Price Taking and Market Power: Elasticities and Welfare Analysis, Ejercicios de Sociología Económica

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Unit 1 Introduction, concepts and models of trade • Definition of economics o Economics studies how societies administer scarce resources • The Opportunity Cost o The opportunity cost is what you sacrifice o The opportunity cost is the best available alternative o Subjetive • Efficiency and equity o The Three Main Questions in Economics ▪ What (and how many) ▪ How (and who should do it) ▪ For whom o Efficiency (in production) ▪ A reallocation of resources increases efficiency (in production) when the production of, at least, one good increases without decreasing the others. ▪ An allocation of resources is efficient (in production) if it is not possible to reallocate the resources and increase efficiency (in production). o Efficiency (in consumption) ▪ A reallocation of resources increases efficiency (in consumption) when the welfare of, at least, one individual increases without decreasing the others. ▪ An allocation of resources is efficient (in consumption) if it is not possible to reallocate the resources and increase efficiency (in consumption). o Pareto Efficiency (不使其他人条件变坏的情况下至少使一人条件变好) ▪ We sometimes refer to Pareto efficiency to emphasize the welfare criterion. ▪ In economics, the main concern is how to achieve efficient allocations. ▪ A state of allocation of resources from which it is impossible to reallocate so as to make any one individual of preference criterion better off without at least one individual or preference criterion worse off o Equity ▪ The size of the pie vs. how it is distributed ▪ Fairness, equality, justice ▪ Economics has more to say on efficiency than equity. • Market o In modern societies most resources are allocated by free trade in the MARKET o Markets and efficiency ▪ Under some conditions markets are efficient (Unit 4) • Intuitive: o Everybody that trades improve. • More subtle: o Surprising way of coordinating decisions through prices. ▪ In others, the market is not efficient (Units 6 and 7). • There is a “market failure” • The methodology in economics o How do economists work? ▪ Models ▪ Data analysis o Economics is a social science that studies systematically how scarce resources are allocated in a society. o Systematic approach (the scientific method): ▪ Observe reality ▪ Formulate theories to explain reality ▪ Test the theories empirically o Model ▪ The set of assumptions that constitutes a theory is formulated through a MODEL. ▪ A model is a simplification of reality through assumptions to make it more understandable. ▪ Models use assumptions to make reality more understandable ▪ The main challenge is which assumptions to use. • The Solow Test (“one-yes test”): o Do the conclusions depend on the assumptions? o Are the assumptions realistic? ▪ Different questions require different assumptions. • Micro and Macroeconomics o Microeconomics studies the behavior of the individual units in each economy (households and firms) and how they interact in individual markets ▪ How consumers choose their consumption, work… ▪ How firms chose production, hirings… ▪ How they interact and trade o Macroeconomics studies ▪ Interactions between markets in an overall economy ▪ The processes that affect the economy as a whole • The effect of government spending • The evolution of unemployment • The causes of inflation (or deflation) • Economic analysis • Positive analysis/descriptive analysis tries to understand the world as it is. o “The comparative advantage of the United Kingdom in banking explains the decline of its industrial exports.” o “The main explanation for inflation in the long run is the expansion of the quantity of money” • Normative analysis/prescriptive analysis makes a claim about how the world ought to be. o “Monopolies are bad for the economy” o “The government should regulate the banking industry to avoid excessive risk taking” o The demand and consumer’s income ▪ A normal good is a good whose demand increases whenever the consumer’s income increases. (有钱了还是会买的东西-大米) ▪ An inferior good is a good whose demand decreases whenever the consumer’s income increases. (有钱了就不会买的东西-淘宝便宜货) o Complements and substitutes ▪ Two goods are substitutes when the demand of one increases when the price of the other increases. (替代品，竞争关系-可口可乐 vs百事可乐) ▪ Two goods are complements when the demand of one decreases when the price of the other increases. (共生关系-面包&果酱) Unit 3 The Model of Perfect Competition (II): The Supply • The Supply (I): Introduction o The quantity supplied: the quantity (of a good) that seller is willing (and can) sell under any possible circumstances. o The supply curve: a function (or a graph) that shows us the supply as a function of the price. ▪ The supply curve is constructed under the ceteris paribus condition. ▪ The supply function satisfies the law of supply: Greater prices imply greater quantities • The Supply (II): The Uni-Demand Case o Seller’s reservation price (or willingness to sell): It is equal to the seller’s opportunity cost. • The Supply (III): The Costs o Cost for economists always means opportunity costs. o Costs definitions ▪ Marginal cost: Increase in cost when production increases one unit. ▪ Variable costs: Costs that vary with the quantity produced. ▪ Fixed costs: Costs that are independent of the quantity produced. ▪ Sunk costs: Costs that are unavoidable. • The Supply (IV): The General Case o The Individual Supply o Marginal Costs ▪ The marginal cost is how much costs increase as production (or sales) increase in one unit. ▪ The law of decreasing marginal returns: The marginal cost increases with quantity once production increases sufficiently. ▪ Economies of scale • The economies of scale measure how cost vary when we change all the productive factors. • We say that there are economies or diseconomy • ies of scale depending on whether average cost go down or up, respectively, as we increase the production scale. o Market Supply ▪ The market supply is the total supply of all the sellers in a market. ▪ This can be computed by summing all the individual supplies at each price level. Recall that this operation is called horizontal summation. ▪ The law of supply • The individual supply curves have positive slope. • As price increases, more firms enter the market. • Movements and Shifts o Quantity supplied and movements ▪ Movement • There is a change in the quantity supplied or movement along the supply if: The price of the good changes, ceteris paribus. o Shifts in supply ▪ Some other factor that affects the supply other than the price of the good changes: There is a shift in the supply or a change in the supply. ▪ Determinants of supply (beyond the price) • Input Prices • Technology • Number of producers • Expectations • Elasticities: Definitions o Price elasticity of demand (and supply) ▪ Elasticity measures how sensitive is a variable to changes in another one. ▪ The price elasticity of demand (supply) measures how sensitive is the quantity demanded (supplied) to changes in the price of the good o Price elasticity ▪ The (price) elasticity of demand is computed a Price elasticity of demand= Percentual change in quantity demanded Percentual change in price ▪ The (price) elasticity of supply is calculated analogously ▪ Values for the elasticities • Perfectly elastic ε = ∞ • Elastic ε > 1 o What happens to price and quantity if the supply and demand shift? • Welfare Economics o Use a model to evaluate the allocation of resources of an institution. o Here, we use the model of perfect competition to evaluate whether the market allocates the resources efficiently. o Measuring welfare ▪ Consumers’ and Sellers’ Gains • The consumer surplus is the gains of the buyer thanks to the existence of the market. • The producer surplus is the gains of the seller thanks to the existence of the market. • The total (or social) surplus is the sum of the consumer surplus and the producer surplus. Unit 5 Government intervention in the market • Regulated prices • Price ceiling • Taxes (I): classification o Many taxes in reality ▪ Income tax ▪ Tax on profits ▪ Inheritance tax o Sale tax ▪ Per unit or specific tax ▪ Ad valorem tax ▪ Tax on sellers ▪ Tax on buyers • Taxes (II): analysis o A tax on sellers o A tax on buyers • Taxes (III): welfare o The Alternative Method to Study Taxes o The Consequences of a Tax o A subsidy in general • Subsidies (II): welfare o Subsidies and welfare o Subsidy and elasticities ▪ Inelastic supply • More elastic supply • If demand is more inelastic than supply • If demand is more inelastic than supply Unit 6 Market Failures (I): Imperfect competition and asymmetric information • 4 reasons why markets fail o Market power. o Asymmetric information. o Externalities. o Public goods. • Market Power (I): definition o Market Structures with market power ▪ Monopoly: A single seller (no close substitutes). ▪ Oligopoly: A few numbers of sellers ▪ Monopolistic Competition: Many sellers but with slightly different products • Other Market Structures • Market Power (II): a model o Marginal revenue of a monopolist ▪ The monopolist has to reduce the price to sell more. ▪ Monopoly price increases when demand decreases. • Market Power (V): barriers to entry o Barriers to entry ▪ Monopoly (or oligopoly) resources. ▪ Government regulation. ▪ The nature of production (natural monopoly). ▪ Business strategies o Monopoly resources ▪ Only one firm owns an essential resource. o Government regulation ▪ Patents, copyrights. ▪ Licences. ▪ Professional regulations. o Natural monopoly ▪ In certain cases, the average cost is lower with one firm than with several. o Business strategies ▪ Marketing. ▪ Force distributors to sell your own product only. ▪ Deny access to an essential input/infrastructure. • Market Power: Solutions o Government intervention ▪ Competition policy. ▪ Regulation. ▪ Public ownership. • Market Failures: Asymmetric Information o Information in Economics ▪ Perfect competition assumes everybody knows everything relevant. ▪ However, an important feature of some markets is the lack of information. o Asymmetric information: an example ▪ Asymmetric information: only one side of the market knows something that it is relevant to the other side. • A characteristic (adverse selection) • An action (moral hazard) Unit 7 Market Failures (II): Externalities and public goods • Externalities o Externalities: classification • The analysis of externalities o Externalities in production ▪ Negative externalities in production: social cost > private cost. ▪ Positive externalities in production: social cost < private cost. o Externalities in consumption ▪ Positive externalities in consumption: social value> private value. ▪ Negative externalities in consumption: social value < private value. o Negative externalities (both in consumption and production) mean that the market delivers too much, whereas positive externalities mean that the market delivers too little. • Solutions to externalities o Internalization of externalities ▪ The problem of externalities is that agents do not take into account the effect on others. ▪ Most of the solutions pass by inducing agents to take into account their externalities, this is to force them to internalize the externality. ▪ Two possibilities: • Private solutions. • Public solutions. • Private solutions to externalities o Private solutions ▪ There are several mechanisms to solve externalities without public intervention • Moral codes and social sanctions. • Charities or NGO’s. • Integrating different types of business. • Contracting between the interested parties. • Public solutions to externalities o Public policies ▪ Command-and-control: • Forbid smoking, make vaccinations compulsory. ▪ Market based policies: • Taxes or subsidies. • Tradable permits. o Pigouvian tax o Advantages of cap and trade mechanisms ▪ The quantity is set directly to be optimal. ▪ As in any market, the allocation is efficient. ▪ Similar to a tax • The four sectors of the economy o In the National Accounts System (NAS) the all the economic activities in a country are assigned to one of the four sectors ▪ Households ▪ Firms ▪ Public Sector ▪ Foreign Sector • The expenditure o Recall: GDP is total spending. o Four components: ▪ Consumption (C) ▪ Investment (I) ▪ Government Purchases (G) ▪ Net Exports (NX) o GDP = Y = C+I+G+XN • Consumption (C) o It is total spending by households on goods and services excluding new houses. o Note on housing costs: ▪ For renters, consumption includes rent payments. ▪ For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments. • Investment (I) o It is total spending on goods that will be used in the future to produce more goods. o Includes spending on ▪ capital equipment (e.g., machines, tools) ▪ structures (factories, office buildings, houses) ▪ inventories (goods produced but not yet sold) – Involuntary investment by firms • Government Purchases (G) o It is all the spending on the goods and services purchased by government at the national, regional or municipal level. o Subsidies, pensions or unemployment insurance benefits are excluded from G ▪ They are transfers to other sectors of the economy but they are not purchases of goods and services • Net exports (NX) o Exports represent foreign spending on the economy’s goods and services o Imports are the portions of private consumption, investment, and public expenditures that are spent on goods and services produced abroad. o NX = exports – imports • Nominal and real GDP o Using market prices to measure GDP implies that if we observe a significant increase in the GDP in a given period, we cannot be sure whether it is due to an increase in the quantities produced or in their prices. o To solve this ambiguity, we define ▪ Nominal GDP: total production of goods and services valued at current prices. – Current prices = prices of each year. ▪ Real GDP: total production of goods and services valued at constant prices. – Constant prices = prices of the base year. o Calculating real and nominal GDP o Calculating nominal GDP with intermediate goods • The GDP deflator o Changes in the ratio between nominal GDP and real GDP reflect very well changes in the overall price level of the economy o Inflation rate can be measured as the percentage change in the GDP o Calculating a GDP deflator Price Quantity (kg) Price Quantity (Kg) Price Quantity (lit) 2 10 4 2 1 4 Price Quantity (kg) Price Quantity (Kg) Price Quantity (lit) 2 10 4 2 1 1 (10x2)=20 (4x2)=8 1 GDP = 29 Price Quantity (kg) Price Quantity (Kg) Price Quantity (lit) 2 10 4 2 1 4 (10x2)=20 (4x2)-(3x1)= 5 (1x4)=4 GDP = 29 Added value in each sector Bread Butter Milk Bread Butter Milk If three fourths of the milk is used for producing butter Value of ALL FINAL goods o GDP deflator and inflation rate • Differences in GDP per capital o The determinants of productivity ▪ Physical capital ▪ Human capital ▪ Natural resources ▪ Technological knowledge • The MLF and policy changes o The MLF and changes in the incentives to save ▪ An increase in private savings will expand national savings ▪ Lower equilibrium interest rate, higher savings and investment equilibrium ▪ Fiscal incentives to save would end up in higher savings, higher investment and lower interest rate o The MLF and an increase in public deficits ▪ An increase in public deficits higher equilibrium interest rate ▪ Lower equilibrium level of savings and investment smaller capital stock in the long run • Summarizing the MLF o In a closed economy savings equal investment o In the MLF, the interest rate plays a role to equalize savings and investment o Exogenous changes in savings behavior –i.e. for policy interventions- affect investment and capital accumulation in the long run • Population and Labor Force o Statistical offices in each country collect information about the labor market through household surveys o Main categories ▪ Employed: paid employee, self-employed or unpaid worker in a family member’s business ▪ Unemployed: not employed and looking for a job ▪ Not in the labor force: neither employed nor unemployed. o Labor Force = Employed + Unemployed • The unemployment and labor participation rate o The unemployment rate is calculated as o The labor force participation rate is calculated as • Types of unemployment o The natural rate of unemployment is the normal rate of unemployment around which the actual unemployment rate fluctuates. o The cyclical component of unemployment is closely associated to the economic situation and its fluctuations are mainly generated by the changes in the demand for workers by firms • Unemployment and economic cycles o Cyclical unemployment can be affected by economic policies that reduce the severity of economic recessions • Growth rates • Inflation and the Consumer Price Index (CPI) o The inflation rate is the increase in the overall level of prices in the economy o It is measured as the growth rate of a price index like the GDP deflator we have defined in the previous unit or like the consumer price index (CPI) • The Consumer Price Index (CPI) o The Consumer Price Index (CPI) measures the overall cost of a basket of goods bought by a typical family. o Step 1: Definition of a basket through surveys on consumption of “typical” families ▪ The basket is regarded “fixed” because it only changes every several years o Step 2: Collecting information on prices of each good of the basket o Step 3: The cost of the basket is calculated by multiplying prices and quantities o Step 4: A base year is defined, and the index is computed dividing the cost of the basket in each year by the cost of the basket in the base year o Step 5: Using the formula of the percentage growth of a variable, the inflation rate is calculated as the percentage growth of the CPI • Comparison between the CPI and the deflator CPI GDP Deflator Includes some imported goods consumed by typical families Includes only goods domestically produced Excludes capital goods (they are not in the consumers’ basket) Includes capital goods (if they are domestically produced) Uses a fixed basket The basket is given by the goods and services produced each year o There are some differences in the short run, but in general both indices show a similar evolution • Comparing purchasing powers and the CPI o Nominal variable: a variable not adjusted for changes in prices over time o Real variable: a variable adjusted for changes in prices over time o Comparison of economic variables across time is not straightforward because of prices change o We transform nominal variables in real variables using the CPI • About nominal and real variables o Most of the time, economic analysis is based on real variables o Transformation of nominal into real variables should be obtained with the “right” price index ▪ Wages: the CPI ▪ GDP: the GDP deflator ▪ Reducing the discount rate, the money supply increases ▪ Increasing the discount rate, the money supply decreases 3. Changes in the legal reserve requirement ▪ An increase in the reserve requirements can increase the reserve ratio, reduce the multiplier and reduce the money supply ▪ Not very common • Price level and the value of money o When prices increase, goods are more expensive more money is needed to buy a given basket of goods o If P is the price of goods, 1/P is the value of money in terms of goods. o If prices (P) increase, the value of money (1/P) decreases. • Money demand o MD = f (P, r, Y) o If P increases, ceteris paribus, the quantity of money demanded increases. o If 1/P decreases, the quantity of money demanded increases • Money supply o MS controlled by the Central Bank o Independent of P or 1/P -> A vertical line • The classical theory of inflation o Price level in equilibrium ▪ If 1/P = 2 ➔ P=1/2 ▪ If 1/P = 1 ➔ P=1 o Any increase in the money supply leads to an increase in the price level in the long run. • The classical dichotomy o Does a monetary expansion produce some effect on variables like production or unemployment? ▪ Nominal variables – measured in monetary units ▪ Real variables – measured in physical units – measured in monetary units but adjusted for inflation ▪ Classical dichotomy – states that nominal variables are affected by changes in the monetary side of the economy while real variables are not. – changes in the money supply will affect the price level but will not have any effect on the quantity produced, the real GDP or unemployment. – True in the long run, not necessarily in the short run • The quantity equation o A relationship between money supply and price levels o Velocity of money (V): how many times (in average) a banknote is exchanged for newly produced goods and services. • The quantity theory of inflation o If V and Y are unaffected by changes in M, changes in the money supply (M), produce proportional changes in prices (P) Unit 4: Open-Economy and Exchange Rates • Closed and open economies o A closed economy does not interact with the rest of the world. o An open economy is interacting freely with the rest of the world. • Exports, imports and trade balance o Y = C + I + G + X - M ▪ Trade of goods and services – Exports (X) – Imports (M) ▪ Trade balance – X-M • Trade balance and degree of openness o Degree of openness: (X+M) / GDP • Capital flows o The residents of one country participate in the international financial market buying or selling assets ▪ Money or Stocks ▪ Bonds ▪ Real estate ▪ Firms o Net capital outflow (NCO) ▪ Domestic residents’ purchases of foreign assets - foreigners’ purchases of domestic assets. ▪ Net capital outflow can be positive or negative ▪ domestic residents’ purchases of goods and services - foreigners’ purchases of domestic assets. o If the exchange between two countries is stocks or real estate for money ▪ It is an exchange of assets for assets ▪ The NCO will be zero for both countries o The NCO will be different from zero only if there is an exchange of assets for goods and services • National accounts, trade balance and capital flows o Positive trade balance ▪ The foreign sector pays that difference with an asset ▪ The interior sector is investing in foreign assets. o Positive capital outflow (NCO) • Capital flows and national accounts o S = I + NX o NX = NCO o S = I + NCO Unit 5: Economic fluctuations and the model of aggregate demand and aggregate supply • Long run vs. short run o In the long run ▪ The classical dichotomy: changes in nominal variables do not influence real variables o In the short run ▪ Real and nominal variables are highly intertwined. ▪ For instance, changes in price level (a nominal variable) can produce changes in the real GDP • Macroeconomic fluctuations o Unemployment does also fluctuate a lot o It increases in recessions and decreases in periods of expansion o It is a countercyclical variable • AD-AS model o An equilibrium will be the point at which the quantity demanded is equal to the quantity supplied. o The curves will shift (for instance the aggregate demand) if for a given price level there is a smaller or large quantity demanded. • The aggregate demand (AD) o The aggregate demand curve shows the quantities of all goods and services demanded in the economy at any given price level. o The expenditure in domestically produced goods and service is AD = Y = C + I + G + NX • The slope of aggregate demand o The wealth effect ▪ An increase in prices produces, ceteris paribus a reduction in total wealth (money is less valuable) of some consumers ▪ These consumers reduce their purchases of goods and services ▪ There is a reduction of aggregate consumption ▪ An increase in price levels reduce aggregate consumption o The interest rate effect ▪ An increase in prices induces people to change the composition of their wealth: They sell bonds to hold more money ▪ The higher money demand generates an increase in the interest rate ▪ A higher interest rate discourages investment ▪ An increase in price levels reduce aggregate investment o The impact of changes in price levels on consumption and investment o The two effects explain the negative slope of the aggregate demand • Shifts of the aggregate demand o The shifts of the AD are produced by any change in the aggregate demand of goods and services that are independent of the price level. • The aggregate supply o The aggregate supply curve, shows the relationship between the economy’s price level and the total quantity of final goods and services produced o Short run aggregate supply (SRAS) is upward-sloping o Long run aggregate supply (LRAS) is completely inelastic o In the short run the aggregate supply is upward sloping, but with time, all prices, including nominal wages are flexible o In the long run, the level of output will correspond to the LRAS • The long run aggregate supply (LRAS) o The long run aggregate supply (LRAS) is the potential output. o YN = F (K, L, H, N, T) ▪ K: capital stock ▪ L: labor ▪ H: human capital ▪ N: natural resources ▪ T: technology o Because of the Classical Dichotomy, it does not depend on prices o Shifts in the LRAS ▪ The long run aggregate supply is independent of prices ▪ If human capital (H) or labor (L) increase, the LRAS shifts to the right to YN’. • The slope of the SRAS o In the short run the aggregate supply has a positive slope. ▪ Nominal wages adjust slowly to changes in economic conditions ▪ An unexpected increase in the price level changes the cost of goods and services relative to workers earnings. o In the short run the aggregate supply has a positive slope. o If P increases, the value of what a firm sells increases o If nominal wages does not change, an important part of the costs does not change o The profit per unit increases, production increases • Shifts in the SRAS Unit 6: Monetary and fiscal policies • Nominal and real interest rate o The interest rate is the price, calculated as a percentage of the amount borrowed, charged by a lender to a borrower for using their savings for a period, typically, one year. o Real interest rate: adjusted for changes in prices o Nominal interest rate: unadjusted for changes in prices o The real increase in the purchasing power of money depends on the inflation rate o Real interest rate = Nominal interest rate – inflation rate • Determination of the interest rate o In the long run: the market for loanable funds o In the short run: a new theory • The theory of liquidity preference o Why households hold money? o They choose between ▪ Bonds or money in interest-bearing banks accounts ▪ Money in cash o Money has an opportunity cost: the interest rate ➔ The quantity demanded for money is inversely related with the interest rate. • The money demand o The main variables in the money demand ▪ Interest rate ▪ Household’s income ▪ Price levels o The quantity demanded for money is ▪ inversely related with the interest rate ▪ directly related with households’ income. ▪ directly related with price level. o MD = f (P, r, Y) • The interest rate effect o If prices increase ▪ Households sell bonds to hold more money ▪ The higher money demand generates an increase in the interest rate ▪ A higher interest rate discourages investment ▪ An increase in price levels reduce aggregate investment • Monetary policies o The central bank controls the money supply o An expansionary monetary policy can be summarized in an expansion of the money supply ▪ A reduction of the discount rate or a purchase of government bonds o A contractionary monetary policy can be summarized in a reduction of the money supply ▪ An increase of the discount rate or a sale of government bonds • Expansionary monetary policies • The nature of fiscal policies o Changes in government expenditure (G) ▪ It is one of the components of the GDP and aggregate demand o Changes in taxes (T) ▪ Influence households’ disposable income or take-home pay ▪ Influence consumption o Changes in G or T shifts the aggregate demand (AD) • Expansionary fiscal policies o Expansionary fiscal policies: An increase in G or a reduction in T expand the AD. o In the new short run equilibrium there are higher price levels, higher GDP and lower unemployment • Contractionary fiscal policies o Contractionary fiscal policies: A reduction in G or an expansion in T shrinks the AD. o In the new short run equilibrium there are lower price levels, lower GDP and higher unemployment • The multiplier o Multiplier: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income o How large is the multiplier? ▪ It depends on the share of the extra income that households use for consumption.