however in a market with only one or two major players, any changes in cost can be passed onto the consumers without having to change supply.
• Government policy - Governments may change taxes, or introduce legislation restricting supply. Each would have an effect on supply.
• Natural disaster - Something such as a hurricane may wipe out workers or factories, thus decreasing supply.

When you combine a supply curve and a demand curve onto one diagram, we get presented with a price. The supply and demand diagram is usually set up with price up the y axis and quantity along the x axis. Here is an example...

This is a simple demand and supply diagram, which shows us how prices are determined. The point 'PQ' on the diagram is where the supply curve and the diagram curve meet, meaning the position where both buyers are willing to buy and sellers are willing to sell -  both parties are satisfied. This point is referred to as the market equilibrium price or the clearing price. 

The equilibrium point isn't set in stone and changes as either the demand or supply curve changes. The next image will show this... 

In this new diagram we can see that supply and demand have both changed. Supply has increased, so the curve has shifted to the right from "supply" to "supply 1". Demand has also increased, and thus the curve has shifted to the right from "demand" to "demand 1". The result of this is a new market equilibrium point of 'P-Q1'. What this shows is that any changes in supply or demand will result in a new equilibrium price.

That's all the basics for supply and demand, the next post will be about complimentary and sustitute goods. Thanks for reading!