econ

ECON 111*S Introductory Microeconomics

Winter 2009

Detail from The School of Athens showing Plato and Aristotle by Raphael, 1509–1510

Key Sessional Dates for WINTER 2009 Complete sessional dates at http://www.queensu.ca/calendars/artsci/pg2.html

January 2009 5 Winter Term classes begin. 5 Last date for students not registered in any other course to register in Winter Term

without a registration administration fee.16 Students unable to register by this date must appeal in writing to the Associate Dean

(Studies) and pay a registration administration fee.16 Last date to add Winter Term courses.16 Last date to drop Winter Term courses without financial penalty.

February 200916-20 Mid-term reading week.27 Last date to drop Winter Term courses.

March 200916 Registration for Spring-Summer Session courses begins on QCARD.

April 20093 Winter Term classes end.4-8 Winter Term pre-exam study period.9-25 Final examinations.10 Good Friday – exams will not be held.25 Winter Term ends.

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Julia Zhu I am the instructor for your course ECON 111*S. Currently, I am a Ph.D. candidate in the Department of Economics at Queen’s University. My e-mail address is: [email protected] and my telephone number is 613-533-6660. My office is Mac-Corry A424. The office hours for this course are Thursdays 9:00 am - 12:00 p.m. The website for the course is: http://qed.econ.queensu.ca/walras/custom/100/firstyear/corresp/index111.html. Economics Discussion Forum or Chat Line- http://www.econ.queensu.ca/discus/ is another very important on-line resource for this course. Please make frequent visits to these web sites to keep yourself up-to-date about the course. The midterm exam and solutions to assignments and mid-term exam will be posted in the course website. Any changes in the office hours or important notices will be posted on the Chat Line. Please feel free to ask me as many questions regarding the course materials as you want. Always remember that there are no ‘stupid questions’ in my course. You can contact me by phone or come to my office during the office hours. If you cannot contact me during the office hours, you are always welcome to send me e-mails or post questions/comments on the Chat Line. I will respond to e-mails or questions/comments posted on the Chat Line as early as possible. I highly encourage everybody to take the advantage of the Chat Line. If you need to meet me or call me outside my scheduled office hours, please feel free to send me an e-mail to make an appointment. I look forward to teaching ECON 111*S by correspondence.

TABLE OF CONTENTS GUIDE TO CORRESPONDENCE STUDY........................................................................................... QLINK E-MAIL & WEB-CT.................................................................................................................. Introduction to Microeconomics..................................................................................... Introduction - i

Introduction......................................................................................................... Introduction - i Readings............................................................................................................. Introduction - ii Course Outline .................................................................................................. Introduction - iii Assignments, Examinations and Grading ......................................................... Introduction - iv Assignment Schedule........................................................................................ Introduction - vi Inquiries ........................................................................................................... Introduction - vii Method of Study ............................................................................................. Introduction - viii

Optional Assignment #1 ............................................................................................... Introduction - ix Optional Assignment #2 .............................................................................................. Introduction - xii PART I

Introduction................................................................................................................... Part I - 3 CHAPTER 1: ECONOMIC ISSUES AND CONCEPTS ............................................ Part I - 3 CHAPTER 2: HOW ECONOMISTS WORK ............................................................. Part I - 7 CHAPTER 33: THE GAINS FROM INTERNATIONAL TRADE (PP 802-13)........ Part I - 9

PART II

DEMANDAND SUPPLY APPLICATIONS............................................................ Part II - 15 CHAPTER 3: DEMAND, SUPPLY, AND PRICE................................................... Part II - 15 CHAPTER 4: ELASTICITY ..................................................................................... Part II - 20 CHAPTER 5: MARKETS IN ACTION.................................................................... Part II - 29

PART III

HOUSEHOLD DECISIONS ....................................................................................Part III - 34 CHAPTER 6: CONSUMER BEHAVIOUR ............................................................Part III - 34 SUPPLEMENTARY CHAPTER: OTHER HOUSEHOLD DECISIONS ..............Part III - 42

PART IV

PRODUCER THEORY............................................................................................Part IV - 51 CHAPTER 7: PRODUCERS IN THE SHORT RUN ..............................................Part IV - 51 CHAPTER 8: PRODUCERS IN THE LONG RUN ................................................Part IV - 59

PART V OUTPUT MARKETS................................................................................................Part V - 63 CHAPTER 9: COMPETITIVE MARKETS .............................................................Part V - 63 CHAPTER 10: MONOPOLIES, CARTELS AND PRICE DISCRIMINATION….Part V - 70 CHAPTER 11: IMPERFECT COMPETITION & STRATEGIC BEHAVIOUR…..Part V - 75 CHAPTER 12: ECONOMIC EFFICIENCY & PUBLIC POLICY ………………..Part V - 82

PART VI

THE GAINS FROM TRADE REVISITED .............................................................Part VI - 87 CHAPTER 33: THE GAINS FROM INTERNATIONAL TRADE (PP 813-22)…Part VI - 87

CHAPTER 34: TRADE POLICY ...........................................................................Part VI - 90

PART VII CHAPTER 13: HOW FACTOR MARKETS WORK............................................ Part VII - 93

FORMS FORMS &. . . Library Loan Request Form End-of-Year Course Evaluation Assignment Cover Sheets Academic Change Form Biographic Change Form Transcript Request Form

January 2009

Correspondence Study

Q & A COMPENDIUM

Fall-Winter 2008-09

MOVING?

PLEASE REMEMBER: If you move, inform the University as soon as possible.

• change your mailing address on QCARD • or complete the Biographic Change form in the Forms section of the course guide and send it to the

Office of the University Registrar — address is on the form• the University’s records will then be updated so that we have your current address. • a change of address will NOT update your exam location. If, as a result of moving, your EXAM

LOCATION must be changed, notify CDS by telephone at 613 533-2470, attention Candy Randall-Quesnel or fax 613 533-6805 or email [email protected]

Q & A COMPENDIUM TABLE OF CONTENTS

IMPORTANT ACADEMIC DATES FOR CORRESPONDENCE COURSES . . . Compendium - i

Continuing & Distance Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - ii

Academic Success . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - ii

Computer Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - v

Student ID Card . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - v

Library Access . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - v

Course Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - vi

Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - vii

Examinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - x

Adding or Dropping a Course . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - xiv

Grades . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compendium - xvi

Compendium - i

IMPORTANT ACADEMIC DATES FOR CORRESPONDENCE COURSES

Register early to avoid disappointment; all correspondence courses have limited enrolments.

EVENT DATES

Fall Term Begins 8 September 2008Fall - Winter Session Begins 8 September 2008Winter Term Begins 5 January 2009

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Last date to register/add Fall and Fall - Winter courses 19 September 2008After September 19 students must appeal in writing to the Associate Dean (Studies)

and pay a registration administration fee.

Last date to register/add Winter courses 16 January 2009After January 16 students must appeal in writing to the Associate Dean (Studies)

and pay a registration administration fee.

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Deadline for Dropping a Course (Full Refund)Fall term courses 19 September 2008Fall - Winter session courses 19 September 2008Winter term courses 16 January 2009

Deadline for Dropping a Course (No Academic Penalty)Fall term courses 31 October 2008Fall - Winter session courses 16 January 2009Winter term courses 27 February 2009

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Deadline for requests to change Exam Centre location Fall term courses 31 October 2008Fall - Winter session courses 16 January 2009Winter term courses 27 February 2009

Register with Health Counselling & Disability Servicesfor Special Exam Accommodation Fall, Fall-Winter, Winter courses as soon as possible

after registrationÈ

Final Examinations*Fall term courses 3 - 18 December 2008Fall - Winter session courses 9 - 25 April 2009Winter term courses 9 - 25 April 2009

*The University reserves the right to adjust the published exam period dates, as required.

Compendium - ii

Welcome to correspondence study!

The series of questions and answers below are grouped under headings to help you find theinformation you need quickly. Still have questions? Or suggestions? Please contact us!

Throughout this document, Continuing & Distance Studies is referred to as CDS.

Continuing & Distance Studies

How do I contact CDS?

LocationThe Division of Continuing & Distance Studies/Faculty of Arts & ScienceF-200 Mackintosh-Corry Hall (main level)68 University AvenueQueen's UniversityKingston, ON K7L 2N6

HoursMonday to Friday 9:00 a.m. - 4:00 p.m.

Telephone number613 533-2470

FAX number613 533-6805 • our fax machine receives 24-hours per day

Web sitehttp://www.queensu.ca/cds/• Includes current correspondence offerings (with course outlines), admission,

registration and fee information, important academic deadline dates, links to studentresources, and more

E-mail [email protected]• Can’t find the information you need on the CDS web site? Please send us an email.

Academic Success

How can I maximize my chances of doing well in my correspondence course?

• Ensure you have all the materials necessary to get started on your course: course guide,textbooks and any other items specified in your course guide.

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• Allot a specific amount of time each day or each week to study in a quiet place awayfrom distractions.

• Note the assignment due dates in your course guide. Read your course guide todetermine what the instructor is asking you to do in order to prepare each assignment,e.g. textbook readings, supplementary library readings, or accessing multimediapresentations, etc. Then, working back from the due date, you will be able to plan aschedule that will enable you to complete the work and submit your assignment ontime.

• Try the Assignment Calculator at: http://www.queensu.ca/qlc/calculator.html for helpin planning your assignment completion.

• Some correspondence students have found that initially their grades are lower thananticipated. This is not unusual as it may take time to familiarize yourself with yourinstructor's expectations; it is important to be aware of this so as not to becomediscouraged. If you encounter difficulty with your courses, we encourage you to get intouch with your instructor or CDS.

What sort of time commitment will my correspondence course require?

• You can expect to spend at least 15 hours per week studying and preparing assignmentsfor a 12-week half-credit or a 24-week full-credit correspondence course.

• More time is required for a full-credit course in the compressed spring/summersession.

What is academic integrity?

• The following is excerpted from Academic Regulation 1 Academic Integrity in theArts & Science Calendar

For the most recent version of this academic regulation, please consult the internet atwww.queensu.ca/artsci. The Queen’s University Senate Policy on Academic Integrity may be found onthe internet at www.queensu.ca/secretariat/senate/policies/AcadInteg.html.

a DEFINITIONAcademic integrity provides a foundation for the “freedom of inquiry and exchange of ideas”fundamental to the educational environment at Queen’s University (seewww.queensu.ca/secretariat/senate/policies/princpri/index.html). As a member of the Centrefor Academic Integrity (CAI), Queen’s subscribes to the definition of academic integrity “as acommitment, even in the face of adversity, to five fundamental values: honesty, trust, fairness,respect, and responsibility” ( see www.academicintegrity.org/ )

c DEPARTURES FROM ACADEMIC INTEGRITYAny departure from these values compromises the “free enquiry and the free expression ofideas, both of which are basic to the University’s central purpose”(www.queensu.ca/secretariat/senate/policies/princpri/index.html). The following list defines thedomain of relevant acts without providing an exhaustive list:

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i Plagiarism (presenting another’s ideas or phrasings as one’s own without properacknowledgement)Examples: copying and pasting from the internet, a printed source, or other resourcewithout proper acknowledgement; copying from another student; using directquotations or large sections of paraphrased material in an assignment withoutappropriate acknowledgement; submitting the same piece of work in more than onecourse without the permission of the instructor(s).

ii Use of unauthorized materialsExamples: possessing or using unauthorized study materials or aids during a test;copying from another’s test paper; using unauthorized calculator or other aids during atest; unauthorized removal of materials from the library, or deliberate concealment oflibrary materials.

iii Facilitation (enabling another’s breach of academic integrity)Examples: making information available to another student; knowingly allowing one’sessay or assignment to be copied by someone else; buying or selling of term papers orassignments and submitting them as one’s own for the purpose of plagiarism.

iv Forgery (submitting counterfeit documents or statements)Example: creating a transcript or other official document.

v Falsification (misrepresentation of one’s self, one’s work or one’s relation to theUniversity)Examples: altering transcripts or other official documents relating to student records;impersonating someone in an examination or test; submitting a take-home examinationwritten, in whole or in part, by someone else; fabricating or falsifying laboratory orresearch data.

h FAILURE TO ABIDE BY ACADEMIC RULESStudents must abide by all Faculty and University academic rules, including rules imposed bycourse instructors, or others (for example, teaching assistants, laboratory demonstrators, guestor substitute instructors) regarding the preparation, writing, and submission of assignments, orthe writing of tests and examinations. Students must also abide by other University-wideacademic regulations, such as those governing ethics reviews. For penalties that can be assessedand procedures to be followed if a student fails to abide by academic rules, see Regulations 1dand e (available online at http://www.queensu.ca/calendars/artsci/pg4.html). For a complete list of the Academic Regulations at Queen's University, please consult the Facultyof Arts and Science Calendar. You may view the Calendar online at:http://www.queensu.ca/calendars/artsci/

I would like help resolving a problem with my course, choosing my courses, planningmy degree program, improving my study skills, etc. What can I do?

• Call CDS at (613) 533-2470 to arrange an appointment with an academic advisor.• Visit http://www.queensu.ca/artsci/advising/index.html for a comprehensive list

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• of advising services and resources available on campus• Visit the Learning Commons in person at Stauffer Library or visit the web site

http://www.queensu.ca/qlc/ for information about study skills workshops and otheracademic resources available to you.

Computer Requirements

Do I need to have a computer to take correspondence courses?

• Internet service is required for all correspondence courses to access online materials onWebCT and for email communication with the University.

• A current operating system and Mozilla Firefox (PCs) or Safari (Macs) are preferredbroswers for WebCT

• High speed Internet is recommended for streaming media• See the Email & WebCT page in your course guide for details on how to activate your

NetID and begin using Queen’s internet resources.• If you do not have Internet service, please contact CDS for assistance.

Student ID Card

I’m a new student. How do I get a student card? What do I use it for? • In Spring - Summer, all new students will be mailed a validated off-campus student card,

even if they are taking on-campus courses. Returning students will be mailed avalidation sticker.

• Students who take on-campus courses in the Fall-Winter need to trade in their off-campus card for a photo ID card at the Office of the University Registrar, 74 UnionStreet, Gordon Hall Room 125.

• Students are required to show their student card when writing final exams andborrowing library materials in person.

• For more information see: www.queensu.ca/registrar/studcard

Library Access

Will I have access to Queen’s Library if I am at a distance?

• Any supplementary or additional readings which may be listed in your course guide areavailable from Stauffer Library's Circulation Desk. If you are not within travellingdistance of the university, you may use the distance education library loan request form(http://library.queensu.ca/librequest/de_request.php or the paper form found in theFORMS section of your course guide) to request books from this list. If you are able tocome to the campus, bring your student card with you so that you can charge booksout of the Library. Stauffer Library is open during the week and is also usually open onthe weekends: call ahead for exact hours (613) 533-2524 or visit the web site: http://library.queensu.ca/

Compendium - vi

• The loan period for books is 3 weeks days (excluding mailing time for those orderingthrough the mail). The length of time allowed for mailing will vary with the distance thebooks are sent from the University. A fine of 40 cents per day per book will be chargedfor books not returned on time.

• Stauffer Library will send the books to you by courier at no charge. You may returnthem by Canada Post. There is a $3.00 cost per requested photocopied article. There isno charge for borrowing books.

• You are expected to securely wrap any materials which you return through the mailand pay the replacement cost and a processing fee for any book which you damage orlose.

Am I able to borrow books from another university library?

• As a student registered in an Ontario university, you automatically have borrowingprivileges in all other Ontario university libraries (with the exception of OISE and theUniversity of Toronto). All you need is a student card with a current validation sticker. If you did not receive a validation sticker, you may request one by writing to theRegistrar's Office, Richardson Hall, Queen's University, Kingston, Ontario, K7L 3N6. Remember to include your name, address, and student number in your letter.

• If you want to gain admittance to libraries affiliated with educational institutions outsideof Ontario, Queen's can supply you with a letter of introduction. Address yourrequests to the Chief Librarian, Stauffer Library, Queen's University, Kingston, Ontario,K7L 5C4.

Course Materials

I’ve just signed up for a correspondence course. How do I begin?

• The first step is to get your textbooks and course guide package from the Campus Bookstore.

• Texts and course guide packages are generally available about two weeks before the beginningof term.

• The course guide package is also available to registered students on WebCT<www.its.queensu.ca/webct> beginning the first day of term.

• If you are in Kingston, you can pick up the texts and course guide in person from the CampusBookstore (it is located in Clark Hall on Queen’s Main Campus).

• Or order online from the Bookstore web site <www.bookstore.queensu.ca>, by fax (613)533-6419, or phone at (613) 533-2955 or (800) 267-9478 and have the course materialsshipped to you.

Compendium - vii

What is the course guide package?

• The course guide package contains the lessons, assignments, a schedule for submittingassignments and administrative information.

Is there a charge for the course guide package?

• Yes. The printed course guide package distributed through the Bookstore is sold for a minimalprice that covers printing and handling costs.

• However, registered students have access to the course guide on WebCT<www.its.queensu.ca/webct> beginning the first day of term. Students may download thecourse guide file (in .PDF format) to their own computers and print sections as required.

• Adobe Acrobat Reader is required to view the file. If you do not already have this program onyour computer, download it for free from <www.adobe.com>

Once I have the textbooks and course guide package, can I begin to work on thecourse?

• Yes. Look through the course guide to familiarize yourself with its contents. Be sure to readthe introductory pages to see how to contact the instructor, to find the assignment due datesand lesson schedule and any special instructions the instructor has given.

Assignments

How do I submit my correspondence assignments?

• Check your course guide: Most courses accept assignments on paper; these may besubmitted in person, by fax or by mail to CDS. Some courses permit or require electronicsubmission by email or WebCT. Your course guide will tell you.

When do I submit my assignments?

• Ensure that your assignments arrive at CDS on or before the due date. We record the dateassignments arrive at the office, not the postmarked date.

Before Submitting Your Assignment

C make sure that your work is legible, double-spaced, and on 8 ½ x 11 inch paperC number the pages of your assignmentC write your name, student number, and course on each page of your assignmentC for assignments on paper, complete and attach an Assignment Cover Sheet (found in the

Forms section of the course guide) to the front of each assignment. C keep a copy of your assignment. If your assignment is lost in transit, we will ask you to

resubmit it.

Compendium - viii

Mailing Assignments

• attach an Assignment Cover Sheet to the front of your assignment and mail it to the addressindicated on the cover sheet.

Submitting Assignments in Person

• place your assignments in the drop box found in the Arts & Science Faculty Office (F-200,Mackintosh-Corry Hall). If the office is closed, there is an after hours drop-off slot next tothe front door.

• No envelope is required, but please remember to staple your Assignment Cover Sheet to yourassignment before handing it in.

Faxing Assignments

• our FAX number is 613 533-6805 and the machine receives 24 hours a day.• remember to include an Assignment Cover Sheet and indicate the total number of pages being

FAXed. • include the following information on every page of your FAX, eg.Jane Smith Student# 123-4567 Course Code Page 1 of 5 Tel# 613-555-2345• leave w-i-d-e margins (one inch) on top, bottom and sides of each page of your FAX.• check your confirmation report to ensure all pages have transmitted. We check incoming

faxes for legibility and number of pages transmitted—if there is a problem we will contactyou.

• please keep the original copy of your assignment; do not mail it to us in addition to FAXing it.

• Sorry, we cannot return graded assignments by FAX.

Submitting Assignments Electronically (E-mail and WebCT)

• See your course guide for details.• Assignments may be submitted by email only in instances where the instructor or tutor-

marker has indicated that e-mailing is acceptable.

When will my assignment be marked and returned?

• The amount of time required to return graded assignments varies from course to course. • We try to have your assignments graded and returned to you within two weeks of receipt,

but it may take as long as four weeks for an assignment to be returned. You may,therefore, be required to submit an assignment before the previous one has beenreturned.

What happens if I submit an assignment early?

• If you submit an assignment early, it will not necessarily be graded early since, for the sake offairness and consistency of marking, tutor-markers prefer to grade several assignments at asitting.

Compendium - ix

What happens if I submit an assignment late?

• Check the late assignment policy in your course guide. • If you submit an assignment late you can expect that the grading will be delayed, since the

tutor-marker will have moved to the next section of the course and will mark yourassignment as time permits.

• If you have an illness or other extenuating circumstances which prevent you from submittingan assignment on time, contact your instructor to request an extension. If you have difficultyreaching your instructor, contact us at CDS.

• Do not send the bulk of your assignments near the end of the course. This will create majordelays in grading your assignments so that you may not have any feedback on your workbefore the final exam. It may result in a loss of marks or even rejection of your assignments. If you have questions regarding submitting late assignments, contact your instructor.

How is my assignment returned?

• If you are on campus regularly, please pick up your paper-based assignment from theContinuing & Distance Studies/Faculty of Arts & Science Office, F200 Mackintosh-Corry Hall. Assignments are filed alphabetically by last name in the assignment pick-up cabinet.

• If you are not on campus regularly, check the appropriate box on the assignment cover sheetand fill in your mailing address. It will be mailed back to you.

• If a preference as to assignment return is not indicated, the assignment will be held for pickup.

• Assignments submitted electronically are generally returned electronically.

What is an “A”, “B”, “C” grade, etc?

• The following table shows the alphabetical grade and its numerical equivalent in the Facultyof Arts & Science at Queen's University.

A 80 to l00 per centB 65 to 79 per centC 50 to 64 per centF less than 50 per cent

• The grade will be written on your assignment. However, the comments made by theinstructor or tutor-marker are far more important than the grade, as they are designed tohelp you improve your work.

Compendium - x

Examinations

Most, but not all, correspondence courses have final exams. Consult your course guidefor information on examinations and the use of special aids (dictionary, open book,calculators) during the exam.

Who is a KINGSTON student? (Exam Centre Location for Kingston ON Campus is #4251)• A KINGSTON student is one who is registered in a day or evening course as well as

correspondence course(s) in the same term.

Who is a DISTANCE student?

• A DISTANCE student is one who is registered exclusively in correspondence course(s) in agiven term and does not reside in Kingston or surrounding area.

What is an Exam Centre?

• An Exam Centre is a site where a student writes a proctored (supervised) exam. When youregistered for your correspondence course on QCARD, you were prompted to enter anExam Centre code.

I don’t remember which Exam Centre code I entered on QCARD. How can I find outwhere I am writing my exam?

• You can view your Exam Centre code for correspondence courses on QCARD afterregistration.

• Requests to change exam centre locations must be directed to:Candy Randall-Quesnel, Correspondence Examination Coordinator, at Continuing &Distance Studies (email: [email protected], fax: 613 533-6805, telephone: 613 533-6000, Ext. 77188).

Here are some rules which govern where you will write your exam:• if you are a KINGSTON student (see definition above) you MUST write your exam(s)

on the Kingston campus (Exam Centre Location for Kingston ON Campus is #4251)• only DISTANCE students (see definition above) are permitted to write at off-campus

Exam Centres• all registrations will be checked to determine student eligibility to write at off-campus

Exam Centres• ***it is the student’s responsibility to read all of the information/regulations pertaining to

exams contained in both the course guide (see Guide to Correspondence Studiessection) and the regulations in the current Arts and Science calendar. Furthermore,students are expected to write examinations at the date/time published and are not tobook vacations, appointments, etc. during the exam session.***

Compendium - xi

• employment is common to most correspondence students and, although weacknowledge its importance, it is not considered sufficient grounds to reschedule anexam. Please direct any questions to the Correspondence Examinations Coordinator bythe published deadlines.

I didn’t indicate an Exam Centre when I registered. What happens in this case?

• The Correspondence Examination Coordinator will assign an Exam Centre code afterlooking at your course registration for the term to determine if you are Kingston or Distancestudent (see definitions above).

• Distance students will be assigned an Exam Centre code based on their “mail” address onQCARD. This is why it is important to keep this address up to date at all times.

• Please remember: students are responsible for keeping the ‘mail’ address onQCARD up to date at all times as this is the only address used by the University forthe purposes of scheduling exams.

How can I change my Exam Centre? Is there a fee involved?

To request a change to your Exam Centre:• you must notify Candy Randall-Quesnel, the Correspondence Examination Coordinator• you must request the change prior to the published deadlines (below) or you will be

subject to an administrative fee of $100.00 per exam affected!• remember that only DISTANCE students will be permitted to write at off-campus

Exam Centres

Deadlines for changing Exam Centres for Fall 2008 and Fall - Winter 2008-09 Examination SessionsFall Term 31 October 2008Fall - Winter Session 16 January 2009Winter Term 27 February 2009

How will I know the date, time, and location of my exam?

If you are a KINGSTON student, you will write your exam on the Kingston campus. Youwill be required to access the exams schedule at www.queensu.ca/registrar/exams/ for bothon-campus and correspondence exam details. The exam timetable is posted about eightweeks before the exam period begins (3 - 4 weeks for Spring, Spring/Summer and Summerexams). Kingston students will also be linked to the Queen’s exam schedule through theWeb-CT course site using their Queen’s NetID.

* If you are a DISTANCE student, you will be notified via Queen’s email when examcentre details become available on your Web-CT course site. Exam information will beposted on Web-CT as quickly as the proctors from the external Exam Centres canprovide the final details.

a) Students who do not have access to the Internet must notify the ExaminationsCoordinator immediately following registration.

Compendium - xii

b) Distance students writing in “remote” areas where an established test site does notalready exist (as determined by the Examinations Coordinator) will not need to accessWeb-CT for this purpose because they are directly involved in setting up the actual examwith the proctor.

c) Incarcerated students will be notified of the date/time/location of their exam in writingapproximately three weeks before the exam session begins.

d) Distance students who have a deferred exam from a previous term must notify theExaminations Coordinator by the “deadline for changing exam centres” (see above)pertaining to the exam session in which they expect to write.

N.B. See your course guide for information on activating your Queen’s NetID andaccessing WebCT or visit: http://www.queensu.ca/its/netid.html

Are exams at the Kingston campus and at off-campus Exam Centres scheduled at thesame time?

• The date and time of an exam is normally the same for both on-campus and off-campuscentres, but the AM and PM start times may vary for exams written at off-campus examcentres.

• Occasionally, it may be necessary for the Correspondence Examinations Coordinator tochange the date/time of an exam to resolve conflicts with other exams or proctor access atthe off-campus exam centres. Notification will be sent to your Queen’s email account inthese cases.

Are correspondence course exams held in the evenings or on weekends?

• NO! Weekend or evening exams are rarely scheduled at off-campus exam centres. Youmay expect that all exams written at off-campus sites will be held during the normal workday, either in the morning or early afternoon.

I can’t write my exam as scheduled. How can I change the date and time of my exam? Isthere a fee involved?

• Dates and times for examinations are set by the University and students are expected tocomply! DO NOT schedule vacations, appointments, etc., during the exam period. Consultyour course guide or the Sessional Dates section of the current-year Arts and Sciencecalendar for the exam period. Note: The University reserves the right to adjust thepublished exam period dates, as required.

• Any student who requests and is permitted a change in the date/time of an exam will besubject to an administrative fee of $100.00 per exam affected, regardless of the timing ofthe request, providing the request is first approved by the Correspondence ExaminationCoordinator, the course instructor, and/or the Associate Dean of Studies

Compendium - xiii

• Appealing to write the exam EARLIER than scheduled: such appeals are very rarelysuccessful even with extenuating circumstances. Students must first notify theCorrespondence Examination Coordinator, Candy Randall-Quesnel, and appeal in writing toboth the course instructor and the Associate Dean of Studies. The Associate Dean of Studiesmay be contacted through the Faculty of Arts & Science, F200 Mackintosh-Corry Hall,Queen’s University, Kingston, Ontario K7L 3N6 or by calling (613) 533-2470.

• Appealing to write the exam LATER than scheduled: students must appeal in writing to boththe course instructor and the Correspondence Examination Coordinator, Candy Randall-Quesnel.

I’m scheduled to work at the same time as I’m scheduled to write my exam. Can Ireschedule my exam for this reason?

• NO. Employment is common to most correspondence students and is not considered avalid reason to postpone or reschedule an exam.

Do I need to show identification at my exam?

• Yes, photo id is required for exams. Students are required to bring their Queen’s PhotoID to all exams.

• Students writing exams without a Queen’s Photo ID card (or a Queen’s off-campus cardwith supporting photo ID for distance students) must contact the Correspondence ExamsCoordinator ahead of time for further instructions.

• Students may obtain a replacement student card (photo ID or off-campus card) for $20 atthe Office of the University Registrar, 74 Union Street, Gordon Hall, Rm 125; telephone(613) 533-2040 (fall-winter office hours 8:30 am - 4:30 pm).

• The Queen’s photo ID (or off-campus card) does not need to be validated with a sticker forthe purposes of writing an exam.

Are there correspondence exam accommodations for disabled students?

• Students requiring accommodations for exams in correspondence courses due to specialneeds must contact the Correspondence Exams Co-ordinator and Health, Counselling andDisability Services by the published deadlines to be assessed so that arrangements can befinalized well in advance of the exam period.

Who do I contact if I change my address?

• Change your address on QCARD.• However -– a change of address will NOT update your exam location. • If, as a result of moving, your EXAM LOCATION must be changed, notify CDS by telephone

at 613 533-2470, attention Candy Randall-Quesnel, or fax 613 533-6805 or [email protected]

• Students are responsible for keeping the ‘mail’ address on QCARD up to date at alltimes as this is the only address used by the University for the purposes ofscheduling exams.

Compendium - xiv

ESTABLISHED CENTRES FOR WRITING CORRESPONDENCE EXAMS

British Columbia0015 Comox0071 Kelowna0143 Trail0158 Vancouver0159 Victoria

Alberta0215 Calgary0229 Edmonton0238 Ft. McMurray

Saskatchewan0529 Regina0536 Saskatoon

Manitoba0744 Thompson0764 Winnipeg

Northern Ontario1028 Bracebridge1101 Elliot Lake1251 Kapuskasing1252 Kenora1253 Kirkland Lake1305 Marathon1327 North Bay1452 Sault Ste. Marie1454 Sudbury1476 Thunder Bay1477 Timmins

Western Ontario2160 Guelph2276 London2351 Owen Sound2500 Sarnia2552 Windsor2553 Waterloo

Central Ontario3020 Barrie3051 Collingwood3176 Hamilton3351 Orillia3352 Oshawa3376 Parry Sound3377 Peterborough3400 Richmond Hill (only availableduring Spring/Summer term)3451 St. Catharines3476 Toronto3477 Brampton3478 Mississauga

Eastern Ontario4027 Belleville4028 Brockville4051 Cloyne4052 Cornwall4176 Hawkesbury4251 Kingston4350 Ottawa4376 Pembroke4451 Smiths Falls

Quebec5113 Montreal - Concordia

New Brunswick6036 Fredericton6085 Moncton6136 Saint John

Nova Scotia6202 Amherst6250 Halifax6336 Sydney6343 Truro

N.T.6778 Yellowknife

Yukon6965 Whitehorse

Newfoundland7060 Cornerbrook 7151 Gander7457 St. John’s

International8102 Edinburgh, Scotland8125 Fort Myers, Florida USA8158 Glasgow, Scotland8176 Bermuda8179 Hong Kong8183 International Study CentreHerstmonceux Castle, England8281 London, England8329 New York, NY, USA8465 Seoul, Korea8485 Trinidad

Penitentiaries9028 Bath Institution9051 Collins Bay9127 Frontenac Institution9151 Gravenhurst9226 Joyceville9251 Kingston9302 Millhaven9551 Warkworth

Adding or Dropping a Course

The rules that govern adds and drops are established by Queen's, not CDS. Therefore, ifyou wish to add a course or drop a course, you must follow the University policies. Acomplete list of these regulations can be found in the Faculty of Arts and Sciencecalendar. A summary of the rules follows.

Compendium - xv

How do I add a course?

• if you are already registered in a course and want to add a course in the same term, add thecourse online on QCARD

• alternatively, fill out the Academic Change Form at the back of the course guide and fax ormail it to CDS

• remember to contact the Campus Bookstore to receive the textbooks• students residing overseas must take into account the longer transit time for course materials• please add any courses and request course materials well before the deadline dates.

How do I drop a course?

• you may drop a course online on QCARD. • alternatively, complete and fax or mail the Academic Change Form at the back of the course

guide or simply write us a letter before the last date to drop without failure. Remember toinclude your student number and mailing address.

• Be sure to familiarize yourself with the drop deadline dates. They are listed in the courseguide and in the Arts & Science course calendar: http://www.queensu.ca/calendars/artsci/index.htm

• Failure to submit assignments does not constitute withdrawal from the course, and doing sowithout officially dropping the course will result in your instructor assigning you a failinggrade.

Will I get a fee refund?

• Fee refunds are calculated from the date the course is dropped from your academic record.• When the full-refund period ends an initial 25 per cent is deducted from the total fee

charged; thereafter a daily percentage is deducted from the total fee charged until no refundis left.

• The last date to drop a course and still receive a full refund is earlier in the term than the lastdate to drop a course without receiving a failing grade.

• Students who need assistance in calculating their fee refund after officially dropping a courseshould contact the Office of the University Registrar at 613 533-6894

• You may also visit http://www.queensu.ca/registrar/fees/refund.html

It is past the drop deadline date, but I can’t finish the course. What can I do?

• If, after the academic deadline to drop has passed, you encounter extenuating circumstancesthat prevent you from continuing with the course, you may appeal to the Associate Dean ofStudies for permission to drop the course late.

• Such an appeal must be made in writing and be accompanied by a $25 non-refundablecheque payable to Queen's University. The appeal should include your name, studentnumber, mailing address, and email address. State the reasons you are requestingpermission to withdraw from the course. Supporting documentation (e.g. a medicalcertificate in the case of illness) should also be provided. Direct your appeal to:

Compendium - xvi

Associate Dean of StudiesFaculty of Arts & ScienceF200 Mackintosh-Corry Hall68 University AvenueQueen's UniversityKingston, Ontario K7L 3N6

• Further information is available online at: http://www.queensu.ca/artsci/• Click on “Appeals”.• In some cases, rather than appealing to drop the course, the student may request:

C an incomplete (IN) grade C an exam deferral (ED)C aegrotat standing (AG) an estimated final grade based on course work • see Regulation 18 in the Arts & Science Calendar:

http://www.queensu.ca/calendars/artsci/pg537.html or contact CDS at 613 533-2470 forfurther details.

Grades

When will I get my final grade?

• Marks reports (final grades) are made available on QCARD by the Office of the UniversityRegistrar approximately three weeks after the end of the examination period.

• If you have any questions concerning the receipt of your final grades, call the Registrar’sOffice at 613 533-6000, Ext. 74080.

How do I order an official transcript?

• Students requiring an official transcript may order it online at: http://www.queensu.ca/registrar/transcript/inform.html

• Alternatively, you may complete the Transcript Request Form found in the Forms section atthe back of the course guide; mail it to the address on the form.

• Or telephone 613 533-2219 for information on how to order an official transcript.

I am a visiting student and need my grade in order to graduate. How can I get it?

• If you are graduating from another university and require a final grade in order to completethe requirements for your degree, you may contact Continuing & Distance Studies/Faculty ofArts & Science at 613 533-2470 for assistance.

• Please be prepared to provide the name and position of the person at your home universitywho is to receive your grade. We will make every effort to notify your home university bythe required date.

• As confirmation of your final grade, you must order an official transcript from the TranscriptClerk at the Office of the University Registrar (see above) to be sent to the appropriateindividual at your home university.

Compendium - xvii

I want to request a review of my assignment and exam grades. What is theprocedure?

Academic Regulation 13 in the Arts & Science Calendar

TERM WORKa Students have the right to a review of any grade assigned in a course subject to themarking scheme set out by the course instructor(s). The student should request an informalreview with the instructor concerned, and instructors are strongly encouraged to consent.This request should be made within 21 calendar days of the grade being received. Usuallythe instructor will provide a reconsidered grade within 21 calendar days of the receipt of therequest and any further information being submitted by the student. If the request for aninformal review is denied, the student may ask for the assistance of the Office of theAssociate Dean (Studies) in order to facilitate an informal review. If a more formal appeal of term work is proposed, the student should refer to AcademicRegulations 29 and 30, in Appeal of Academic Decisions<http://www.queensu.ca/calendars/artsci/pg32.html> Moreover, in any formal appeal ofterm work, the student must accept the responsibility for ensuring that the term work atissue is in fact the original term work submitted for evaluation.

FINAL EXAMINATIONS AND FINAL GRADESStudents have the right to a review of their final examination papers. For this purpose, finalexamination paper means the final examination question paper in a course and the gradedanswer paper written by the student which, by Senate policy, must be retained for a periodof 12 months.

i As a first step, the student should request an informal review with the instructorconcerned, and instructors are strongly encouraged to consent. This request must be madewithin 21 calendar days of receipt of the final mark. The instructor will normally provide areconsidered grade within a further 21 calendar days of receipt of the request and anyfurther information being submitted by the student. However, access to the finalexamination paper may not be granted before the final marks are released.

ii If the request for an informal review is denied or if the student is not satisfied with theinstructor’s decision following a formal review of the examination or final grade, the studentmay appeal the decision, in writing, to the Associate Dean (Studies) (see Regulation 30, inAppeal of Academic Decisions <http://www.queensu.ca/calendars/artsci/pg32.html>) . Theappeal must be submitted to the Arts and Science Faculty Office within 21 calendar days ofreceiving the instructor’s decision. The appeal must include copies of all relevant documents,and be accompanied by the Faculty appeal fee. (See chapter on Fees for Faculty appealcharge.)

É

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Correspondence Study Q&A CompendiumE-MAIL AND WEB-CT ACCESS

Introduction

Every student at Queen's is entitled to an E-mail / Internet account. Students are required to obtain anduse the University's e-mail system to communicate with the University and to receive information fromthe University.

• GetID (http://www.its.queensu.ca/itsc/useIT/qcard_getid/getid.html) is the process students gothrough to establish their e-mail / internet account.

• NetID (http://www.its.queensu.ca/netid/) is the common sign-on you will use for services andapplications operated by ITServices on the Queen's network, including e-mail.

IMPORTANT: If you do not have Internet access, please contact Continuing & DistanceStudies as soon as possible after registration.

NetID

ITServices has a common sign-on model for services and applications on the Queen’s network. Thecommon sign-on will use a Queen's Network Userid and Password (NetID).

What is NetID?

• You may know it as your Userid or log on. NetID will be the Userid you need to sign on to theapplications and services that are operated by ITServices such as e-mail, WebCT, dial-in accessand new web services.

• Many people will recognize their NetID as the unique part of their Queen's e-mail address (thepart in front of @queensu.ca for example).

• When asked for your NetID, type the first part of your Queen's e-mail address.Example: Your e-mail address is: [email protected], then helpme is your NetID.

WebCT (Web Course Tools) is the online course management system located at:www.its.queensu.ca/webct/

Requirements:

• Internet access

• Minimum Computer requirementsCurrent Operating System (Windows or Mac)Mozilla Firefox Browser preferred or Safari (for Mac)High speed internet recommended for streaming media

• Browser settingsBrowser settings that are incompatible with WebCT tools frequently cause WebCT users toexperience problems with hyperlinks (nothing happens when you click on them), Chat, or theDiscussion Board (you can't read messages) as well as other WebCT features. Please check yourbrowser settings to make sure they are compatible with the settings described below.

StyleSheets Some browsers allow stylesheets to be disabled. Do not disable stylesheets.Cookies Browsers must be set to accept cookies.Javascript Both Java and Javascript should be enabled. (Javascript is called "Scripting" by

Microsoft.)Cache Cache should be set to "always reload a page".Pop-Up Blockers Browsers must be configured to allow pop-up windows for WebCT at Queen's.

Browser Tune-up

Either on the WebCT login page

or

http://www2.blackboard.com/tuneup

Problems (E-mail or WebCT)

Either submit your problem to ITS (http://www.its.queensu.ca/itsc/helpform.html) or phone 613-533-6666.

If you have added a course on QCARD and it doesn’t show up on your “my webCT” page after 24 hourse-mail [email protected] or phone 613-533-6000, ext. 74109

i

Economics 111*S Introduction to Microeconomics Introduction There are two main branches in Economics: Microeconomics and Macroeconomics. Economics courses are commonly divided into two sections to deal with "Micro" and "Macro" separately. Microeconomics (the subject of this course) by its name suggests that it is primarily concerned with the smaller economic agents - the consumer, the producer, the buyer, the seller, inputs, outputs, individual markets or a small set of closely connected markets, etc. Macroeconomics, on the other hand, is primarily concerned with the larger economic agents - governments, taxes, national income, inflation, monetary and fiscal policy. Whether you take Micro or Macro as your first course in economics will not hinder your understanding of the material. However, it is generally accepted that if one has a strong understanding of the micro concepts, one will have a stronger appreciation and awareness of macroeconomics; because macroeconomics is in a sense, the "summation" of microeconomics. The textbook for this course is Microeconomics, 12th Canadian Edition, by Ragan and Lipsey. This textbook has proven itself for many years and in many countries to be one of the best first year economics texts. It contains all of the material presented in a modern form with superb diagrams to aid the learning process. The Study Guide that accompanies the text is recommended, but not required. A course such as this at the university would have three lecture hours per week usually with an assignment to follow. On average you should spend about 10 - 12 hours per week on the course. Any questions about the grading of assignments or the mid-term should be directed to the instructor. The instructor will grade the final exam and will be available to answer questions about the course material. If you have any difficulties, do not hesitate to call for help. Inquiries Regarding Course Content Instructor: Julia Zhu Office Location: Mackintosh-Corry A424 Office Hours: Thursday s 9:00 am - 12:00 pm Inquiries concerning the course content should be addressed to me, the instructor. If you have difficulties with any of the assigned work, you can send questions by email ([email protected]) or you can phone me (613 533-6660). I also urge you to post questions about assignments and the content of the course on the course bulletin board and chat line and I will answer them there. There is a link to it from our course web page at: http://qed.econ.queensu.ca/walras/custom/100/firstyear/

ii

Inquiries Regarding Administrative Concerns General inquiries about adding or dropping courses, obtaining transcripts, paying fees, receiving fee refunds, changing your address, etc. should be directed to the Division of Continuing & Distance Studies/Faculty of Arts & Science Office, F-200 Mackintosh-Corry Hall, 68 University Avenue, Queen's University, Kingston, ON K7L 2N6. Please send any inquiries separately from your assignments. The Continuing & Distance Studies Office is open 9:00 a.m. to 4:00 p.m., Monday to Friday. The phone number is (613) 533-2470, the office FAX number is (613) 533-6805, the e-mail address is: [email protected]

iii

Readings All the required readings for the course are contained in the textbook or these course notes:

Christopher T.S. Ragan, and Richard G. Lipsey, Macroeconomics, 12th Canadian Edition. Published by Pearson Addison-Wesley, 2008.

Course Outline

PART I INTRODUCTION Chapter 1 Economic Issues and Concepts Chapter 2 How Economists Work Chapter 33 The Gains from International Trade (pgs 802-813) PART II SUPPLY AND DEMAND APPLICATIONS Chapter 3 Demand, Supply, and Price Chapter 4 Elasticity Chapter 5 Markets in Action

Optional Assignment #1, Due: February 2, 2009 PART III HOUSEHOLD DECISIONS Chapter 6 Consumer Behaviour Supp Chapter Other Household Decisions “Take home” Mid-Term Exam, Due: February 23, 2009 PART IV PRODUCER THEORY Chapter 7 Producers in the Short Run Chapter 8 Producers in the Long Run (Omit the Appendix) PART V OUTPUT MARKETS Chapter 9 Competitive Markets Chapter 10 Monopoly Chapter 11 Imperfect Competition and Strategic Behaviour Chapter 12 Economic Efficiency and Public Policy Optional Assignment #2, Due: March 18, 2009 PART VI THE GAINS FROM TRADE REVISITED Chapter 33 The Gains from International Trade (pgs 813-822) Chapter 34 Trade Policy PART VII INPUT MARKETS Chapter 13 How Factor Markets Work

iv

Assignments, Examinations and Grading There are two optional assignments, the solutions for which will be posted to the website according to the schedule below. You are required to complete a take home mid-term and a final examination to receive credit for the course. The distribution of marks is as follows:

Take Home Mid-Term 30% Final Examination 70% You must pass the final exam in order to pass the course.

The midterm will be posted on the course web site <http://qed.econ.queensu.ca/walras/custom/100/firstyear/> the week of February 2. You are required to obtain a copy of the mid-term from this site. If you do not have access to the Internet, it is your responsibility to contact Continuing & Distance Studies promptly (telephone 613 533-6000, Ext. 77770) to request that a copy of the mid-term be mailed or faxed to you. The mid-term is due back by February 23, 2009 Please note: NO MID-TERMS WILL BE ACCEPTED AFTER THE DUE DATE. This is designed to give you feedback on your mid-term performance before the drop date of February 27. You may email or call the instructor for your mid-term grade if you do not pick up or receive your graded mid-term by mail with adequate time to make a decision. Note that you must pass the final examination to pass the course. The same grading scheme is used for extramural and intramural students, as follows: 80% and above Grade A 65% - 79% Grade B 50% - 64% Grade C Below 50% Grade F 50% is the passing grade. The formal, supervised final exam will consist of three parts: multiple choice, true/false/uncertain, and long answer questions. To get practice in doing multiple-choice questions, be sure to see the ones in the Study Guide or on past exams. You are permitted to bring a non-programmable calculator to the final exam. Final Examination Period: 9 - 25 April, 2009 Students requiring accommodations for exams in correspondence courses due to special needs must contact Candy Randall-Quesnel and Health, Counselling and Disability Services immediately following registration to be interviewed/assessed so that arrangements can be finalized well in advance of the exam period.

v

Please read “Examinations” in the Q & A Compendium (at the front of this course guide) for IMPORTANT administrative details about final exams. ALL students residing in Kingston and vicinity MUST write their exams on the Kingston campus. They are required to access the exams schedule at www.queensu.ca/registrar/exams/ to find out the date, time, and location of their exam. Kingston students will also be linked to this site through their Web-CT course site. A Queen’s NetID is required to access Web-CT. Students who are eligible to write exams off-campus will be notified of exam arrangements on their Web-CT course site. A Queen’s NetID is required to access Web-CT. Please consult this course guide for information on how to activate your Queen’s NetID and access Web CT or visit http://www.queensu.ca/currentStudents/onlineResources/http://www.its.queensu.ca/itsc/useIT/qcard_getid/getid.htmlhttp://www.its.queensu.ca/students/ NB a) Students who do not have access to the Internet must notify the

Examinations Coordinator immediately following registration.

b) Distance students writing in “remote” areas where an established test site does not already exist (as determined by the Examinations Coordinator) will not need to access Web-CT for this purpose because they are directly involved in setting up the actual exam with the proctor.

c) Incarcerated students will be notified of the date/time/location of their

exam in writing approximately three weeks before the exam session begins.

ALL students are expected to write exams when they are scheduled. Exams will be held on a weekday commencing at 9 a.m. or 2 p.m. (AM and PM start times may vary at off-campus exam centre locations.) Questions? Direct any questions about final exam scheduling or location to the Correspondence Examinations Coordinator, Candy Randall-Quesnel, by e-mail [email protected], fax 613 533-6805, or by telephone 613 533-6000, Ext 77188.

Have you activated your NetID? You need a NetID to sign on to Queen’s e-mail and WebCT.

Ensure you receive important information, including exam schedule and location, by activating your NetID and checking your email and WebCT course site regularly.

Visit http://www.its.queensu.ca/students/

vi

Assignment Schedule The assignments are optional and due on the following dates if you wish to have them graded (assignments received after the deadline will not be marked). Note that the mid-term is required. NOTE: Please ensure that you attach an Assignment Cover Sheet (found in your FORMS

section at the back of these course notes) with each assignment you submit. To safeguard against loss, keep a copy of each piece of work you submit.

Assignment #1 (optional) February 2

REQUIRED Midterm “take home” exam February 23

Assignment #2 (optional)* March 18

Final Examination Period April 9 - 25

*Since this assignment comes late in the term, you may not get it back before the exam. However, if you make the effort to get it in on time, we’ll make every effort to grade it and make it available to you before the exam.

Assignment solutions will be posted to the website on the day after they are due. The mid-term exam will also be posted there and the answers to the mid-term will be posted a day or so after the due date. Visit the website by following the appropriate link from: <http://qed.econ.queensu.ca/walras/custom/100/firstyear/corresp/index111.html> Hard copies of the solutions will be returned to those who submit the mid-term exam and/or assignments. Correspondence students also have access to a Chat line. A link to the Chat line can be found on the course web page. At this site you will be able to pose questions to the instructor, or just “chat” with others in the course about the material.

vii

Inquiries Regarding Course Content Instructor: Julia Zhu Office Location: Mackintosh-Corry A424 Office Hours: Thursdays 9:00 am - 12:00 pm Inquiries concerning the course content should be addressed to me, the instructor. If you have difficulties with any of the assigned work, you can send questions by email ([email protected]) or you can phone me (613 533-6660). I also urge you to post questions about assignments and the content of the course on the course bulletin board and chat line and I will answer them there. There is a link to it from our course web page at: http://qed.econ.queensu.ca/walras/custom/100/firstyear/ Inquiries Regarding Administrative Concerns General inquiries about adding or dropping courses, obtaining transcripts, paying fees, receiving fee refunds, changing your address, etc. should be directed to the Division of Continuing & Distance Studies/Faculty of Arts & Science Office, F-200 Mackintosh-Corry Hall, 68 University Avenue, Queen's University, Kingston, ON K7L 2N6. Please send any inquiries separately from your assignments. The Continuing & Distance Studies Office is open 9:00 a.m. to 4:00 p.m., Monday to Friday. The phone number is (613) 533-2470, the office FAX number is (613) 533-6805, the e-mail address is: [email protected]

viii

Method of Study This course has two sources of information. First, the textbook provides a complete discussion and presentation of all the material including examples and figures. Second, the Course Notes provide a re-explanation of the material so that you can get a more informal lesson. The Course Notes cannot stand on their own; they must be used in conjunction with the textbook. The beginning of the notes can be a bit verbose; they try to say the same thing in a variety of ways so you have a greater opportunity to relate. Later in the notes, however, a greater understanding of the material is assumed and the notes tend to be more direct and to the point; yet they still try to emphasize the important points, walk you through examples, cut through the less important information and provide a less formal presentation of the material. 1. Consult the course notes and go through these and the textbook simultaneously. In the notes

you will find the objectives of the lesson and a breakdown of the chapters to be studied. 2. When you start to study make complete notes of your own. These will serve to be your study

notes when you are doing assignments and preparing for the final exam. You will find that there are a number of concepts that neither the text nor the notes will help you on. Don't be discouraged if you have to read the same chapter numerous times - it is imperative you have a good grasp of the knowledge. If this happens re-read your study notes every day for a week until you are comfortable with the material; your study notes are tailored to you. They present things to you in the perfect manner so you can remember them. Use your study notes as much as possible for this reason. An integral part of studying economics is using graphs. Many relationships among variables are presented graphically in the course. Reviewing graphing techniques can only be beneficial. There is a review of graphing techniques in the Appendix to Chapter 2 in your text.

3. When you have completed what you have set out to do in the lesson go to the study guide

and do some related problems. Also, on the website, there are some additional Practice Problems taken from previous years’ Assignments and exams. You should treat these as you would a written assignment, then turn to the solutions on the following page. If you are still having difficulty at this point call the instructor. Oh yes, I would like to pass on an interesting observation: The students who actually call the instructor (or tutor, if one is assigned) with questions are the same students that also tend to have the highest grades. Keep this in mind!!!

4. During the term there are two optional assignments. Although you will not be graded on

them, please take the time to do them carefully. Try to do them first without using the textbook; this will also test your knowledge. Then, when you have completed as much as you can consult the text. The assignments are made up of two parts - True, False and Uncertain - and Long Answer or Problem questions. The assignments are designed to be challenging so don't get discouraged; they also reflect the final examination.

Use your knowledge gained from the lessons and apply it to the problems. Economics is a "hands-on" course, so treat it as one.

ix

Economics 111*S Optional Assignment #1

Due Date: February 2 Late assignments will not be marked. Note: This assignment covers material from Chapters 1, 2, 33 (first part) and 3-5 in the

text. True, False, or Uncertain Explain why each of the following statements is True, False, or Uncertain according to the economic theory you have learned. A diagram and/or a few lines of explanation should be sufficient. Unsupported answers will receive no marks. It is the explanation that is important. A1-1. The cost of taking a correspondence course is the amount spent on tuition, books,

mailing, and any travel to the exam site. A1-2. Moving from one point to another on a production possibility curve can decrease the

opportunity cost of both goods. A1-3. International trade allows a country to consume at a point outside its production

possibility curve. A1-4. Suppose tickets to a concert are sold on a first come first serve basis. After resale

(scalping) outside the arena the night of the concert, the price of a ticket has risen and everyone who makes a transaction is better off.

A1-5. Producing a quantity grater than equilibrium would increase consumer surplus, therefore,

it must be efficient to do so. A1-6. Property taxes on commercial real estate fall only the owners of the property. [Hint: Be

sure to consider both the short-run and the long-run.] A1-7. Consumers bear more of a tax levied on buyers the less elastic is the demand curve.

[Hint: Assume that elasticity is neither completely elastic nor completely inelastic.] A1-8. An increase in Kingston bus ride prices results in increased revenue for the Kingston bus

company. (continued on next page)

Please ensure that each assignment you submit is accompanied by an Assignment Cover Sheet found in the FORMS, FORMS & . . ." section at the back of these course notes. Keep a copy of each assignment you submit

x

Problems A1-9. Using supply and demand diagrams, separately analyse the effects of each of the

following on the market for rental housing in the student housing area around Queen’s University.

(a) Attendance at Queen's increases by 25%.

(b) The Ontario government doubles student aid.

(c) The Kingston City Council removes the height restriction on buildings near Queen’s

while the summer unemployment rate for students increases dramatically.

(d) The Ontario government orders all rents in the area reduced by 20%. A1-10. Suppose the daily supply and demand curves for cigarettes in Kingston are given by:

Q S = & 38 + 20P Q D = 24 & bP

where Q S and Q D are the quantities in thousands of packages and P is the price per package.

(a) Neatly graph the supply and demand curves being sure to identify the P and Q intercepts

for the demand curve and the P intercept for the supply curve. Calculate the equilibrium price and quantity.

(b) Calculate the price elasticities of both supply and demand at the equilibrium point.

(c) Now suppose that the government decides to increase the tax per package and that the

resulting supply curve is given by:

Q S = -100 + 20P

Graph this new function in your diagram. What is the increase in the tax per package? Calculate the new equilibrium price and quantity. Has the amount spent on cigarettes increased or decreased? Explain how you could have predicted this result from the information you found in part (b).

(d) How much of the tax increase is passed on to consumers? How much is paid by

producers? (continued on next page)

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A1-11. The tables below show possible combinations of Personal Computers (PCs) and Main Frame Computers (MFs) that can be produced with one unit of resources in Canada and in Mexico. Production Possibilities for Canada Production Possibilities for Mexico PCs MFs PCs MFs A 500 0 G 250 0 B 400 60 H 200 50 C 300 120 I 150 100 D 200 180 J 100 150 E 100 240 K 50 200 F 0 300 L 0 250

(a) Draw the (per unit of resources) production possibilities frontiers for Canada and Mexico (on separate graphs). What is the opportunity cost of MFs (i.e. the number of PCs per MF) in the two countries? Explain.

(b) Suppose that, in absence of trade, Canada would have chosen to produce at point C and

Mexico at point I. What are the total amounts of MFs and PCs produced by the two countries? What would be the relative price of MFs in the two countries?

(c) Which country has an absolute advantage in production of MFs? In PC’s? Which country

has a comparative advantage in MFs? In PC’s? Explain. (d) If specialization occurs and trade takes place between the two, which country will

produce MFs and trade some of them for PCs? Can you give a range for the “trade”? price of an MF in terms of the number of PCs?

(e) Explain why both countries are better off (or at least no worse off) under the pattern of

trade you describe above. (end of assignment )

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Economics 111*S Optional Assignment #2

Due Date: March 18 Late assignments will not be marked. Note: This assignment covers material from Chapters 7-12 of the text. True, False, or Uncertain Explain why each of the following statements is True, False, or Uncertain according to the economic theory you have learned. A diagram and/or a few lines of explanation should be sufficient. Unsupported answers will receive no marks. It is the explanation that is important. A2-1. If the marginal product of labour is declining over a certain range of labour input, then

the marginal cost curve must be rising over the range of output produced by this labour. A2-2. Since economic profits are zero in the long-run for a perfectly competitive industry, there

is no incentive to produce and we would expect output to decline to zero in the long-run. A2-3. Profit maximization requires that a perfectly competitive firm hire labour until the

marginal product of labour equals the wage rate. A2-4. A monopolist always prices on the elastic portion of the demand curve. A2-5. In the short-run a monopolist can earn positive economic profits, but in the long-run a

monopolist can only earn zero economic profit. A2-6. An increase in the wages paid to workers in an industry characterized by monopolistic

competition results in a smaller selection of products produced by the industry. A2-7. Cartels fail to restrict output and earn monopoly-like profits because it is in each firm’s

interest to cheat on any cartel agreement. A2-8. Monopoly output levels are inefficient. (continued on next page)

Please ensure that each assignment you submit is accompanied by an Assignment Cover Sheet found in the FORMS, FORMS & . . ." section at the back of these course notes. Keep a copy of each assignment you submit

xiii

Problems A2-9. Suppose the marginal and average variable cost curves for each of the 100 firms in a

perfectly competitive industry are given by:

MC = 2 + q AVC = 2 + 0.5 q

Furthermore, assume that fixed costs for each firm are equal to $50.

(a) Graph the MC and AVC curves. Write out the equation for average total costs (ATC). At what level of output does ATC reach its minimum? Illustrate the ATC curve in your diagram.

(b) Write out the equation of an individual firm's supply curve [Hint: a supply curve has the

form "q equals some function of p"]. Calculate the short-run market supply curve.

(c) Suppose demand is given by:

Q D = 1300 – 50 p

Calculate the market price and quantity. Given this price, what is the quantity supplied and profit level of each firm?

(d) If the firms are already at the efficient size of plant what would happen over time to the

market price and quantity, the output per firm, the level of profit per firm, and the number of firms in the industry? Calculate the long run equilibrium values of these variables.

A2-10. Suppose the demand, marginal revenue, and marginal cost curves facing a monopoly are

given by:

Demand: P = 1400 - Q Marginal Revenue: MR = 1400 - 2Q

Marginal Cost: MC = AC = 200

(a) Calculate the profit maximizing quantity, price and profit level for the monopoly. Illustrate in a diagram.

(b) Calculate, illustrate and explain the deadweight loss from this monopoly.

(c) Suppose this is rally a cartel composed of 2 firms, each of which produces one half of the

monopoly output. Suppose each firm is deciding whether to produce this amount or the duopoly amount equal to 400. Derive a table showing each firm’s profit as a function of its output and the other firm’s output (see Figure 11-3 in the textbook). Explain the Nash equilibrium to this “game”.

(d) Is society better off under collusion or the Nash equilibrium?

(continued on next page)

xiv

A2-11. For each of the short-run production functions (Total Product) curves depicted below, graph corresponding marginal and average product curves.

L

TPq (a)

L

TPq (b)

L

TPq

5

2

(c)

L

TPq

5

(d)

(end of assignment )

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1

PART I

INTRODUCTION

What exactly is economics? The 2004 edition of the Oxford Canadian Dictionary provides the following definition for economics:

economics: a the social science of the production and distribution of wealth in theory and practice. b the application of this discipline to a particular subject or sphere. 2 a the condition of a country etc. as regards material prosperity. b the financial consideration attaching to a particular activity, commodity, etc.

More broadly, however, economics is the study of how people chose among available alternatives based on the resources they have at their disposal or, alternatively, the study of how people use their limited resources to satisfy their unlimited wants.

“It keeps cropping up all over the place. There is an economics of money and trade, of production and consumption, of distribution and development. There is also an economics of welfare, manners, language, industry, music, and art. There is an economics of war and an economics of power. There is even an economics of love. Economics seems to apply to every nook and cranny of human experience. It is an aspect of all conscious action. Whenever alternatives exist, life takes on an economic aspect. It has always been so. But how can it be? It can be because economics is more than just the most developed of the sciences of control. It is a way of looking at things, an ordering principle, a complete part of everything. It is a system of thought, a life game, an element of pure knowledge.”

<Robert A. Mundell, a Canadian economist (and Nobel Prize winner)

Perhaps the best definition of economics is also the simplest. Economics is the study of how a society fulfills it material needs and wants.

Chapter 1 begins with a discussion of how markets are crucial as devices for organizing complex economies. It then addresses the fundamental concepts of scarcity, choice, and opportunity cost, illustrating these ideas with consumption and production possibilities boundaries. The central themes of scarcity, choice, and opportunity cost are relevant to all economies, regardless of how they are organized, and can be applied to many aspects of human interaction. We then examine the flow of income and expenditure, the importance of marginal decisions, and the concepts of specialization, the division of labour, and globalization. Finally, we examine different types of economic systems, including traditional, command, and free-market systems. We emphasize that all actual economies are mixtures, containing elements of all three pure systems.

Chapter 2 provides an introduction to the methodological issues of economics. Economic theories are subject to empirical testing and evolve as a result of what the empirical evidence shows. In this way, the social sciences are not all that different from the “hard” sciences, at least in their basic approaches. The chapter begins by making the distinction between positive and normative statements. We then work carefully through the various elements of economic models, including definitions, assumptions,

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and predictions. Testing theories is as important as developing them, so we emphasize the interaction between theorizing and empirical observation. We then present various types of economic data, and this gets us into a detailed discussion of index numbers, time-series and cross-section data, and graphs.

We weave international themes throughout the course, talking about trade and exchange rates when useful and mentioning the importance of globalization in the functioning of modern economies. While international trade is one of the most interesting and most important applications of applied microeconomic theory, a detailed and systematic treatment of international economics is beyond the scope of this course. Chapter 33 offers a first glimpse of these themes by explaining the gains that arise from trade and specialization, emphasizing the role of comparative advantage. However, this material can also be read as offering insight into the development and functioning of markets more generally and the key concept of the division of labour. It is for this reason that we cover this material so early in the course.

3

_______________________________________

Chapter 1: Economic Issues and Concepts _______________________________________

This chapter uses consumption and production possibilities boundaries to illustrate the concepts of scarcity, choice, and opportunity cost. We put off our discussion of the role and important of markets until after we discuss the basic economic problem of scarcity and its implications.

Learning Objectives

• Describe the importance of scarcity, choice, and opportunity cost, and how all three concepts are illustrated by consumption and production possibilities boundaries.

• Illustrate the circular flow of income and expenditure.

• View the market economy as a self-organizing entity in which order emerges from a large number of decentralized decisions and comprehend that all actual economies are mixed economies, having elements of free markets, tradition, and government intervention.

Scarcity, Choice and Opportunity Cost The economic problem stems from 2 basic facts and the implications of these facts

Basic Facts

1. Society has virtually limitless needs and wants in terms of goods and services. -distinction between needs and wants is not always clear, or all that important

2. Limited resources with which to satisfy these material needs and wants.

-including natural resources (land, forests, mineral deposits, etc.), human resources (skills and labour force), and physical capital (tools, machinery), time, etc.

⇓

Scarcity -the members of a society cannot have everything they need or want

⇓

Choices -since a society cannot have everything it wants, choices are inevitable

⇓

Opportunity Cost -when a choice is made you have given up on some other alternative

-the opportunity cost of the choice made is the next best alternative that is foregone

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Opportunity cost is probably the most important concept in economics. There are many everyday examples. If you choose to watch the 2 hour premiere of “Prison Break” on TV you are giving up the next best alternative use of the time (watching the baseball game or studying perhaps). If you choose to rent a certain apartment you are giving up the next best alternative apartment. If you choose to travel during the summer you are giving up the next best alternative use of the time (perfecting your tennis forehand or working at a job).

Many, if not most times we make decisions at the margin. We are deciding whether to purchase one more or one less of a good. This is illustrated in the beer and pizza decision in Fig 1-1. It shows the consumption possibility boundary (CPB) for a student. It illustrates:

• Scarcity – combinations outside the CPB are unattainable

• Choice – there are many available combinations, only one can be chosen

• Opportunity Cost – if the student wishes more beer then he must give up 2 slices of pizza

These ideas are valid for an economy as a whole as well.

Production Possibilities Boundary (PPB) The PPB is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology. See Fig 1-2 for a diagram of a typical PPB for an economy that is assumed to produce only two goods. The PPB shows several economic concepts:

• Scarcity—an economy cannot choose a production alternative outside the curve.

• Efficiency—if the economy produces at a point on the curve, it is producing as much as it possibly can, its resources are used efficiently. If an economy is operating within the PPB, either resources are unemployed or resources are inefficiently allocated.

• Opportunity costs—when the economy moves from one production alternative to another, it has to give up some units of one of the goods to gain more units of the other good. Opportunity cost increases as an economy concentrates more and more on one activity. This is shown by the slope of the PPB itself at the current production point.

• Economic Growth—when an economy grows over time, the production possibilities curve shifts outwards, indicating that an economy can now produce more of one or both goods (see Fig 1-3).

Fig 1-2 shows a typical PPB for an economy, one that is non-linear, concave to the origin. As mentioned above, this implies that the opportunity cost of producing a good rises as more of it is produced. This is because some resources are better suited at producing one of the goods than the other. If we produce very little of a good, it is the resources that are best suited that are used first. In order to produce more, we have to use less and less well suited resources leading to higher opportunity costs.

5

We can also use the PPB to think about Four Key Economic Problems that must be solved by any economic system:

• What gets produced and how?

• What is consumed and by whom?

• Why are resources sometimes left idle?

• Is productive capacity growing and how does this come about?

The first two are within the realm of microeconomics which focuses on individual decision makers and individual markets. The second two are within the realm of macroeconomics which looks at the economy as a whole and is concerned with aggregates and broad averages.

The Complexity of the Modern Economy The Canadian economy is a modern mixed but primarily market based economy. It is incredibly complex producing and consuming millions of different goods and services with an untold number of individual transactions taking place every day. How does it work? The answer is: through the institution of markets.

Markets are an efficient way to organize economic activity. As we will see, market prices reflect relative scarcity and provide important signals to potential traders about the perceived value of resources. These prices provide useful information about how resources should be used in order to provide society with maximum satisfaction. A market economy is characterized by firms and households who interact in the marketplace, where prices and self-interest guide their decisions.

Because real life involves literally billions of decisions daily, usually it is best to let the affected individuals evaluate the relative costs and benefits from these choices. In most instances, when individuals pursue their self-interest, they also promote what is best for society as a whole. People enter various professions in order to earn a living and to provide for their families. At the same time, the more things they provide that others value highly, the more successful they will become. In this case, the individual’s success reflects the value that others place on his or her services.

Main Characteristics of Market Economies: Self-Interest: Each agent acts in his or her own best interest; an agent will not agree to something that makes her worse off. For example, an employee asking his employer for a raise is trying to maximize his income. The employer, however, will only grant the raise if it is in her best interest to do so.

Incentives: Incentives influence agents' behaviour and choices; people respond in predictable ways to changes in the costs and benefits of their actions. Prices are a direct, monetary cost. But costs can also be of a psychological or subjective nature. Examples include having to wait, being embarrassed or restricted, or any other feelings that we do not enjoy. Common sense dictates that when the cost of doing something increases, it becomes less attractive and some people will begin to avoid that activity.

Market Prices and Quantities: The quantity of a good produced and the price a good is sold at is determined by the market, rather than a central planner as in a command economy.

Institutions: Institutions play an important role in market economies by facilitating transactions between various agents. The banking system has introduced money, cheques, credit cards, and debit

6

cards – these developments have made it easier for people to buy, sell, and trade goods and services. The legal system provides a foundation for the enforcement of contracts and the protection of property rights. These institutions allow the market to function smoothly.

Who Makes the Choices and How? As discussed above, in a market economy it is individual economic agents who make the bulk of the economic decisions. Their interactions can by summarized by the:

Circular Flow of Income and Expenditure A useful way to begin seeing how simple modelling and abstract reasoning help us understand the operation of our economy is to consider the circular-flow diagram of the economy (see Fig 1-4). In this simplified version of the model, the economy consists of two sectors: (1) the business sector and (2) the household sector. In the top half of the diagram, businesses and household members are brought together in the goods market for one primary purpose—to exchange final goods and services for money. Individuals from the household sector go to the final goods market to purchase goods and services. They are the demanders of products. Others from the business sector produce and bring to the product markets the goods and services buyers wish to purchase. They are the suppliers of products. The forces of supply and demand will determine the equilibrium prices of goods and the equilibrium quantities that are produced and exchanged.

The bottom half of the diagram illustrates the market for factors of production (also known as inputs or resources e.g. land, labour and capital). Households own all of the factors of production and in this market the roles of the businesses and household are reversed—household members become resource suppliers and businesses become factor demanders. The forces of supply and demand also determine input prices and levels of resource employment.

Households own all the factors of production and sell them in factor markets to firms, who use those inputs to produce goods and services to sell in product markets. The inner loop is goods and services; the outer loop is money. Factors of production are transformed into goods and services, and the revenue firms receive pays income to households in the forms of wages, rent, interest, and profit.

The circular flow also helps us understand the microeconomics – macroeconomics distinction. Micro examines individual household’s or firm’s decisions or looks at individual product or factor markets. It is a “bottom-up” view of the circular flow. Macro is a “top-down” look focusing on the entire flow and broad aggregates and averages. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

7

_________________________________

Chapter 2: How Economists Work _________________________________

This chapter provides an introduction to the methods that economists use in their research. We integrate an introduction to graphing into our discussion of how economists present economic data and how they test economic theories.

Learning Objectives

• To understand the difference between positive and normative statements

• To understand how and why economists use models to help them think about the economy

• To understand the interaction between the development of economic theories and empirical observation

• To be able to identify and recognize several types of economic data, including index numbers, time-series and cross-sectional data, and scatter diagrams

• To review basic graphing and techniques and understand how the slope of a relation between X and Y is interpreted as the marginal response in Y to a unit change in X

Positive versus Normative Advice

Positive statements are statements of what “is” and are therefore testable

EXAMPLES:

1. Taxing cigarettes discourages smoking.

2. Using monetary policy to fight inflation leads to higher unemployment

Normative statements are statements of what “should be” and require a value judgement to evaluate. Thus they are inherently un-testable.

EXAMPLES:

1. Taxes on cigarettes should be raised in order to discourage smoking.

2. The Bank of Canada should ignore inflation and pursue a monetary policy designed to minimize unemployment

Clearly how you would evaluate the normative statements above depend on the positive statements that underlie them. But the statements themselves cannot be proven either right or wrong.

In this course, we will be focusing on primarily on positive analysis: What is the relationship between inflation and unemployment? Will higher interest rates slow economic growth? Anytime we discuss policy issues, however, normative aspects will come into play.

Disagreements among economists can be based on the positive (is this the right model? does the empirical analysis really test the positive proposition?, etc.), but also on the normative.

8

Economic Theories Economics is a social science. As such it adheres to the scientific method. Theories are proposed, tested, and then modified or discarded as indicated in a continual process. Given the complexity of the economy, economists use models to describe theories. These are most often diagrammatic or mathematical in nature. Models propose relationships between endogenous variables (those determined within the model) and exogenous variables (those that affect the model but are not determined within it). A model’s definitions and assumptions lead, through a process of logical deduction, to a set of testable predictions about how the endogenous variables will respond when there is a shock to the system.

Testing Economic Theories Figure 2-1 lays out the process of testing theories based on the scientific approach. Empirical observations leads to the construction of theories, theories generate testable predictions, and these predictions are tested by more detailed empirical observation.

A testable prediction is a prediction that can be proven false. If a theory's predictions are proven false by empirical evidence, the theory may not be valid or may need to be altered. Following the scientific approach, economists make a distinction between a “failure to reject” a hypothesis and a “confirmation of” a hypothesis. Predictions can never be proven to be true, since confirming evidence can be found to support just about any theory.

Another crucial distinction that economists make is between causation and correlation. What economists really care about is causation, but what we observe in the data is correlation. For example, human capital theory says that education increases an individual's productivity and, as a result, leads to higher wage earnings. When we look at the data on individuals' educational attainment and earnings, we do see that individuals with low education have low earnings and that individuals with high education have high earnings. However, we have not proven that higher education causes higher earnings. It's possible that income causes education – people with high income consume higher levels of education, people with low income cannot afford as much education. Another explanation for the positive correlation is that there is no causation between education and income, but that they are both caused by the same thing, ability. Individuals with high ability will obtain a lot of education and they will also earn high incomes; however, they earn the high income because of their high ability, not because of their high education.

Economic Data & Graphing Economic Theories Read over this material and make sure you are comfortable with data and graphing.

Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

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______________________________________________________

Chapter 33: The Gains from International Trade (pg 802-813) _______________________________________________________

In this chapter, we develop the standard theory of the gains from trade that result from the exploitation of comparative advantages. We then explore in some detail the sources of the gains from trade. Although the chapter is written in context of international trade, the principles apply within economies and shed light on voluntary trade of any kind, and specialization and the division of labour.

Learning Objectives

• To understand why there are gains from trade

• To understand the concept of comparative advantage and how the gains from trade depend on the pattern of comparative advantage

The Gains from Trade There are two basic ways people can satisfy their wants. The first is to be economically self-sufficient. This means that people produce individually all of the goods and services they consume. There is no exchange and no trading interaction. The other way to satisfy our wants in a world of scarcity is to specialize in the production of something and trade with others for the things we desire. This second method is referred to as economic interdependence. Two interesting questions arise: (1) why is economic interdependence the norm? and (2) what determines the pattern of production and exchange?

The answer to the first question is simple, but the underlying reasons may not be obvious at first. Over time and between each other, between regions in a country and across nations, people choose economic interdependence because they are better off materially when they specialize and trade with others. If economic self-sufficiency resulted in more total output and greater consumption opportunities, people would quickly recognize this advantage and produce and consume in economic isolation. Therefore there are gains to specialization and trade.

The gains from trade form the basis for all consumption levels beyond subsistence at the interpersonal level. The logic goes through to the interregional and international levels as well. As we will see, the gains from specialization and trade arise spontaneously and do not require a government plan.

An Individual Level Example We start with an individual level example. This shows the gains from specialization and trade at the lowest level and explains the division of labour within an economy. This also sheds light on the non-linear economy-wide PPB introduced in Ch 1.

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Autarky (no trade) Suppose Crusoe and Friday are each alone at opposite ends of an island. Crusoe can produce either 10 coconuts or 5 fish a day (or any linear combination). Friday can produce either 5 coconuts or 10 fish a day (or any linear combination). Their individual level PPBs are shown below:

2 4 6 8 100

2

4

6

8

10

Coconuts

Fish

Crusoe’s PPB

A

2 4 6 8 100

2

4

6

8

10

Coconuts

Fish

Friday’s PPB

A

In autarky (with no trade) each person’s PPB is also their Consumption Possibilities Boundary (CPB). Suppose that in autarky, Crusoe chooses 2 fish and 6 coconuts, and Friday chooses 8 fish and 1 coconut. These are shown above at the points A. Total output in autarky is 10 fish and 7 coconuts.

What if these two were brought into the same economy? The economy-wide PPB would be as shown below:

2 4 6 8 100

2

4

6

8

10

Coconuts

Fish

Economy-Wide PPB

A

12

14

12 14

It is clear that the overall autarky production point (A above) is inefficient since it leaves this “economy” operating inside its PPB. Voluntary trade brings the two into the same economy. The gains from trade allow the two to reach the economy-wide PPB.

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Gains from Specialization and Trade Suppose Crusoe transfers 1/5 of his time from fish to coconuts and Friday transfers 1/5 of his time from coconuts to fish. The changes in production are summarized in the table below.

Coconuts Fish

Crusoe +2 -1

Friday -1 +2

“World” +1 +1

This change moves them closer to the economy wide PPB and the additional output is a measure of the gains from trade.

This would arise spontaneously due to the difference in opportunity costs for the two:

Crusoe: Opp cost of an additional fish is 2 coconuts (opp cost of a coconut is ½ of a fish)

Friday: Opp cost of an additional fish is ½ of a coconut (opp cost of a coconut is 2 fish)

Therefore any “trade price” for fish between ½ of a coconut and 2 coconuts would cause Friday to produce more fish and trade for coconuts and would cause Crusoe to produce more coconuts and trade for fish. Both would be better off – they are sharing the gains from trade.

In this way, trade allows for the division of labour and generates gains for the economy as a whole.

We can also see how non-linear PPBs come about (imagine an economy with many people each of whom has a slightly different individual linear PPB).

Absolute and Comparative Advantage It was clear in our example above that Crusoe was better at producing coconuts and Friday was better at producing fish. Crusoe could produce a coconut in 1/10 of a day while Friday took 1/5 of a day. Friday could produce a fish in 1/10 of a day; Crusoe took 1/5 of a day.

In this example Crusoe had an absolute advantage in the production of coconuts and Friday had an absolute advantage in the production of fish. A producer has an absolute advantage when it has a lower resource cost of production (as above) or, equivalently, higher productivity (more output per unit of input) in production. However it turns out that this is not really important to the generation of the gains from trade.

What is important is comparative advantage – having a lower opportunity cost. What generated the gains above was the fact that Crusoe had a lower opportunity cost of coconuts and Friday had a lower opportunity cost of fish. When a producer has a lower opportunity cost of producing a good compared to another producer it has a comparative advantage in the production of that good. Given the reciprocal nature of opportunity cost, this implies that the other producer has a comparative advantage in the production of the other good.

It is comparative advantage that leads to the gains from trade. This is shown in the following international level example.

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International Level Example (see also the example in Table 33-1, 33-2, and 33-3)

Suppose that per unit of resources France can produce 4 cases of Red wine or 2 cases of White wine, and that per unit of resources Germany can produce 1 case of Red wine or 1 case of White wine. This productivity information is summarized in the table below:

Per unit of resources

Red Wine OR White Wine

France 4 2

Germany 1 1

It is clear that France has an absolute advantage in the production of both goods – a higher productivity in both.

But if we examine the opportunity costs we see that France has a comparative advantage in Red production and Germany in White.

France: Opp cost of an additional Red is ½ of a White (opp cost of a White is 2 Reds)

Germany: Opp cost of an additional Red is 1 White (opp cost of a White is 1 Red)

The gains from trade can be shown if we consider France moving 1 unit of resources from White to Red production and Germany moving 2 units of resources from Red to White production. This yields the following changes in production:

Red Wine White Wine

France +4 -2

Germany -2 +2

“World” +2 0

The gain for 2 Reds can be shared. What trade prices would generate these gains and make both better off? Any “trade price” for White between 1 Red and 2 Reds would cause France to produce more Red and trade for White and would cause Germany to produce more White and trade for Red.

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Exhausting the Gains from Trade The gains from trade are not infinite. If they were, there would be no scarcity. When are the gains from trade exhausted? Or, to put it another way, when are the gains from trade fully taken advantage of? There are two possibilities:

1. When at least one of the trading partners becomes fully specialized in its production (it can no longer move resources into the production of the good for which it has a comparative advantage).

2. When variable costs are present and the trading partners have specialized to the point where opportunity costs are now equalized.

Full Specialization

In our example of France and Germany, suppose Germany is a small wine producer overall. Furthermore, suppose for simplicity that the trade price agreed to is the French internal price, that is, each case of White wine costs 2 cases of Red wine. In the linear PPBs below suppose that the autarky points are given by the A’s.

0

Red

White

A

-2

C

P

France’s PPB

exports

imports

0

Red

White

A

-2

C

P

Germany’s PPB

imports

exports

After trade is opened between the two, the production points move to the P’s and the consumption points to the C’s. The difference between these is possible because of the import and export pattern shown in the diagram. Germany has become fully specialized, so there are no further gains from trade. It is not that there are no gains from trade, but rather the gains from trade have been fully exhausted.

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Interestingly it is the small producer that reaps the gains from trade, while producers (and consumers) in France are essentially indifferent. This is because the trade price is assumed equal to the internal price (opportunity cost) in France.

Equalized Opportunity Costs

The Extensions in Theory 33-1 box shows the case of a small country with a non-linear PPB. Its autarky point of production and consumption is a. When it is opened to trade at a relative price given by the slope of the green line in panel (i), it can consume outside its PPB and will choose to do so (at a point like b) since it can buy X on the world market more cheaply than it can make it itself. These are the gains from exchange only with no change in production. However, if it adjusts its production to point d in panel (ii) (where its internal opportunity cost is now equal to the trade price) it can consume an even more desirable point like f. At his point the gains from (partial) specialization and trade have been fully exhausted.

Sources of Comparative Advantage The sources of comparative advantage include:

• taking advantage of scale economies

• learning by doing

• differences in factor endowments

• differences in climate

• innovations that allow for acquired comparative advantage

Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade by obtaining a good at a cost below their own opportunity cost. Everyone has a comparative advantage in something. If one producer has a comparative advantage in one good; the other producer has a comparative advantage in the other. Differences in comparative advantage create opportunities to trade with both parties ending up better off than they were without trade. They each obtain goods for a price that is lower than their opportunity costs. In addition, total production rises.

At the individual level it is clear that voluntary trade makes both parties better off. If we think about this at the international level, can we say that everyone is made off? Not necessarily. Both economies are made better off, but within these economies the gains from trade may not be shared in such a way that every individual in an economy is better off. Those involved in growing (comparative advantage) sectors are made better off, but those involved in shrinking (comparative disadvantage) sectors will be made worse off in the short run (lost jobs, reduced stock prices, etc.) and perhaps in the long-run if they are unable to adjust. The winners win more than the losers lose (there are gains accruing to the economy) but this does not change the fact that some individuals may be made worse off. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

15

PART II

DEMAND AND SUPPLY APPLICATIONS

___________________________________

Chapter 3: Demand, Supply, and Price ___________________________________

This chapter covers the basic theory of demand, supply, and price. It is crucial to be very comfortable with the material covered in this chapter, as these concepts format an important underpinning to all economics whether micro or macro

Learning Objectives

• To understand what determines the amount of a product that consumers want to purchase, referred to as the “quantity demanded” of a good

• To understand the difference between a shift in a demand curve and a movement along a demand curve, and to be able to distinguish between the two

• To understand what determines the amount of a product that producers want to sell, referred to as the “quantity supplied” of a good

• To understand the difference between a shift in a supply curve and a movement along a supply curve, and be able to distinguish between the two

• To be able to distinguish the various forces that drive market price to equilibrium

Demand

Demand is the amount of a good that buyers are willing to purchase (at various prices). Therefore, demand describes how the quantity of goods and services bought can change with changes in a number of variables like income, social trends, and population. The quantity demanded of a good is the total amount of that good or service that consumers wish to purchase during a given time period; the quantity purchased refers to the quantities of a good actually purchased.

Quantity Demanded The quantity demanded for a good in a particular market depends on several “variables”

• Product’s own price – the quantity demanded is negatively (inversely) related to price. For example, if the price of ice cream rises, you buy less ice cream; if prices fall, you buy more ice cream.

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• Average income – when income increases the demand increases for normal goods but decreases for inferior goods. We might think that steak is a normal good but hamburger is an inferior good.

• Prices of other related goods – sometimes prices of others goods can affect the price of the good in question. When a decrease in the price of one good reduces the demand for another good, the goods are called substitutes (goods used in place of one another). For example, Coke and Pepsi are considered to be close substitutes; therefore, a decrease in price of Coke causes a decrease in demand for Pepsi. When a decrease in the price of one good raises the demand for another good, the goods are called complements (goods that are used together). Consider these complementary goods: ice cream and fudge, computers and software, camera and film.

• Tastes – your preference for one particular product or another. If you like something, you buy more of it. Economists consider changes in tastes but generally they do not try to explain why people have the tastes they have. For example, Pepsi uses Britney Spears to promote their product. Although, there is no change in actual product, it is expected that this move will help PEPSI to boost its sales among consumers of younger generation.

• Distribution of Income – if income is very unevenly distributed then it may influence which goods are normal or inferior for the market as a whole.

• Population – the more buyers there are in the market the higher the demand.

• Expectations about the future – your demand for a good or service today may depend on your expectations about the future. For example, if you expect more income next month, you may buy more ice cream today. If you expect ice cream to go on sale next week, you may buy less this week.

Demand Curves Demand curves are drawn by holding the other variables constant and varying the price of the product. Therefore it represents a relationship between the quantity demanded and the price, other things being equal. Fig 3-1 shows the usual downward sloping demand curve. As the price rises consumers wish to purchase less of the product.

Shifts in the Demand Curve are caused by changes in any of the determinants, other than the price of the good itself. When one of the non-price determinants of demand changes, consumers will want to purchase more or less of a good at any and all prices. This is shown graphically as a rightward or leftward shift of the demand curve (refer to Figure 3-2). For example, if it is discovered that hot dogs cause cancer in children, people obviously will alter their hot dog purchases. At any and all prices, consumers will want to buy fewer hot dogs than before the news. Similarly, if carrots are shown to reduce the risk of heart attacks, consumers will want to buy more carrots at any and all prices (See Fig 3-3). This is referred to as a change in demand.

Changes in the price of the good itself cause movements along the demand curve. This is referred to as a change in the quantity demanded. Changes in any of the other variables cause the demand curve to shift. This is referred to as a change in demand.

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Supply

Supply is defined as the amount of a certain good that producers are willing to make available for sale at all various prices. Quantity supplied is the amount that sellers are willing to sell (at a given price). Therefore, supply describes how the quantity of goods and services sold can change with changes in a number of variables like technology and the weather. Again, economists focus on price as the most important determinant of the level of supply.

Quantity Supplied The quantity supplied for a good in a particular market depends on several “variables”

• Product’s own price – the quantity supplied is positively related to price. Suppliers find it more profitable to produce at higher prices than lower prices. Higher prices result in higher quantities supplied.

• Input Prices – when the prices of one or more of the inputs that are used to make a product rise, producing the good becomes less profitable, and sellers supply less of the good. For example, by increasing the production costs of the ice cream, an increase in the price of sugar causes less supply of ice cream at any given price.

• Technology – by reducing firms’ costs, advances in technology raise supply. For example, a mechanized ice-cream maker that can make more ice cream in a given time period decreases the unit cost of ice cream causing more to be supplied.

• Government taxes or subsidies – taxes and subsidies create a wedge between the price that consumers pay for a good and the price that producers receive for that good. For example, if the government provides a $2 per hour subsidy to child care workers, childcare workers will be willing supply childcare services to consumers at a lower price. Similarly, when the government imposes a tax on an input used in production, a firm's costs of production increase, and they will be willing to supply fewer at each price.

• Expectations – the quantity of a good a seller supplies today may depend on her expectations of the future. For example, if the seller expects ice cream prices to rise, she’ll put some of her current production into the storage freezer to sell in the future at the higher price.

• Number of suppliers – the more sellers, the more of a good will be made available for sale.

Supply Curves Supply curves are drawn by holding the other variables constant and varying the price of the product. Therefore it represents a relationship between the quantity supplied and the price, other things being equal. Fig 3-5 shows the usual upward sloping demand curve. As the price rises producers wish to supply more of the product.

Market supply curves slope upward for two reasons. First, as a general rule, when we increase the output of a good, it becomes increasingly costly to produce the extra units of output. In other words, holding technology and input prices constant, as market output increases, the cost of the extra units becomes greater. This is so for reasons described earlier—at first we produce a good with inputs that are most efficient toward the production of that good. As total output increases, it becomes necessary

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to draw upon increasingly less efficient (higher opportunity cost) inputs. In order to get suppliers to produce these additional goods, it is necessary that the sellers receive a higher price. In other words, higher unit cost of production means that sellers will have to receive higher prices to get them to make the good available. The other reason market supply curves slope upward is that, in general, higher prices, at least in the short run, will generate greater profits for the sellers. If resource owners can receive higher than average profits in this market, they will reallocate their resources and produce and offer for sale more of the goods that yield a higher profit. If a higher price has associated with it higher than average (or alternative) profitability, firms will quickly shift production toward these goods. The quantity supplied will be greater as a result of the higher price.

Shifts in the Supply Curve are caused by changes in any of the determinants, other than the price of the good itself. When one of the non-price determinants of supply changes, producers will want to supply more or less of a good at any and all prices. This is shown graphically as a rightward or leftward shift of the supply curve (refer to Figure 3-6). For example, foot-and-mouth disease in U.K. has caused a significant decrease in number of cows. A decrease in number of cows causes a significant decrease in the quantity of beef supplied.

Changes in the price of the good itself cause movements along the supply curve. This is referred to as a change in the quantity supplied. Changes in any of the other variables cause the supply curve to shift. This is referred to as a change in supply.

The Determination of Price

A market is any institution, mechanism, or arrangement that facilitates the voluntary exchange of goods and services. More generally, it is a “place” where individuals can exchange at some established price goods and services they wish to acquire (when acting as buyers or demanders) or to relinquish (when acting as sellers or suppliers). For example, although there are various government restrictions there exists a market for marijuana on a university campus.

A competitive market is a market in which there are many buyers and many sellers so that each one has a negligible impact on the market price; generally the sellers sell similar products and the buyers buy small amounts. No seller wants to charge a price higher than the prevailing market price for fear that buyers will go elsewhere to buy. Since buyers only buy small amounts they cannot influence the price much either. In this chapter, markets are assumed to be competitive.

Equilibrium is the price at which supply and demand have been brought into balance and the quantity demanded is equal to the quantity supplied. As shown in Fig 3-7, this occurs where the supply and demand curves cross. The equilibrium price is the price that balances supply and demand, sometimes called the market-clearing price. At this price, the quantity of the good that buyers are willing to buy is exactly equal to the quantity that sellers are willing to sell. The quantity is the quantity supplied and the quantity demanded when the price has adjusted to balance supply and demand.

At prices above equilibrium, a surplus develops. This is a situation in which quantity supplied is greater than quantity demanded (a situation of excess supply). Producers begin to produce less (since they cannot sell their current levels of production) and prices are bid down until the excess supply is eliminated. At prices below equilibrium a shortage develops. This is a situation in which quantity supplied is less than quantity demanded (a situation of excess demand). Producers begin to produce more and prices are bid up until the excess demand is eliminated.

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Shifts in either supply or demand cause changes in the equilibrium price and quantity in the market. A shift in demand causes a movement along the existing supply curve (see panel (i) in Fig 3-8). A shift in supply causes a movement along the existing demand curve (see panel (ii) in Fig 3-8). Simultaneous shifts in both supply and demand will lead to changes in the equilibrium where the effect on either price or quantity will be ambiguous. For example, shifts to the left of both supply and demand are certain to decrease quantity, but whether price rises or falls depends on the relative strength of the shifts.

Recall that markets are usually a good way to organize economic activity. In any economy, scarce resources have to be allocated among competing uses. Market economies use the forces of supply and demand to perform that function.

The prices determined by the interaction between suppliers and demanders serve as signals that guide the allocation of resources. Because resources are scarce, their prices are usually indications of how much society values them. Beachfront property is very valuable; only those willing to pay high prices have ocean views. Prices, in conjunction with people’s income, determine who gets what. Prices also help determine who produces each good and how much is produced. Prices will rise if there is a great demand for farm products and more people will be attracted to farming. Prices serve to co-ordinate markets—millions of people buying and selling millions of products. Prices and Inflation

The price of a product is the amount of money that must be spent to acquire one unit of that product. This is called the absolute price or money price. A relative price is the ratio of two absolute prices; it expresses the price of one good in terms of another. What matters for demand and supply is the price of the product in question relative to the prices of other products; that is, what matters is relative price.

Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

20

________________________

Chapter 4: Elasticity ________________________

Learning Objectives:

• Describe the measurement of price elasticity of demand, and know its determinants.

• Understand the relationship between demand elasticity and how movements along the demand curve affect the total amount spent on a good.

• Describe the measurement of price elasticity of supply, and know its determinants.

• Explain why the effect of a sales tax on price and quantity depends on relative demand and supply elasticities.

• Explain the effect of a change in income on quantity demanded, and how this elasticity defines normal and inferior goods.

• Differentiate between substitute and complement goods, and show how this difference relates to the cross elasticity of demand

Comparative static exercises in the supply and demand model give us the direction of changes in equilibrium prices and quantities. But sometimes we want to know more, we want to know about the magnitudes of these changes. Put another way sometimes it is important to know how much of a market adjustment comes through price adjustment and how much comes through quantity adjustment. We will start by looking at a measure that shows the relative magnitude of price and quantity changes as we move along a demand curve

Price Elasticity of Demand

Loosely speaking, demand is said to be elastic when quantity demanded is very responsive to a change in the product’s own price. When quantity demanded is very unresponsive to changes in its price, demand is said to be inelastic. Elasticity is related to the slope of the demand curve, but it is not exactly the same.

Refer to Figure 4-1. When demand is elastic (as in panel (i)), a decrease in supply from S0 to S1 leads to a small increase in price and a large decrease in quantity demanded. In contrast, when demand is inelastic (as in panel (ii)), the same decrease in supply leads to a large increase in price and only a small decrease in quantity demanded. Since these changes in equilibrium occur as we move along the demand curve, we have developed a measure of responsiveness along the demand curve.

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The Measurement of Price Elasticity The measure of the responsiveness of quantity demanded to a change in the product’s own price is denoted by the symbol η in your text. We will use ED in these notes.

Price elasticity of demand is defined as follows:

ED = (percentage change in quantity demanded)/(percentage change in price)

or

ED = –(ΔQD/QD)/(ΔP/P)

Since demand curves have negative slopes, price and quantity demanded move in opposite directions along the demand curve. Because the changes in price and quantity have opposite signs, demand elasticity would return a negative number. However, this would lead to confusion about when speaking about “higher” or “lower” elasticity so economists convert the measure to a positive number. That is why we include the minus sign in the formula for ED. Another way to do this is to think of the absolute value of the measure.

There is one more important point to consider when measuring elasticity. Since we are dealing in percentage changes, elasticity relates the absolute change in P and Q to some base levels of P and Q. This seems simple but actually raises an important issue. Consider the two points A and B in the diagram below.

P

Q

D

A

B

PA

PB

QBQA If we use the starting points for any move as our base levels we get contradictory measures of elasticity over the same segment of the demand curve depending on which direction we are going.

EXAMPLE: Suppose PA = 100, QA = 25 and PB =50, QB = 75.

Elasticity (A B) – using A as the base:

%2002550

252575% ==

−=QΔ and %50

10050

10010050% −=

−=

−=PΔ

So 450200

%50%200

==−

−=DE

Elasticity (B A) – using B as the base:

%7.667550

757525% −=

−=

−=QΔ and %100

5050

5050100% ==

−=PΔ

So 667.100

7.66%100

%7.66==

−−=DE

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Average Arc (or mid-point) Method To avoid this problem we use the average values of P and Q when computing the percentage changes. This is referred to as the average arc or mid-point method because we are using the average or mid-point in calculating the percentages. In general, the formula for elasticity is therefore given by:

QBQAPBPA

PBPAQBQA

PBPAPBPAQBQAQBQAED +

+×

−−

−=+−+−

−=}2/)/{()(}2/)/{()(

EXAMPLE:

Using the values from above we obtain:

5.1100150

5050

752550100

501007525

=×−

−=++

×−−

−=DE

Optional Material:

These two methods of calculating elasticity are shown here for those who are especially comfortable working with equations/slopes and/or for those who are comfortable with calculus. They are optional and understanding them is not necessary. Point Method

If you have a linear equation and wish to calculate elasticity at a certain point the formula for elasticity of demand is given by:

QP

slopeQP

riserun

QbasePbase

PQED ×−=×−=×−=

1ΔΔ

The “base P and Q” are the point you are interested in

EXAMPLE: In our example, if demand was linear, its equation would be:

Q = 125 – P or P = 125 – Q

So the slope (rise/run) = –1. If we calculate elasticity at our previous mid-point (Q = 50, P = 75):

5.15075

5075

11

==×−

−=DE

Calculus Method

If you have a specific demand function (linear or not) and wish to calculate elasticity at a certain point, you can use the derivative of demand with respect to price and calculate elasticity as:

QP

dPdQED ×−=

Or, if you have a demand function with many independent variables, use the partial derivative:

QP

PQED ×∂∂

−=

23

Summing Up

You can always use the average arc method to calculate elasticity. If you only have two points just apply formula. If you have an equation pick points above and below the point you are interested in (such that the averages are the point you are interested in) and apply the formula

Range of Values for ED Inelastic: If the percentage change in quantity demanded is less than the percentage change in price, then demand is inelastic and 0 < ED < 1.

Unit Elastic: If the percentage change in quantity demanded is equal to the percentage change in price, then demand is unit elastic and ED = 1.

Elastic: If the percentage change in quantity demanded is greater than the percentage change in price, then demand is elastic and ED > 1.

What Determines the Elasticity of Demand?

• Demand is elastic when the product has more close substitutes.

• Demand is inelastic when the product has fewer close substitutes.

The availability of substitutes is determined by several factors:

• The longer the time interval considered, the more elastic is demand – long-run elasticity is greater than short-run elasticity (consumers have more time to search out and try substitute goods).

• The less a good is a necessity, the more elastic is demand (so demand for iPhones would be more elastic than would be the demand for insulin).

• The more specifically a good is defined; the more elastic is its demand (so the demand for apple juice would be more elastic than the demand for all fruit juice).

Special Cases

Linear Demand

Elasticity falls as you move down a linear demand curve (Figure 4-2). Mathematically:

QD = c – dP (where c, d > 0 are constants)

DQdd

cP 1−=

QPd

QPd

QP

PQED ×=×−−=×−= )(

ΔΔ

At points near the P axis, P is large and Q is small so the percentage change in Q is large and the percentage change in P is small – ED is large. At points near the Q axis, P is small and Q is large so the percentage change in Q is small and the percentage change in P is large – ED is small.

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Recall that demand is more elastic for goods with available substitutes. Since a particular demand curve holds income constant, people tend to substitute from high-price goods to low-price goods when they can. Consumers have more opportunities to substitute towards low-price goods when the price of the good is high. As the price of a good falls, the number of similar goods that have lower prices falls.

Demand Curves with Constant Elasticity (Figure 4-3)

D1: QD = Q0 (where Q0 > 0 is some constant) Clearly %∆Q = 0 everywhere on D1 so ED = 0 everywhere on D1.

D2: P = P0 (where P0 > 0 is some constant) Clearly %∆P = 0 everywhere on D2 so ED = ∞ everywhere on D2 (something divided by zero equals infinity)

D3: QD = k/P (where k > 0 is some constant) This is a “rectangular hyperbola”. Here %∆Q = %∆P everywhere on D3 so ED = 1 everywhere on D3 (more on this below).

Short-Run and Long-Run Equilibrium Following an Increase in Supply

Given our discussion of the change in elasticity over time, the changes in equilibrium P and Q following a shift in supply depend on the time that consumers have to respond. As shown in Fig 4-4, in the long run, the change in quantity is greater and the change in price is smaller than in the short run.

Elasticity and Total Expenditure Along the demand curve, total expenditure by consumers is the product of price and quantity demanded; equivalently, total revenue to producers is the product of price and quantity demanded.

Total Expenditure = Price x Quantity = PxQ

If demand is inelastic, the percentage change in price is greater than the percentage change in quantity. So the price change direction dominates total revenue. For example, an increase in price increases total expenditure (the percentage increase in price is greater than the percentage decrease in quantity).

If demand is elastic, the percentage change in price is smaller than the percentage change in quantity. So the quantity change direction dominates total revenue. For example, an increase in price decreases total expenditure (the percentage increase in price is smaller than the percentage decrease in quantity).

If demand is unit elastic the two effects offset so a rise in price has no effect on total expenditure. So a demand curve that is unit elastic everywhere has unchanging revenue. That is PxQ = k where k >0 is some constant. As discussed above, this is a rectangular hyperbola.

Refer to Figure 4-5 to see how revenue changes along a linear demand curve and how this relates to the measure of elasticity discussed above.

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Price Elasticity of Supply Supply elasticity is very similar to demand elasticity. Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good; computed as the percentage change in quantity supplied divided by the percentage change in price.

It is denoted by ES, and is defined as:

ES = (percentage change in quantity supplied)/(percentage change in price)

All of the discussion relating to the calculation of percentage changes, and using average quantity and price is the same here, (as is the optional material on the point method or the calculus method) so we will not repeat them here. Just note that we are moving along the supply curve now, rather than the demand curve. Note too that, because supply curves are upward sloping, we don’t have to worry about taking the absolute value (or multiplying by –1). We will always get a positive value for the elasticity of supply.

A Numerical Example of Supply Elasticity:

The price of milk increases from $2.85 to $3.15 causing the quantity supplied to increase from 9,250 to 10,750 litres.

p0 = $2.85 p1 = $3.15 q0 = 9,250 q1 = 10,750

1010

0101

}2/)10/{()01(}2/)10/{()01(

qqpp

ppqq

ppppqqqqES +

+×

−−

=+−+−

=

5.120000

00.630.

1500107509250

15.385.285.215.3

925010750=×=

++

×−−

−=SE

In the extreme cases of no supply response and an infinite response, the schedules are vertical and horizontal, respectively. A vertical supply curve is called perfectly inelastic and a horizontal supply curve is called perfectly elastic. Since a perfectly inelastic supply curve has no quantity response to a price change, it has a coefficient of zero. A perfectly elastic supply curve has an elasticity coefficient of infinity.

Determinants of Elasticity of Supply

The elasticity of supply depends on how easy it is for producers to expand production or to switch between the production of one good to another. This depends on:

$the technical ease of substitution in production

-can different products be produced given the technology and available inputs?

$the nature of production costs

-how steeply do costs rise with increases in production?

Clearly we would expect a difference in short run versus long run. In the short run existing firms can hire more of only some inputs to increase production. In the long run, firms can expand their use of all factors (new plant, etc.). Also in the long run, higher prices may bring entry leading to larger changes in quantity

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An Important Example where Elasticity Matters: The Burden of Sales Tax Analysing the burden of a tax is referred to as tax incidence analysis. It answers the question – who bears the burden of a tax? The short answer is that it doesn’t matter who the government says owes the tax, or is responsible for collecting the tax on a transaction (for example the GST is collected and “paid” by retailers – the sellers – but the sales tax on private used car sales is “paid” by the buyers). What matters is how the tax affects the market and its participants. How much more do buyers pay because of the tax? How much less do sellers receive because of the tax?

After the imposition of a sales tax, the price paid by consumers is higher, whereas the price received by producers is lower (see Fig 4-8). The difference between the consumer and seller prices is equal to the tax. The burden borne by consumers is the difference between the price they paid before the tax was introduced and the price they pay after the tax is introduced. The burden borne by producers is the difference between the price they received before the tax was introduced and the price they receive after the tax is introduced. The new equilibrium quantity is less than the quantity before the tax was imposed.

Upon what does this tax burden sharing depend? It depends on the relative elasticities of demand and supply. Figure 4-9 shows that the more elastic is demand, the less of the burden is borne by consumers – therefore the more of the burden is borne by producers. The intuition behind this result is that, with an elastic demand, sellers are less able to “pass on” the burden to buyers in the form of higher prices.

But ES matters too. We will show this by considering the special cases of supply elasticity.

P

Q

S

D

ST

t

Q*

P*

P

Q

D

S = ST

Q*

P*

Panel (i) Panel (ii)

Panel (i) shows a supply curve with ES = ∞ – a perfectly elastic supply curve. With this supply curve, consumers pay: PT – P* = P* + t – P* = t while producers pay 0. The intuition is that, with perfectly elastic supply, sellers cannot be forced to bear any of the burden.

Panel (ii) shows a supply curve with ES = 0 – a perfectly inelastic supply curve. With this supply curve, producers pay: PT – P* = P* + t – P* = t while consumers pay 0. The intuition here is that, with perfectly inelastic supply, sellers cannot avoid any of the burden.

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Other Demand Elasticities: The following elasticities are associated with changes in variables other than the price of the good in question. Therefore we are dealing with shifts of the demand curve rather than movements along it

P

Q

D

P

Q’Q

D’

Income Elasticity of Demand (ηY in your text – we will use EI)

EI = percentage change in quantity demanded percentage change in income

or

ED = % ∆ QD % ∆ I

Range of Values for EI

EI < 0 – inferior goods

EI > 0 – normal goods

0 < EI < 1 -income-inelastic normal goods (necessities)

EI > 1 -income-elastic normal goods (luxuries)

Cross Price Elasticity of Demand (ηXY in your text – we will use EXY)

EXY = % change in quantity demanded of good X % change in price of good Y

Range of Values for EXY

EXY < 0 – complements

EXY > 0 – substitutes

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For a summary of all the different elasticity measures, review Extensions in Theory 4-2. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

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____________________________

Chapter 5: Markets in Action ____________________________

By now you should have a firm understanding of the market process. This chapter will further develop understanding of supply and demand by analyzing the effects of non-equilibrium prices imposed by the government. Learning Objectives:

• Recognize that individual markets do not exist in isolation, and that changes in one market typically have repercussions in other markets.

• Describe the operation of a market with price ceilings or price floors.

• Explain the different short-run and long-run effects of legislated rent controls.

• Introduce the notions of economic and surplus and economic efficiency, and take our first look at the efficiency of supply and demand equilibrium.

The Interaction Among Markets

The markets for all products and factors are interconnected. This is obvious when we think about the circular flow of income diagram. Indeed we have already seen some examples of inter-connectedness. In Ch 3 we saw how changes in the prices of substitutes and complements or changes in income earned in the factor markets affect the demand curves for products.

Does this mean we have to account for the effects on all markets and any potential feedbacks in order to conduct any analysis? In theory – yes. This kind of analysis is referred to as “general equilibrium analysis”.

In practice – no. Provided the conditions are right we can concentrate on one market or a few closely connected markets. That is, we can perform “partial equilibrium analysis”. What are these conditions? First, the market in question is small relative to the size of the economy. Second, the effects on other markets are diffuse (spread out) so that no particular other market is greatly affected. In addition, the feedback effects are small and diffuse. It is actually quite common for these conditions to be met. What should you do when answering questions? Perform partial equilibrium analysis unless you are told to do otherwise

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Government Controlled Prices

There have been many instances over the years where governments have controlled prices. Given that, in the absence of this government intervention, prices are determined in markets, what effect do these kinds of policies have?

Disequilibrium Prices

Suppose a price is prevented (ex. by the government) from adjusting to its equilibrium level. What quantity is traded in the market? This is governed by the “short-side rule” – the lesser of the quantity demanded or quantity supplied at the disequilibrium price is the quantity traded. Examine Fig 5-1.

At P > P0: QD < QS so is QD traded

At P < P0: QS < QD so is QS traded

In many cases governments don’t actually set a price, but rather set a maximum or minimum price at which something can legally trade.

Price Floors

Here the government sets a minimum price P1 at which trades can take place. Examine Fig 5-2. If the minimum price P1 < P0 then the price floor is referred to as “ineffective” or “non-binding”. It has no effect on the market. However, if P1 > P0, the price floor is “effective” or “binding”. The result in the market is a permanent state of surplus or excess supply. In addition, the difference in valuations of buyers and sellers at Q = Q1 forms a basis for illegal trades (trades on the so-called “black market”).

Applying Economic Concepts 5-1 shows an example of a common price floor, minimum wage laws. As shown in the diagram, this leads to a surplus in the market for unskilled labour equal to E2 – E1. That is, minimum wage laws lead to unemployment. As with all government interventions in the market, the policy leads to winners and losers relative to market equilibrium. The E1 workers who are employed receive higher wages than they otherwise would and therefore better off. There are E0 – E1 workers who do not get jobs they otherwise would and are therefore worse off. The firms pay higher wages than they otherwise would and therefore worse off. In addition, E2 – E0 workers now want to work (due to higher wages) but can’t – they are arguably worse off.

Price Ceilings

Here the government sets a maximum price P1 at which trades can take place. Examine Fig 5-3. If the minimum price P1 > P0 then the price ceiling is referred to as “ineffective” or “non-binding”. It has no effect on the market. However, if P1 < P0, the price ceiling is “effective” or “binding”. The result in the market is a permanent state of shortage or excess demand. In addition, the difference in valuations of buyers and sellers at Q = Q2 (P2 versus P1) forms a basis for illegal trades (trades on the so-called “black

31

market”). Since there is a shortage of output at the going price, the goods must be allocated on a basis other than the price system. Mechanisms such as “first-come-first-served” (line-ups), or “seller’s preference” (having sellers chooses who they want to sell to) are common in markets affected by excess demand.

A government might have three main goals for imposing a price ceiling:

1. restrict production,

2. keep specific prices down,

3. satisfy notions of equity in the consumption of a product that is temporarily in short supply.

Rent Controls: A Case Study of Price Ceilings

Predicted Effects

In the short-run the supply of rental housing is very inelastic, but it is much more elastic in the long-run (land and buildings have alternative uses). Fig 5-4 assumes for simplicity that supply is completely inelastic in the SR and that demand elasticity doesn’t change over time. The analysis leads to several predictions about the rental market. These predictions are: a shortage of housing that grows over time (Q2 – Q1 in SR, Q2 – Q3 in LR), the allocation of housing by “seller’s preference”, illegal charges like “key money”, and (often) reduced maintenance on the rental housing stock. All of these have been seen in housing markets affected by rent controls.

Who Wins and Who Loses

In the SR, Q1 tenants get lower rents than they otherwise would and therefore better off. This number falls to Q3 in the LR. In the SR Q2 – Q1 prospective tenants are unable to find rental accommodation and are therefore worse off (this expands to Q2 – Q3 in the LR). In addition, landlords receive lower rents than they otherwise would and therefore worse off.

Alternative Policies As an alternative to rent controls, housing shortages can be removed if the government (at taxpayer’s expense) either subsidizes housing production or produces public housing directly. The government may also provide lower-income households with income assistance, allowing them to access better housing than they would otherwise be able to afford. Whatever policy is adopted, it is important to recognize that providing greater access to rental accommodations has a resource cost.

Introduction to Market Efficiency By setting up a method for evaluating the efficiency of market outcomes we can evaluate the overall effect of policies like those discussed above (as well as many others).

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Demand and Willingness-to-Pay (WTP) This is a “vertical” interpretation of the demand curve as opposed to our usual “horizontal” view. The willingness-to-pay for a given unit of production is the maximum amount that would be paid for that unit. It is measured by the height of the demand curve for that unit. So the demand curve can be viewed (vertically) as measuring the WTP for successive units (a marginal idea). This can be shown by examining the figure below. At price P, consumers will purchase Q units. What would cause consumers to purchase unit #Q+1? If the price were equal to P’. So the WTP for unit #Q+1 is equal to P’. A similar story applies to every unit along D. So the height of D measures the WTP for successive units.

P

Q

D

P

Q Q+1

P’

Supply and Willingness-to-Accept (WTA) This is a “vertical” interpretation of the supply curve as opposed to our usual “horizontal” view. The willingness-to-accept is the minimum amount that sellers would accept for a given unit. This is measured by the height of the supply curve for that unit. So the supply curve can be viewed (vertically) as measuring the WTA for successive units (a marginal idea). This can be shown by examining the figure below. At price P, sellers will supply Q units. What would cause sellers to supply unit #Q+1? If the price were equal to P’. So the WTA for unit #Q+1 is equal to P’. Similar story applies to every unit along S. So the height of S measures the WTA for successive units. In addition, it is important to understand that the WTA is equal to the additional cost to the firm of producing the unit. Remember that that WTA is the smallest amount that the seller would accept for the unit so that this must just cover its costs of producing that marginal unit.

P

Q

S

P

Q Q+1

P’

33

Economic Surplus: The economic surplus that is generated when a unit is sold in the market is equal to the WTP – WTA for that unit. So the total economic surplus in a market is the sum of the surpluses generated on each unit that is traded. Market Efficiency:

As shown in Fig 5-6, in supply and demand equilibrium, the total amount of economic surplus generated in the market is maximized because Q* units (250 in the figure) are traded. The economic surplus is shown by the area above S and below D.

What if QL < Q* is traded in the market? For units between QL and Q* the market does not generate the potential surplus. For each of these units, WTP > WTA. This loss of surplus is referred to as the deadweight loss (DWL) from being at QL.

What if QH > Q* is traded in the market? For units between Q* and QH the cost exceeds the value placed on them by consumers. For each of these units, WTP < WTA. This loss of surplus is referred to as the deadweight loss (DWL) from being at QH.

Inefficiency of Price Controls As shown in Fig 5-7, effective (binding) price ceilings or effective (binding) price floors lead to a reduction in quantity traded below the equilibrium level. That is, they lead to DWL in the affected market.

Inefficiency of Quantity Controls In an effort to increase prices in some markets, governments have been known to use quantity controls. This often in the form of a quantity quota system whereby producers must have units of the quota (licences) to legally produce and sell units of output. As shown in Fig 5-8 this leads to DWL in the affected market.

An additional result is that the difference in valuations (WTP vs WTA) also means that the quota itself has a value. How much would a unit of quota be worth? WTP(Q1) – WTA(Q1) = P1 – MC(Q’). Most quota systems allow the quota to be traded among producers. Over time this will become the price of a unit of quota (where a unit of quota gives permission to produce a unit of output). The effect of this is to raise the costs of production by the value of the quota. Therefore, who benefits from the quota system? The answer is that those who gain are the original producers who were granted the quota. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading. You should be submitting the Optional Assignment #1 at this point if you are going to do so. For the due date, see the course outline.

34

PART III

HOUSEHOLD DECISIONS Consumer theory is the theory used to describe household behaviour and choices. We will use the theory to describe the demand for products in Chapter 6. In addition, we will use the same framework to study the supply of factors such as labour and capital (through saving choices) by households. These decisions are discussed in the Supplementary Chapter “Other Household Decisions” which follows Chapter 6 in these notes.

_________________________________

Chapter 6: Consumer Behaviour _________________________________

Learning Objectives

• Differentiate between marginal utility and total utility.

• Show that maximizing utility requires consumers to adjust expenditure until the marginal utility per dollar spent is equalized across all products.

• Understand the more modern indifference curve approach to understanding consumer choices.

• Explain how any change in price generates both an income and a substitution effect on quantity demanded.

• Describe consumer surplus as the “bargain” the consumer gets by paying less for the product than he or she was willing to pay.

• Differentiate between total value and marginal value. Marginal Utility and Consumer Choice Diminishing Marginal Utility The central hypothesis of utility theory, often called the law of diminishing marginal utility, is as follows:

The utility that any consumer derives from successive units of a particular product diminishes as total consumption of the product increases (holding constant consumption of all other goods).

That is, marginal utility falls as the level of consumption rises. (For example, think about your consumption of pizza during a late night of studying economics. Doesn’t the first piece hit the spot a lot more than the fourth piece?) Diminishing marginal utility and the relationship between total utility and marginal utility is shown in Fig 6-1.

35

Maximizing Utility Consumers adjust their purchases to get the highest possible level of satisfaction. That is, they maximize utility. This involves choosing purchases so that the utility from the last dollar spent on each good is equalized. We can summarize this idea in the utility max condition (assuming a two good world):

y

y

x

x

pMU

pMU

=

Why does this consumption pattern maximize utility? Suppose instead that

y

y

x

x

pMU

pMU

>

Transferring a dollar from y consumption to x consumption would raise utility. Of course the opposite story for the reverse inequality. Alternative Interpretation We can rearrange the equation to the following form

y

x

y

x

pp

MUMU

=

The LHS is relative ability of x to add to utility, while the RHS is the relative price of x. The LHS is also referred to as the marginal rate of substitution (mrs) – it is the internal preference trade-off between the goods. The RHS is the relative price – it is the external trade-off between the goods in the market. We will discuss the income and substitution effects of a price change and the derivation of the household’s demand curve in the context of indifference curve analysis – see the appendix Indifference Curve Approach (appendix) This approach is more modern and powerful than the marginal utility approach. It makes explicit the fact that consumer preferences are defined over bundles of goods rather than implying that individual goods can be looked at separately (even though MU doesn’t really do this, it is often assumed by students that it does). Consumer theory is really the theory of consumer choice. To examine any choice we need to specify two elements: 1. possibilities (illustrated by consumption possibilities boundaries or “budget lines”), and 2. preferences (illustrated by indifference curves). 1. Possibilities Assume that consumers are “endowed” (start with) a given amount of money income (I) and that they face prices for the various products (1, 2, 3, …) they might like to buy: p1, p2, p3, …. So possible consumption bundles (purchases) must satisfy a “budget constraint”:

36

p1×q1 + p2×q2 + p3×q3 … ≤ I We simplify and assume only two goods, x and y with prices px and py, so the budget constraint is given by:

pxx + pyy ≤ I

The boundary of this constraint is called the budget line (BL) and its equation is given by:

pxx + pyy = I

In the form y = b + mx, this can be written as y = I/py – (px/py)x. The x-intercept is given by I/px and the y-intercept is given by I/py

y

x Similar to our discussion in Chapter 1, the diagram of the budget line illustrates:

• Scarcity – attainable vs unattainable bundles of goods are illustrated by points on or inside the budget line and those points outside the budget line

• Opportunity cost is shown by (minus) the slope of the BL (px/py). This is the relative price of x, sometimes called simply the price ratio).

Income Changes cause parallel shifts in the budget line. That is, the slope is unchanged. Think about the intercepts to see this. (EXAMPLE: An increase in income I, shifts the budget line out.)

Price Changes cause the budget line to pivot in or out around one of the end points. The slope is changed. Again, think about the intercepts to see this. (EXAMPLE: A decrease in px moves the x-intercept out but leaves the y-intercept unchanged – the budget line pivots out around the y-intercept.) 2. Preferences Preferences are defined over bundles of (x, y) and are assumed to satisfy the following properties:

(a) Preferences are complete, that is, all bundles can be ranked

-A is preferred to B or, B is preferred to A or, the consumer is indifferent between A and B (b) Preferences are subject to non-satiation, that is, “more is better”

-consumers strictly prefer a bundle with more of at least one good and no less of any good (c) Preferences are transitive

-if A is preferred to B and B is preferred to C, then A is preferred to C, or -if the consumer is indifferent between A and B and indifferent between B and C then the consumer is indifferent between A and C

(d) Preferences are characterized by “diminishing marginal rate of substitution” -gives “convexity to indifferences curves (more on this later)

37

Indifference Curves Indifference curves connect all bundles over which the consumer is indifferent (all are “equally preferred”). To derive an indifference curve choose a bundle A = (xA , yA) at random and show the indifference curve through A.

y

x

A

1

A

2

4 3

B

• bundles that are equally preferred to A can’t lie in region 4 since A has more of at least one good than do those bundles

• bundles that are equally preferred to A can’t lie in region 2 since each of those bundles has more of at least one good than does A

• so the indifference curve must lie in regions 1 and 3 – there is a trade-off in goods between bundles that are equally preferred

• the assumption of diminishing marginal rate of substitution means that the indifference curve is convex to the origin as shown in the diagram

Why is the indifference curve convex to the origin? That is, why is IC steeper at B than at A? This is because B has more y and less x than does A. So the consumer is willing to give up more y to get another x at B than at A. Another way to look at it is that the consumer would have to be “paid” more y to give up an x at B than at A. We randomly picked A, so full preferences are described by a family of indifference curves as shown in Fig 6A-2. These indifference curves get arbitrarily close together, but do not cross. This last property, indifference curves do not cross, is an important result, so we will prove it formally. Proof that Indifference Curves Do Not Cross:

Suppose two indifference curves did cross as shown in the diagram below. IC1 tells us that bundles A and B are equally preferred (the consumer is indifferent between them). Similarly, IC2 tells us that bundles A and C are equally preferred (the consumer is indifferent between them). So transitivity would imply that bundles B and C are equally preferred.

But from the diagram it is clear that bundle C contains more of both goods than bundle B. Since “more is better” then C must be strictly preferred to B.

This is a contradiction. The only way for this contradiction to be resolved is that the indifference curves cannot cross.

38

IC1x

y

C

IC2B

A

Consumer Equilibrium As utility maximizers, consumers choose the bundle that puts them on the highest possible indifference curve. As shown in Fig 6A-4, this occurs at the bundle A. At the equilibrium, the indifference curve is tangent to the budget line. That is:

y

x

ppmrs −=−

y

x

ppmrs =

y

x

y

x

pp

MUMU

=

What does this mean? The intuition is that, in consumer equilibrium, the internal trade-off in preferences is set equal to the external trade-off in the market. This confirms our intuition from marginal utility analysis. Income Changes Income changes cause parallel shifts of the budget line – assume I rises. If the consumer’s original equilibrium is at E1 then where is the new consumption point E2? There are 3 possibilities. If both x and y are normal goods then E2 lies between points B and C. If x is normal and y is inferior then E2 lies between C and D. If x is inferior and y is normal then E2 lies between A and B.

y

x

E1

A

B

C

D

Fig 6A-5 shows the full income-consumption line for the case where both goods are normal.

39

Price Changes Price changes cause the budget line to pivot – suppose px decreases. The budget line pivots out as shown below. If the consumer’s original equilibrium is at E1 then where is the new consumption point E2? There actually 2 things going on here. First there is a change in the slope of BL. Second there is a change (in this case expansion) in possibilities.

y

x

E1

S

A

B

C

D

Substitution and Income Effects Since two things are going on, we divide the move to the new consumer equilibrium into 2 pieces. The Substitution Effect isolates the effect of the slope change. In our example, where px falls, the intuition is that the relative price of x has fallen so the consumer will respond by consuming more x and less y. This is summarized by the following:

ylessandxmorepp

py

xx ⇒↓⇒↓

In the diagram we represent the substitution effect as the move from E1 to S. This is where the old indifference curve has the new slope.

The Income Effect adds in the effect of the change in possibilities. In our example, where px falls, the intuition is that the consumer’s real income has increased so the consumer will respond by consuming more of goods that are normal and less of those goods that are inferior. In the diagram this is shown by the move from S to the new consumption point somewhere on the new budget line between A and D. Since this is just like an increase in income as discussed above, the possibilities are summarized by the following:

x and y both normal – more of x and y than at S – E2 lies between B and C x normal and y inferior – more of x and less of y than at S – E2 lies between C and D x inferior and y normal – less of x and more of y than at S – E2 lies between A and B

The total effect of a price change is the summation of the substitution and income effects. Another way to think about this is that we can decompose the total effect of a price change into the substitution and income effects. Fig 6A-6 shows the price-consumption line for a consumer as the price of good x falls.

40

Possible Combinations: We usually put the good we are interested in (the good whose price is changing) on the “x” axis, but in general there are 12 possibilities for the substitution and income effects:

x inferior x inferior px ↓ both normal px ↑ both normal

y inferior y inferior

x inferior x inferior py ↓ both normal py ↑ both normal

y inferior y inferior If you do the analysis on all of these possible combinations, 2 things will happen:

1. you will get bored 2. but you will never forget how to analyze substitution and income effects

Deriving Household Demand: A price change is exactly the change that produces a demand curve. So we can use consumer theory to actually derive the demand curve for a household. Fig 6A-7 shows the derivation of a demand curve. A common “normalization” that is done when thinking about the demand for good x is to think of good y as some composite commodity called “all other goods” where py = 1. So what we are measuring on the y-axis in the consumer theory diagram is really the amount spent on “all other goods” (all goods other than x that is). Giffen Goods and Conspicuous Consumption Goods A Giffen good is a good so inferior that when its price falls so does its consumption. That is, it has an upward sloping demand. In the face of a price decrease, the income effect away from x is stronger than the substitution effect toward it. Extreme conditions are required to produce this result. These include extreme inferior-ness and the fact that the good makes up a huge % of consumer spending. In fact no one has actually found one! Even Giffen’s original case (potatoes during the Irish potato famine) has been shown to have been an error in the data used. As shown in the discussion concerning Conspicuous Consumption or snob goods, other ideas about an upward sloping demand curve are even less sound. So we can safely assume that demand curves are downward sloping. Consumer Surplus (CS) Consumer surplus is a dollar measure of the total benefit to consumers who consume Q units of a good when faced with price p. It is a measure of what part of the economic surplus discussed in Chapter 5 accrues to consumer in a market. We start by formalizing the idea of willingness-to-pay that was also introduced in Chapter 5. In keeping with the discussion in your text we will do so by considering the

41

marginal utility approach to constructing the demand curve, although the idea can also be shown in a consumer theory diagram with budget lines and indifference curves. Willingness-to-Pay (MU approach): Using the consumer equilibrium condition, we can form a demand curve:

xx

xy

y

y

x

x pMUMUp

pMU

pMU

=⇒=

That is:

xy pmrsp =× If y is “all other goods” then py = 1, so:

xpmrs = where mrs is now measured in $ terms. By varying px we can trace out the demand for good x. See the discussion in the text and Figure 6-4. The height of demand is mrs in dollar terms, or the marginal benefit (MB) to the consumer of that unit of good x. As we have seen, this is also referred to as the willingness-to-pay (WTP) for that unit of good x Consumer Surplus Consumer surplus on a particular unit is the WTP for that unit less what is actually paid (the price). Consumer surplus for all units consumed is the area under demand and above the price Market Consumer Surplus Market demand curves are simply the horizontal summation of individual demand curves. See the diagram in Extensions in Theory 6-1 for an example. So market consumer surplus (the sum of individual consumer surplus) is simply the area under the market demand curve and above the price. Paradox of Value (revisited) As shown in Fig 6-5, water has a lower price than diamonds. The price in each market reflects the marginal WTP (height of demand in equilibrium). But water has a much higher “value” than diamonds. This is reflected higher total WTP (area under demand) and consumer surplus. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

42

______________________________________________________

Supplementary Chapter: Other Household Decisions _______________________________________________________

Summary

This supplement is to be read after Chapter 6 of the Ragan/Lipsey text. In Chapter 6 we developed a set of tools for examining the consumption decisions of households. This allowed us not only to study in detail the behaviour that lies behind the demand curve, but also to examine the effect of various price and income changes and their effect on consumer choices and welfare.

We can also use these tools to study the decisions households make regarding factor supplies.

Recall that in the circular flow of income households are “demanders” in the product markets, but act as “suppliers” in the factor markets. The next section uses the tools of consumer theory to examine household labour supply decisions, while the following section does the same for savings supply decisions. Labour Supply The Basic Set-Up

In Chapter 6 the problem we studied was that of how households allocated their limited income across the purchases of various consumer goods. Their income was assumed to be a fixed amount determined outside the model of consumer behaviour. This income was the “endowment” of the household. When studying the labour supply decision of a household, the endowment is no longer money but rather time. We will assume that the household has H amount to time (hours in a day, or hours in a week, or weeks in a year) to allocate between labour, L, and leisure, R. Of these two activities, leisure is considered to be a “good” and labour is considered to be a “bad”. (We like our leisure but work is necessary to earn income.) When the household allocates a unit of its time to the labour market it earns a wage, w. Thus its total income in a given period is wL. The household can then spend this income on the other “good” in the model, consumption, C, which is assumed to have a price equal to 1. (That is, consumption is the amount of money spent on consumption goods.) Variables and Definitions

H – the time endowment of the household to be split between labour and leisure, so H = R + L

R – time spent in leisure activities, a good

L – time spent working, a bad

w – the wage rate faced by the household

wL – the labour income earned by the household

C = wL – consumption by the household, a good

43

Preferences

Preferences over the two goods in the model, leisure and consumption are defined by normal (convex to the origin) indifference curves. In addition, it is usually assumed in this model that both consumption and leisure are normal goods. Budget Line

The maximum amount that consumers can spend on consumption is what they earn in the labour market, so

C = wL

Since labour supply is limited by the total amount of time available and the amount the household decides to take in leisure, we can rewrite the budget constraint:

C = wL = w(H – R) = wH – wR

The budget line is shown as BL in diagram S1-1. The intercepts are as shown in the diagram. If the household decides to spend all of its time in leisure, it would have H units of leisure and zero consumption, while if it spent all of its time in paid work, it would have zero units of leisure and wH units of consumption. The slope of the budget line is given by –w.

We are used to thinking about the wage rate as the reward for labour. While this is certainly one way of looking at the wage, there is another interpretation of the wage rate that becomes evident when we examine Figure S1-1. Since each extra hour of leisure reduces the amount of income available for consumption, then the wage rate can also be interpreted as the opportunity cost (or relative price) of leisure. So, as with all budget lines, the slope of the budget line (here –w) represents the relative price of one good (leisure) in terms of another (consumption).

leisure (hours)

Consumption ($)

BL

IC

E

H

wH

R

C

-w

C = wL = w H - ( )R

L

Figure S1-1 Household Labour Supply Equilibrium Consumer Equilibrium

The household maximizes its utility by consuming at the point where it reaches its highest possible indifference curve. In Figure S1-1 this occurs at point E where IC is tangent to the budget line. At, because the slope of the indifference curve is equal to the slope of the budget line, then at equilibrium mrs = w. This has the usual interpretation. In equilibrium, the marginal rate of

44

substitution (the internal trade-off in terms of taste) is equal to the relative price ratio (the external trade-off in terms of possibilities).

The equilibrium point E shows the bundle of consumption and leisure that the household

chooses, {C, R}. But we can also illustrate the household’s labour supply. Since the household has H units of time to begin with and chooses R units of time in leisure, the labour is simply H – R. This is shown on the diagram by measuring backwards along the leisure axis from the endowment point H to the chosen amount of leisure R.

Non-Labour Income Suppose the household now has access to some non-labour income (income it can consume

regardless of how much it chooses to work). This could take the form of income generated from saving, a government benefit of some kind, etc. How the household responds is shown in Figure S1-2, where the household now can consume $X even if it chooses to supply no labour.

leisure (hours)

Consumption ($)

BL

IC

E

H

wH

X N

X+wH BL'

A

B

Figure S1-2 Non-Labour Income

The budget line shifts up by X to BL’. The end points are now given by the consumption axis intercept, X + wH, and the point N, which shows that the household could choose $X of consumption and H hours of leisure. The slope of the budget line remains unchanged because the wage is unchanged. Since both leisure and consumption are considered to be normal goods, then, if the original consumption bundle was E, then the household would choose some point on the new budget line between A and B, denoting a new bundle with more of both goods. Not that “more leisure” implies less labour.

Wage Changes Now suppose that the household faces an increase in the wage rate. The effect on the budget

line is shown in Figure S1-3. The budget line pivots out around the no-labour end point (H) from BL to BL’. As with all price changes, this will have both a substitution effect and an income effect. To illustrate the substitution effect examine the “imaginary” budget line BL”, which has the new slope –w’ but passes through the original bundle E. If faced with this budget line, the household would choose a bundle like S with more consumption and less leisure (S would be on a higher indifference curve than IC(E)). This is because the increase in wages means that leisure has become more

45

expensive relative to consumption. The income effect can be illustrated by the move from S to a point on the new budget line BL’. Since both consumption and leisure are normal goods, this new bundle will lie somewhere between A and B. Note that this includes possible bundles with more leisure (therefore less labour) than Re. To sum up, both the substitution and income effects are pushing the household to increase consumption (so we can be sure that consumption will rise), but with the substitution effect favouring less leisure and the income effect favouring more leisure, we cannot be sure whether leisure (and therefore labour supply) will rise or fall in the face of a wage increase.

leisure (hours)

Consumption ($)

BL

IC(E)E

H

wH

Re

w' > w

BL'w'H

S

A

B

BL"

Figure S1-3 The Substitution and Income Effects of a Wage Change

Reservation Wage

The reservation wage is defined as the wage below which the household will choose not to

participate in the labour market. To illustrate this concept, examine Figure S1-4. If the household chooses not to participate in the labour market, it consumes at point N and achieves utility shown by IC(N). Suppose that the household faces the low wage w. Given this wage, it is better off with bundle N, so it chooses to supply no labour. If the wage rate rises to w’, the household will maximize utility by choosing point E, supplying some labour. The reservation wage w*, is the wage at which the budget line is tangent to IC(N) at point N. At the reservation wage, the household is just indifferent between choosing point N and supplying the first unit of labour. There is one additional point to note. Since the increase in wage from w* to w’ has resulted in an increase in labour supply (from none to some), then it is clear that at low wages just above the reservation wage, the substitution effect of a wage increase outweighs the income effect.

leisure (hours)

Consumption ($)

IC(N)

H

N

w < w* < w'

E

Figure S1-4 – The Reservation Wage

46

Summing-Up: The Labour Supply Curve

Household Labour Supply

Examine Figure S1-5. As our discussion concerning the reservation wage establishes, at wages below w*, the household will choose to supply no labour and for a least some wages above w*, the substitution effect outweighs the income effect and labour supply increases. However, as our discussion concerning the effect of wages changes establishes, there may come a wage (like w’) above which the income effect outweighs the substitution effect and labour supply actually falls in the face of increasing wages. This raises the possibility that the labour supply curve that is “backward-bending” as shown.

Labour (hours)

wage

w*

income effectoutweighs the substitution effect

w'substitution effectoutweighs the income effect

LS

Figure S1-5 – A “Backward Bending” Household Labour Supply Curve Market Labour Supply

It is important to note that both the reservation wage for a household and the wage rate (if any) where the labour supply “bends back” are based on the individual household’s preferences. Therefore we would not expect the market labour supply curve to look as above in Figure S1-5. However, given the opposing nature of the substitution and income effects of a wage change, we would expect the market supply curve to be fairly inelastic. This indeed is what most empirical studies have found.

Saving Supply The Basic Set-Up

The inter-temporal consumption model we use to study saving is quite powerful and in various forms can be used to study, saving, borrowing, and financial asset choices. In its overlapping generations form it can be used to study bequest behaviour, and even to analyze the intergenerational effects of various government expenditure and tax policies. In this section, since we are focusing on the supply of saving, we will use the model in its simplest form.

We will assume that the household lives for only two periods, the present or working life and

the future during which it will be retired. We will assume that the household has income equal to I that it will earn in the present and that it must decide how to allocate this between saving, S, and present consumption, Cp. Of these two, present consumption is considered to be a “good” and saving is only

47

useful because it provides a method of providing for transferring some of its current income to consumption in the future, Cf. Saving earns a return in the market equal to the interest rate, r. Thus its total consumption in the future is equal to (1+ r)S. Variables and Definitions

I – endowment of the household in terms of income earned in the present to be split between

saving and present consumption, so I = Cp + S

Cp – present consumption, a good

S = I – Cp – saving

r – the interest rate faced by the household

(1+ r)S – the total return to saving earned by the household

Cf = (1+ r)S – future consumption by the household, a good Preferences

Preferences over the two goods in the model, present consumption and future consumption are defined by normal (convex to the origin) indifference curves. In addition, it is usually assumed in this model that both future consumption and present consumption are normal goods. Budget Line

The maximum amount that consumers can spend on future consumption is what they earn in the saving market, so

Cf = (1+ r)S

Since saving supply is limited by the total amount of income available and the amount the household decides to consume in the present, we can rewrite the budget constraint:

Cf = (1+ r)S = (1+ r)(I – Cp) = (1+ r)I – (1+ r)Cp

The budget line is shown as BL in diagram S2-1. The intercepts are as shown in the diagram. If the household decides to consume all of its income in the present, it would have I units of present consumption and zero future consumption, while if it saved all of its income for the future, it would have zero present consumption and (1+ r)I future consumption. The slope of the budget line is given by –(1+ r).

We are used to thinking about the interest rate as the reward to saving. While this is certainly one way of looking at the interest rate, there is another interpretation of the interest rate that becomes evident when we examine Figure S2-1. Since each extra dollar of present consumption reduces the amount of saving to generate future consumption, then one plus the interest rate can also be interpreted as the opportunity cost (or relative price) of present consumption. So, as with all budget lines, the slope of the budget line (here –(1+ r)) represents the relative price of one good (present consumption) in terms of another (future consumption).

48

Cp ($)

Cf ($)

BL

IC

E

I

(1+ )r I

-(1+ )r

Cf = r S = - Cp

(1+ )(I )(1+ )r

S

Cp

Cf

Figure S2-1 Household Saving Supply Equilibrium Consumer Equilibrium

The household maximizes its utility by consuming at the point where it reaches its highest possible indifference curve. In Figure S2-1 this occurs at point E where IC is tangent to the budget line. At E, because the slope of the indifference curve is equal to the slope of the budget line, then at equilibrium mrs = 1+ r. This has the usual interpretation. In equilibrium, the marginal rate of substitution (the internal trade-off in terms of taste) is equal to the relative price ratio (the external trade-off in terms of possibilities).

The equilibrium point E shows the bundle of future consumption and present consumption that

the household chooses, {Cf, Cp}. But we can also illustrate the household’s saving supply. Since the household has income equal to I to begin with and chooses Cp in present consumption, then saving is simply I – Cp. This is shown on the diagram by measuring backwards along the present consumption axis from the endowment point I to the chosen amount of present consumption Cp.

Income Changes Suppose the household’s current income increases. How the household responds is shown in

Figure S2-2.

Cp

Cf

BLE

I

(1+ )r I' BL'

A

B

(1+ )r I

I'

Figure S2-2 Non-Saving Income

49

The budget line shifts out to BL’. The end points are now given by the future consumption axis intercept, (1+r)I’, and present consumption axis intercept, I’. The slope of the budget line remains unchanged because the interest rate is unchanged. Since both present consumption and future consumption are considered to be normal goods, then, if the original future consumption bundle was E, then the household would choose some point on the new budget line between A and B, denoting a new bundle with more of both goods. Not that “more future consumption” implies more saving. This is because, given that the interest rate is unchanged, the only way to increase consumption in the future is to save more.

Interest Rate Changes Now suppose that the household faces an increase in the interest rate. The effect on the budget

line is shown in Figure S2-3. The budget line pivots out around the no-saving end point (I) from BL to BL’. As with all price changes, this will have both a substitution effect and an income effect. To illustrate the substitution effect examine the “imaginary” budget line BL”, which has the new slope –(1+r’) but passes through the original bundle E. If faced with this budget line, the household would choose a bundle like S with more future consumption and less present consumption (S would be on a higher indifference curve than IC(E)). This is because the increase in the interest rate means that present consumption has become more expensive relative to future consumption. The income effect can be illustrated by the move from S to a point on the new budget line BL’. Since both future consumption and present consumption are normal goods, this new bundle will lie somewhere between A and B. Note that this includes possible bundles with more present consumption (therefore less saving) than Cpe. To sum up, both the substitution and income effects are pushing the household to increase future consumption (so we can be sure that future consumption will rise), but with the substitution effect favouring less present consumption and the income effect favouring more present consumption, we cannot be sure whether present consumption (and therefore saving supply) will rise or fall in the face of a interest rate increase.

Cp

Cf

BL

IC(E)E

ICpe

r' > r

BL'

S

A

B

BL"

(1+ )r' I

(1+ )r I

Figure S2-3 The Substitution and Income Effects of an Interest Rate Change

There is one final note to make about the effect of an increase in the interest rate. Although our analysis of the income and substitution effects tells us that we cannot be sure whether saving rises or falls, it tells us that we can be certain the consumption in the future rises. This is possible because, given the increase in the interest rate, each dollar of saving is now more productive at generating future

50

consumption than before. Therefore we can have an increase in future consumption, even with less saving.

Summing-Up: The Saving Supply Curve

Household Saving Supply

In this basic model there is no analog to the reservation wage – no reservation interest rate as it were. This is because the only way to have consumption in the future is through saving. A richer model with endowment income in both periods would allow us to examine the interest rate at which the household switches from being a saver to a borrower. However, our analysis of the income and substitution effects establishes that individual household saving supply is likely to be fairly inelastic and may have a “backward-bending” range.

Market Saving Supply

Again, it is important to note that the interest rate (if any) where the saving supply “bends back” is based on the individual household’s preferences. Therefore we would not expect the market saving supply curve to be backward bending. However, given the opposing nature of the substitution and income effects of an interest rate change, we would expect the market supply curve to be fairly inelastic. This indeed is what most empirical studies have found. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading. “Take-Home” Mid-term You should have completed the course to this point by the time of the “Take-Home” Mid-term. See the course outline for the due date.

51

PART IV

PRODUCER THEORY

_______________________________________

Chapter 7: Producers in the Short Run _______________________________________

Learning Objectives:

• Examine different forms of business organization and the various ways in which firms can be financed.

• Distinguish between accounting profits and economic profits.

• Describe the relationships between total product, average product, and marginal product, and explain the law of diminishing returns.

• Differentiate between fixed and variable costs, and describe the relationships between total costs, average costs, and marginal costs.

• Understand the relationship between marginal product and marginal cost and the relationship between average produce and average variable cost

What are Firms? Organization of Firms Firms come in six basic types:

<Single proprietorships <Ordinary partnerships <Limited partnerships <Corporations <State-owned (“Crown”) corporations <Non-Profit Organizations (such as those that do not sell their output)

Financing of Firms The basic types of financial capital used by firms are equity and debt. A corporation acquires funds from its owners (equity) in return for stocks, shares, or equity (as they are variously called). These are basically ownership certificates. Profits may be distributed to the shareholders in the form of dividends, while the rest is retained for reinvestment. A firm’s creditors (those who provide the firm debt finance) are not owners; they have loaned money in return for some form of IOU. These are often called debt instruments or bonds.

52

Goals of Firms We make two key assumptions about firms:

• All firms are assumed to be profit-maximizers.

• Every firm is assumed to be a single, consistent decision-making unit.

These assumptions allow the theory of the firm to ignore the firm’s internal organization and its financial structure. Economists can predict the behaviour of firms by studying the choices open to the firm, and establishing the effect each choice would have on the firm’s profits. Production, Costs, and Profits Production There are four broad categories of inputs that firms need for production:

Inputs that are the outputs of some other firm (intermediate products). Inputs that are provided directly by nature, such as land or air. Inputs that are provided directly by people, such as labour services. Inputs that are provided by the services of physical capital (machines).

The production function relates inputs to outputs. It describes the technological relationship between the inputs that a firm uses and the output that it produces. It is important to remember that production is a flow: it is a number of units per period of time. In simple functional notation we have:

q = f(L,K) where q is the flow of output per period, K is the flow of capital services, and L is the flow of labour services. Changes in the firm’s technology, which alter the relationship between inputs and outputs, are reflected by changes in the function f. Costs and Profits Economic profit includes both implicit, as well as explicit costs. Unlike the accounting definition of profit, economic profit includes implicit costs like the opportunity cost of owner’s capital or the opportunity cost of an owner’s time. Economic profits are therefore less than accounting profits.

Economic Profit (π) = Accounting Profit – Implicit Costs

In this course, when we refer to profits we are talking about economic profits. If economic profit is positive, then the owner’s capital is earning more than it could in its next best alternative use. If economic profit is negative, the return is less than in its next best use.

53

Profit-Maximizing Output The difference between a firm’s total revenue, TR, and its total costs, TC, is equal to its profits.

Profits = TR - TC Therefore, what happens to profits as output changes depends on what happens to both revenues and costs. As we said before, economists usually assume that firms make their decisions with the objective of maximizing profits. Time Horizons for Decision-Making

$ The short run is a length of time over which some of the firm’s factors of production are fixed. Typically, physical capital (the size of the plant) is the fixed factor -- labour and material inputs are typically variable.

$ The long run is the length of time over which all of the firm’s factors of production can be varied, but its technology is fixed.

$ The very long run is the length of time over which all the firm’s factors of production and its technology can be varied.

Production in the Short-Run Recall the production function:

q = f(factors of production)

This is a very general formulation that would have different factors needed for different goods and even different production functions for firms in different industries. In the short run we can divide the factors of production into those that are variable and those that are fixed.

q = f(variable factors, fixed factors)

For simplicity, as above, we assume two factors:

q = f(L, K) where labour is our variable factor and capital is our (short run) fixed factor Total, Average, and Marginal Products Total Product (TP) is the total amount of output that is produced during a given period of time

TP = q = f(L, K) Average Product (AP) is the total product divided by the number of units of the factor used to produce it. Since labour is usually the most important variable factor in the short run, we usually talk of the average product of labour, given by:

AP = TP/L = q/L

54

Marginal Product (MP) is the change in the total product resulting from the use of one more (or one less) unit of a factor

MP = ΔTP/ΔL = Δq/ΔL Diminishing Marginal Product How does output vary with labour hired? The key assumption is that f(L, K) is subject (eventually) to “diminishing marginal product”. At this point each additional unit of labour hired produces less than the previous unit. That is, each subsequent unit of labour hired adds less to total product (q). To see this consider a worker who does all the tasks required to manufacture a product. As subsequent workers are added, each can specialize on one task and marginal product rises. But if there is a fixed amount of physical capital, eventually the marginal product would decline as described above. Fig 7-1 shows the total, average and marginal product curves for the example in the text. In general, they are as shown below:

L

TP(q)

L

MPAP

TP = q = f(L, K 0)

L 0 L1

L 0 L1

APMP

q0

q1

The relationships among these curves are summarized by:

• MP is the slope of TP • L0 is the point of diminishing marginal product • q0 is the output produced by L0 • AP = TP/L is the slope of a ray from the origin to a point on TP • L1 is the point of maximum average product • q1 is the output produced by L1

55

The Average-Marginal Relationship If an additional worker’s output is to raise the average product of all the workers, the additional worker’s output must be greater than the average output of the previous workers. That is:

If MP > AP, then AP will rise.

Similarly, if the output of the marginal worker is less than the current average, the average product will fall. That is:

If MP < AP, then AP will fall

Therefore, the AP curve slopes upward as long as the MP curve is above it; the AP curve slopes downward when the MP curve is below it. It follows that the MP curve must intersect the AP curve at its maximum point. The marginal/average relationship holds for anything, not just “products”. If marginal is above average, average rises. If marginal is below average, average falls. Think about your assignment grades! Costs in the Short-Run Definitions: Total cost (TC) is the full cost of producing any given level of output. TC is divided into two parts: fixed cost and variable cost. Total fixed cost (TFC or FC) does not vary with the level of output. FC is the cost associated with the firm’s (short-run) fixed factor(s) Total variable cost (TVC or VC) varies directly with output. VC is the cost associated with the firm’s variable factor(s)

TC = FC + VC Average total cost (ATC) is TC divided by the level of output

ATC = TC/q ATC can be separated into average fixed cost (AFC) and average variable cost (AVC)

ATC = AFC + AVC

ATC = FC/q + VC/q Marginal cost (MC) is the increase in total cost resulting from increasing the level of output by one unit. Because fixed costs do not vary with output, the only part of TC that changes is the variable cost.

MC = ΔTC/ΔQ = ΔVC/ΔQ

56

Short-Run Cost Curves We can graph the TC, FC and VC functions that are associated with the short run production function we have assumed. We can also graph the “per unit” cost curves, MC, AVC, AFC and ATC. These are shown for the particular example in your text in Fig 7-2. In general, they are as shown below:

q

$

q

$

TC

FC

AVC

MC ATC

VC

q0

FC

AFCq1 q2

The relationships among these curves are summarized by:

• MC is the slope of TC and VC at any given level of output • q0 is the point of minimum marginal cost • q0 is the output produced by L0 (recall our figure describing short run production) • AVC = VC/q is the slope of a ray from the origin to a point on VC • q1 is the point of minimum average variable cost • q1 is the output produced by L1 (recall our figure describing short run production) • ATC = TC/q is the slope of a ray from the origin to a point on TC • q2 is the point of minimum average total cost

Why is MC upward sloping after q0 ?

Because MP is downward sloping after L0 where q0 = f(L0, K0). After L0 each successive unit of labour produces less output than the last, but each unit of labour costs the same wage (w). So the output produced by that labour is more expensive i.e. increasing MC.

57

Mathematically:

qVC

qVC

qFC

qTCMC

ΔΔ

ΔΔ

ΔΔ

ΔΔ

=+==

In our two factor representation FC = pKK and VC = wL, where pK is the price of capital and w is the wage, so we can write MC as

qwL

qVCMC

ΔΔ

ΔΔ )(

==

But the wage does not change as the firm hires more or less labour, so

qLwMC

ΔΔ

=

Recall that MP is given by:

LqMP

ΔΔ

=

So:

MPwMC =

Since MP is downward sloping after L0 then MC is upward sloping after q0. Why is AVC U-shaped ?

Because AP is hill-shaped

qLw

qwL

qVCAVC ===

Recall that AP is given by:

LqAP =

So:

APwAVC =

Why does MC pass thru the min point of AVC ?

qVCMCΔΔ

=

If marginal < average, average falls, and if marginal > average, average rises. Why does MC pass thru the min point of ATC ?

qTCMCΔΔ

=

If marginal < average, average falls, and if marginal > average, average rises.

58

Capacity Capacity is the level of output that corresponds to the minimum short-run average total cost (q2). It is the largest output that can be produced without encountering rising average cost. A firm that is producing less than q2 is said to have excess capacity. Shifts in Short-Run Cost Curves Recall that the short run cost curves are derived for:

1. given input prices (wage, price of capital)

2. given existing pool of (short run) fixed inputs (capital level K0)

If we change any of these things we must draw new SR cost curves. Changes in capital are a long run decision so will be dealt with in the next chapter. Changes in Fixed Costs

Suppose there is an increase in FC. This could be caused by an increase in the price of capital (for example, an increase in interest rates is an increase in the opp. cost of capital) or by an increase in some other fixed cost (for example a license fee). In terms of our diagrams, FC and TC (= FC + VC) are affected as are AFC and ATC (= AFC + AVC). The other cost curves are unaffected (notably MC and AVC). Changes in Variable Costs

Suppose there is an increase in VC. This could be caused by an increase in the wage or the price of some other variable factor of production. In terms of our diagrams, VC, and TC are affected as are AVC, MC and ATC. This is shown in Fig 7-3. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

59

______________________________________

Chapter 8: Producers in the Long Run _______________________________________

Learning Objectives:

• Discuss why profit maximization requires firms to equate the marginal product per dollar spent for all factors.

• Explain why firms will use more of the factors whose prices have fallen, or less of the factors whose prices have increased.

• Describe the relationship between short-run and long-run cost curves.

• Explain the importance of technological change and why firms are often motivated to innovate to improve their production methods.

The Long Run: No Fixed Factors The Long Run is the length of time such that all factors are variable. In our two factor model this means that capital is now variable Profit Maximization and Cost Minimization A profit maximizing firm chooses the least costly way of producing its desired level of output. So profit maximization implies cost minimization. This is also referred to as “productive efficiency” as we will see later. For given q, if it is possible to reduce total cost by substituting one factor for another, the firm is not using the least costly combination of factors. Therefore the firm will substitute one factor for another until the marginal product per dollar spent on one factor is equal to the marginal product per dollar spent on another factor. Another way to say this is that the firm equalizes the output from the last dollar spent on each factor. Using L and K to represent labour and capital, and w and pK to represent the prices for the two factors, the condition for cost minimization is:

wMP

pMP L

K

K =

Or:

wp

MPMP K

L

K =

In the second equation the interpretation is that the internal trade-off in the relative productivity of factors is set equal to the external trade-off in the market for factors.

60

If:

wMP

pMP L

K

K >

Using more K and less L will reduce costs of producing a given q (recall that MP’s are declining). The text gives an example using some numbers to make this clear. Long Run Cost Curves Since firms can cost minimize in the long run, costs will be at least as low in the long run as they are in the short run. Remember that SR cost curves are drawn for given input prices and for a given pool of fixed factors (capital stock). So changes in the capital stock involve drawing new SR cost curves just as changes in input prices do. This also implies that changes in output levels affect costs less in the LR than they do in the SR. We will examine these ideas by looking at two changes:

1. For a given q, we will examine how changes in input prices affect costs in the SR and LR.

2. We will examine how costs change in the SR and in the LR as we change q. We will show this by deriving the LRAC curve.

Input Price Change The response of the firm is governed by the principle of substitution. Firms will respond to changes in input prices by substituting away from relatively more expensive inputs toward relatively less expensive inputs. Costs will rise for the firm, but in the LR the firm can limit (but not eliminate) this effect since it can change its input mix to (partially) compensate. EXAMPLE (increase in wages):

Output level q is produced using original input mix (K, L)

wMP

pMP L

K

K =

Suppose wages rise from w to w’. In the SR – after w’ but before any input adjustment:

'wMP

pMP L

K

K <

As discussed above, to pursue cost minimization the firm increases K (MPK falls) and decreases L (MPL rises) until at the new input mix (K’, L’)

'''

wMP

pMP L

K

K =

61

Effect on Average Cost Levels:

q

$

SRAC(w, K)

q

AC

AC’

SRAC’(w’, K)

SRAC”(w’, K’)

AC”

The firm can lower costs below AC’ through substitution, but will never achieve original level AC. That is, firm would have lower costs of producing q if wages had stayed low. In our example w > w’ and the firm’s response is such that K’ > K and L’ < L. The relationship between the cost levels is summarized below:

qKpwLAC K+

= q

KpLwAC K+=

'' q

KpLwAC K '''" += '" ACACAC <<

The Long Run Average Cost Curve How do costs change in the LR if we change output? We can capture this through the LRAC curve. This also shows the relationship of LRAC to SRAC. Each level of capital (plant size) has its own associated set of SR cost curves. In the LR the firm will use the plant size that minimizes the costs of producing any q, so the LRAC curve will be the lower envelope of SRAC curves. EXAMPLE:

Suppose the firm has access to only 3 levels of capital (plant sizes): K2 > K1 > K0. Each has its own set of SR cost curves including SRAC. Which will it use at different levels of output? It will use the one that offers the lowest level of cost. Examine the diagram below.

q

$

SRAC0

q’

SRAC1

q”

SRAC2

If q ≤ q’ use K0 SRAC0. If q’ < q ≤ q” use K1 SRAC1. If q” < q use K2 SRAC2.

So the LRAC is the lower envelope of all available SRAC curves.

62

Typical LRAC With fully variable capital (rather than just 3 levels) the LRAC curve will be U-shaped as shown in figure 8-1. It has a region with decreasing costs/increasing returns to scale (“bigger is cheaper”), a region with constant costs/constant returns to scale, and a region with increasing costs/decreasing returns to scale (“bigger is more expensive”). Fig 8-2 shows the relationship between this “continuous” LRAC and the SRAC curves from which it is composed. At each point on the LRAC there is a SRAC curve that is tangent. Changes in LRAC Changes in LRAC can stem from two sources:

1. Input price changes – since the firm is minimizing costs along LRAC then any increase in input prices shifts LRAC up

2. Technological change – will shift LRAC down The Very Long Run: Technological Change Technological change is a change in the productivity of inputs. That is, it is a change in the production function itself

q = f(L, K)

With technological change f itself changes so the q rises for given L and K or, to put it another way, the L and K necessary for a given q decline These changes are often endogenous. For example an increase in an input price causes the firm to substitute away, then innovate away, from the use of that input. Technological change can take the form of: new processes or techniques, “new” inputs (new and more advanced capital or more highly skilled labour) or new products. Skip the Appendix to Chapter 8 – Isoquant Analysis

Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

63

PART V

OUTPUT MARKETS

_________________________________

Chapter 9: Competitive Markets _________________________________

Learning Objectives:

• Understand the key assumptions of the theory of perfect competition.

• Show how to derive a competitive firm’s supply curve.

• Identify whether competitive firms are making losses or profits in the short run.

• Explain the role that profits, entry, and exit play in a competitive industry’s long-run equilibrium. Market Structure and Firm Behaviour Competitive Market Structure The competitiveness of the market is related to the power individual firms have to influence market prices or the terms on which their product is sold. The less power an individual firm has to influence the market in which it sells its product, the more competitive is that market’s structure. A market is competitive if each buyer and seller is small compared to the size of the market and, therefore, has little ability to influence market prices. The term competitive behaviour refers to the degree to which individual firms actively vie with one another for business. For example, Petro-Canada and Esso engage in competitive behaviour but their market is not competitive. In contrast, two wheat farmers do not engage in competitive behaviour but they both exist in a very competitive market. Note that the demand curve for the firm’s output may not be the same as the demand curve for the industry as a whole. The characteristics of the market — the market structure — determine the relationship between the market demand curve for the industry’s product and the demand curve that each firm in that industry faces.

64

Profit Maximization This analysis of profit maximization applies in general, not just for competitive firms. If it is profitable for the firm to produce at all, it will produce q’ where marginal profit equals zero. That is it will produce where the addition to profit from unit # q’ is equal to zero Profit Max: q’ where ∆π = 0

IF ∆π > 0 then the firm can add profit by producing more output

IF ∆π < 0 then the last unit produced actually decreased profit, so reduce profit Now, since π = TR – TC, then ∆π = ∆TR – ∆TC. So profit max implies ∆π = ∆TR – ∆TC = 0 which implies ∆TR = ∆TC. That is, profit max occurs where marginal revenue (MR) equals marginal cost (MC). The Theory of Perfect Competition Perfect competition is a particular market structure characterized by several important assumptions. It is the market structure that underlies the Supply and Demand model. Key Assumptions

1. firms produce identical products (homogeneous products)

2. firms and consumers have full information about products and prices

3. many “small” consumers and producers

-no individual firm’s or consumer’s decisions are large enough to affect the market price

-market participants are “price-takers”

4. MES is “small” relative to the size of the market

5. free entry to or exit from the market in LR Demand Curve for a Firm Since the firm is a “price-taker” it can sell as little or as much as it wants at the going market price. Therefore the “demand curve” for an individual firm is horizontal at the going market price. This is shown Fig 9-1.

65

Short-Run Decisions Profit Maximization and SR Firm Supply At the firm level revenue is given by:

TR = pq Since the firm is a price-taker – that is, it “takes” the price as determined in the market – then:

AR = MR = p If it is profitable to produce at all, given price p’, the profit maximizing firm will choose q’, where:

p’ = MC(q’) By varying p, we can see how the firm changes its quantity (firm supply)

MC

AVC

q

$

p’

p0

q’ At prices below p0 the phrase “if it is profitable to produce at all” becomes important. At these low price levels the firm would lose more by producing where p = MC than it would by producing 0 and losing only its fixed costs. For this reason the price p0 is often referred to as the “shut down” point for the firm. At these low prices the firm shuts down (q = 0) and lays-off all of its variable factors. The firm is still technically “in the industry” since it still owns capital – this capital is just not being used.

Therefore, as shown in Fig 9-2 for the particular numerical example in the text, the SR Firm Supply is its MC curve at or above AVC.

SR Equilibrium in Perfect Competition In the SR the number of firms is fixed since entry/exit decisions involve capital decisions and are therefore LR decisions. So SR equilibrium is characterized by the following:

1. Fixed number of existing firms

2. Existing firms are profit maximizing: Sf = MC above AVC

3. No excess supply or demand in the market as a whole: SR eq’m price such that S = ∑Sf = D

66

Market Firm

MC

AVC

q

$

p’

q’

S

Q

$

p’

p0

Q’

D

In the diagram, S = ∑Sf and Q’ = ∑q’. Also note that with n identical firms, Q’ = nq’.

Profits or Losses in SR Equilibrium In the SR the firm is profit maximizing. But the level of profits may be positive negative or equal to zero. The key is that the firm is doing the best it can in SR even if “the best it can” involves minimizing its losses. Fig 9-7 shows the possibilities. If the market price equals p1 the firm maximizes profits by producing quantity Q1 but earns negative profits equal to the pink shaded region. If the market price equals p2 the firm maximizes profits by producing quantity Q2 but the level of profits equals zero. If the market price equals p3 the firm maximizes profits by producing quantity Q3 and earns positive profits equal to the green shaded region. We could add the shut-down possibility such that if the price falls below the minimum of AVC the firm maximizes profits by producing quantity equal to zero and earns negative profits equal to its (short-run) fixed costs. All of possibilities for short-run profit level make it clear that fixed costs do not affect short-run decisions. Fixed costs are “sunk costs” in the SR, they are unavoidable, and so do not affect decisions. However the profit level (positive or negative) acts as LR signal for entry or exit. Long Run Decisions In the LR the number of firms is endogenous. Entry/exit decisions are based on profits/losses. Positive profits at the margin attract entry. Negative profits spur exit.

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Long Run Equilibrium in Perfect Competition Given that profits /losses at the margin cause entry/exit, LR equilibrium is characterized by the following:

1. Must be a SR equilibrium

2. Firms must be LR cost minimizing: they are operating on LR cost curves

3. No one wants to enter or exit: that is, zero profits for the marginal firm (with identical firms this means all firms are earning zero profits)

Market Marginal Firm

MC

LRAC

q

$

p*

q*

S

Q

$

p*

Q*

D

SRAC

In the diagram, the short-run supply curve S = ∑Sf. Also note that with identical firms we can solve for the number of firms n* = Q*/q* How do changes in supply occur in the LR? The answer is that they occur through entry/exit. Horizontal Long Run Supply Competitive industries composed of more or less identical firms will have horizontal LR supply curves. EXAMPLE: A perfectly competitive industry composed of identical firms experiences a permanent increase in demand

Market Firm MC

LRAC

q

$

p*

q*

S0

Q

$

p*

Q0

D

SRAC

00

12

1

q1Q1 Q2

p1 p1

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Original LR (and SR) Equilibrium:

-point 0 in market diagram -point 0 in firm diagram -original number of firms n0 = Q0/q*

Now demand shifts from D to D’ New SR Equilibrium:

-in SR price is bid up to p1 quantity rises to Q1 -point 1 in market diagram

-existing firms expand output along their SR supply curves (their MC curves) to q1 -point 1 in firm diagram -note that Q1 = n0q1

-existing firms earn positive economic profit -so this is not a new LR equilibrium

Adjustment to New LR Equilibrium: -profits bring entry of new firms -each entrant brings its own SR supply curve (its own MC curve) -price is bid down and quantity rises as the market moves along D’ -original firms respond to falling market price by decreasing output along their MC curves

New LR (and SR) Equilibrium:

-point 2 in market diagram -point 0 in firm diagram -new number of firms n2 = Q2/q*

This implies a horizontal LR Supply curve at p* where changes in output are caused by firms entering or exiting at price p*.

SSR

Q

$

p*

Q*

D

SLR

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Upward Sloping Long Run Supply Curve? -two possible sources of this 1. As output expands a critical input price is bid up.

-costs of all firms rise, so the “zero profit” output price rises 2. Some firms may have a natural cost advantage.

-ex. natural resource or agricultural markets -as demand grows, lowest cost firms enter first as they are able to cover costs at lower prices -as demand grows bidding up price low cost firms expand output, but other firms may enter if they can cover costs -low cost firms can earn positive economic profits

-remember that only marginal firm need earn zero profits for us to be in LR equ’m -these profits are sometimes referred to as “economic rent” to the factor of production that gives these firms the cost advantage

-call this to distinguish them from the profits that bring entry Technological Change As we have seen, tech change (the very long run) leads to lower costs. If there is a single instance of this, new tech firms (old firms who adopt the new tech and new tech entrants) will become the marginal firms and earn zero profits. The old tech firms will continue to operate in SR if the new p > AVC, but will be earning losses. In the LR they will either exit or adopt new tech. As shown in Fig 9-12, if the tech progress is more or less continuous there will always be some firms earning negative profits. Declining Industries If demand is shifting left (due to changes in consumer preferences for example) firms earn negative profits in the SR. This is a signal for resources (and firms) to leave the industry. This does not happen instantly. Firms continue to operate old equipment as long as variable costs are covered but will not purchase new equipment unless total costs are covered. Therefore antiquated equipment in a declining industry is an effect, not a cause of the decline. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

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_____________________________________________________________

Chapter 10: Monopolies, Cartels and Price Discrimination ______________________________________________________________

Learning Objectives:

• Explain why marginal revenue is less than price for a profit-maximizing monopolist.

• Describe how entry barriers allow monopolists to maintain positive profits in the long run.

• Describe how firms can form a cartel in which they restrict industry output and increase price and profits and explain the problems associated with cartels.

• Explain the different types of price discrimination. Single-Price Monopolist Here we have a single firm serving the entire market. In this section we assume that it sells its output for one price. We will examine multiple price strategies when we look at “price discrimination” later in the chapter. Cost and Revenue in the Short-Run

Because a monopolist is the sole producer of the product that it sells, its demand curve is the market demand curve for that product. The monopolist therefore faces a negatively sloped demand curve, and so it faces a tradeoff between the price it charges and the quantity it sells. Marginal and Average Revenue Since the firm serves the entire market, it knows that its output decision affects the market price. It is not a “price-taker” but a “price-maker” because the firm’s demand is the market demand.

TR =p×Q

pQ

QpQTRAR =

×==

pQTRMR <=ΔΔ

MR < p because the firm must lower price on all units if it wants to sell an additional unit. To see this, consider the following.

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EXAMPLE: What is the change in revenue caused by the change from Q1 to Q2?

Q

$

p1

Q1

D

p2

Q2

TR(Q1) = p1Q1 TR(Q2) = p2Q2 The change adds p2(Q2 – Q1) to firm revenue, but also subtracts (p1 – p2)Q1 from firm revenue If we shrink the difference between the quantities to a single unit (ie Q2 = Q1 + 1)

-addition to revenue is now: p2 -subtraction from revenue: (p1 – p2)Q1

So MR(Q2) = p2 – (p1 – p2)Q1 < p2

Q

$

p2

Q2

DMR(Q2)

MR See Fig 10-1 for a numerical example. Aside 1: MR and Elasticity of Demand

MR > 0 %∆Q > %∆p ie. ED > 1 MR < 0 %∆Q < %∆p ie. ED < 1

Aside 2: MR and Linear Demand

We can write an “inverse” demand curve with price as a function of quantity (p = f(Q)). A linear example would be:

p = a – bQ MR = a – 2bQ

The slope of MR is twice that of the demand curve.

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Short Run Profit Maximization If it is profitable for the firm to produce at all, it will produce Qm where marginal revenue equals marginal cost. So it should produce Qm where:

MR(Qm) = MC(Qm) provided AR(Qm) = pm ≥ AVC(Qm)

This is shown in Fig 10-2.

No Monopoly “Supply” Curve A supply curve tells us what quantity will be produced for a given price. With a monopoly there is no unique relationship between price and quantity. This is because the monopolist sets its own price and because the monopolist’s decision depends on “supply-side” factors (MC) but also “demand-side” factors (MR).

Monopoly vs Competition Examine Fig 10-3. In perfect competition S = ∑MC and the equilibrium is characterized by pc = MC and Qc = Q*. In monopoly pm > MC and Qm < Q*. Therefore the willingness-to-pay for unit Qm (price pm) is greater than marginal cost of producing unit Qm (and all units up to Qc). This implies that the monopoly solution is inefficient. The deadweight loss is shown by the shaded region in the diagram.

Entry Barriers and Long-Run Equilibrium LR equilibrium involves:

1. SR equ’m (i.e. MR(Qm) = MC(Qm)

2. Cost minimization (i.e. the firm operating on its LRAC curve)

3. Entry barriers that stop other firms from coming in

Therefore profits can persist, even in the LR Entry Barriers can be natural such as a production technology that involves declining LRAC over the range of the market. This situation is referred to as a “natural” monopoly (more on this in Ch 12). Entry barriers can also be created either by the government (patents, licenses, etc.), or by the firm itself through what is referred to as entry deterring behaviour (more on this in Ch 11).

The Very Long Run and Creative Destruction Natural entry barriers and entry deterring behaviour are often surmounted through process or product innovation. Monopoly rarely persists in the very long run unless the firm is protected by gov’t in some way. The monopoly is “destroyed” by the new entrant but in a “creative” way that better serves consumers. Shumpeter and the Austrian school emphasized how the existence of monopoly profits provides the incentive for innovation in processes and products. This is an important idea for any market structure that generates positive economic profits, not just monopolies

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Cartels as Monopolies

Another way a monopoly-like solution can arise is for the several firms in an industry to form a cartel — to behave as if they were a single seller — in order to maximize joint profits. OPEC is an example of an operating cartel.

The Effects of Cartelization The cartelization of a competitive industry will reduce output and raise price from the perfectly competitive level (see Fig 10-4).

Cartel Problems

However, cartels tend to be unstable because of the incentive for individual firms to violate the output-quotas needed to sustain the monopoly price (Fig 10-5). Any one firm within the cartel has an incentive to cheat — to increase output so as to benefit from the high price caused by the other members’ output restrictions. However, if all of the firms cheat in this way, the price will fall back toward the competitive level. Firms will no longer be maximizing their joint profits. A cartel must not only police the behaviour of its members but it must also prevent the entry of new producers. So a successful cartel must create barriers to prevent the entry of new firms that are attracted by the cartel’s high profits. This is difficult to do. Add to this the fact that formal cartel agreements are usually illegal within countries and unenforceable across borders and it is easy to see why cartels usually do not last for long.

Price Discrimination Price discrimination occurs when a producer charges different prices for different units of the same product for reasons not related to cost differences. If price differences reflect cost differences, they are not discriminatory. When a price difference is based on different buyers’ valuations of the same product, it is discriminatory. Any firm that faces a downward-sloping demand curve can increase its profits if it is able to charge different prices for different units of its product. When Price Discrimination is Possible The conditions for price discrimination are:

• Market Power: Any firm that is a price-taker cannot discriminate because it has no power to influence the price at which it sells its product. Price discrimination is only possible to firms that have some amount of market power.

• Consumers with Different Valuations of the Product: Price discrimination is only possible when consumers value different units of the product differently and the firm is able to identify these.

• No Arbitrage: When the same product is being sold at different prices, there is incentive for buyers to purchase the product at the lower price and re-sell it at higher price. A price-discriminating firm must be able to prevent this resale or arbitrage.

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Different Forms of Price Discrimination Price Discrimination Among Units of Output

A firm that charges different prices for different units of a product is trying to capture consumer surplus. Perfect price discrimination occurs when the firm obtains the entire consumer surplus. This usually requires that each unit be sold at a different price. Recall that consumer surplus is the area above the price line and below the demand curve (Figure 10-6); price discrimination allows the monopoly to extract surplus from consumers. An extreme form of this is called “perfect price discrimination”. It involves the firm charging for each unit of output the willingness-to-pay (WTP) for that unit. Discrimination Among Markets

Profit maximization requires that marginal cost be set equal to marginal revenue in each market (Figure 10-7). A firm with market power that can identify distinct market segments will maximize its profits by charging higher prices in those segments with less elastic demand.

Price discrimination is easier for services than for tangible goods because most services firms transact directly with the customer, and thus can more easily prevent arbitrage. Examples of Price Discrimination

• Movie Tickets—children and senior citizens pay less

• Airline Prices—round-trip tickets between two cities when you stay over a Saturday night are less expensive to the customer. The requirement to stay over Saturday night provides the airlines a means to separate the business traveller from the pleasure traveller

• Discount Coupons—those who wish to pay less take the time and trouble to clip the coupons but those who are willing to pay more for the good do not clip coupons – this is often referred to as hurdle pricing.

The Consequences (Welfare Effects) of Price Discrimination The firm is clearly better off than it is using a “single-price” strategy. It could always have chosen it. So, firm profit is higher under price discrimination. Some consumers have higher consumer surplus, some have lower than “single-price” strategy. With price discrimination there is almost always higher output than with the “single-price” strategy. Therefore the quantity takes us closer to p = MC (in perfect price discrimination the last p = MC so Q = Qc). Therefore, even if the firm gets more of the surplus the DWL from market power is reduced. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

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_____________________________________________________________

Chapter 11: Imperfect Competition and Strategic Behaviour ______________________________________________________________

Learning Objectives:

• Describe how most industries in Canada have either a large number of small firms or a small number of large firms.

• Describe how imperfectly competitive firms have differentiated products and often engage in non-price competition.

• Discuss the key elements of the theory of monopolistic competition.

• Explain why strategic behaviour is a key feature of oligopoly.

• Use game theory to explain the difference between cooperative and non-cooperative oligopoly outcomes.

The Structure of the Canadian Economy

Industries with Many Small Firms: Industries with many relatively small firms cannot be understood by using the perfectly competitive model because the firms, though small, are not price takers.

Industries with a Few Large Firms: There are several examples of monopolies from many years ago. However, market dominance by a single large firm is a thing of the past. Most modern industries that are dominated by large firms contain several firms.

The concentration of economic power in an industry is sometimes measured by the concentration ratio, which shows the fraction of total market sales from the largest 4 or 8 producers. The main problem associated with using concentration ratios is to define the market with reasonable accuracy. Fig 11-1 shows concentration for some industries. However, sometimes the market is much smaller than the whole country in question (for example: cement). Other times, the market may be much larger than one country (for example: gold). Due to globalization, a lone firm in one Canadian industry does not imply monopoly power — it may be competing with several foreign firms that can easily sell in Canada. So concentration does not tell the entire story. What is Imperfect Competition? Monopoly and perfect competition can be thought of as the 2 extremes of market structure. There are many kinds of market structure that lie between. These can be separated along many dimensions:

-number of firms -form of competition

-over quantity, over price, over products, over product quality, over advertising or other “non-price” items

-extent of innovation

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Considering these raises interesting issues that tell us a lot about the kind of “competition” we see in our daily lives as consumers One way of classifying or organizing these ideas is as shown below:

one

Monopoly(Ch 10)

a few

Oligopoly(Ch 11)

many(freeentry)

Number of Firms?

Products?

different identical

MonopolisticCompetition(Ch 11)

PerfectCompetition(Ch 9)

Other than perfect competition, all of these market structures can be thought of as forms of “imperfect competition”. Monopolistic Competition Monopolistic competition is a market structure that contains some “monopoly” elements as well as some that are found in “perfect competition”. It is assumed that there are differentiated (heterogeneous) products. There are many firms and products that are best thought of as being in the same industry. EXAMPLES: books, restaurants, clothing, etc. Assumptions of (Conditions for) Monopolistic Competition:

1. each firm is a monopolist in its own product

2. there are many close substitutes and the firms take the existing number of products in the market and therefore the reactions of its rivals as a given

3. free entry/exit to the industry – firms must enter or exit with their product So each firm is a “price-maker” but an “other products-taker” Basic Analytics The market demand is divided among the various products (firms) according to what individual consumers think is their favourite product given the available alternatives. Therefore each individual firm’s demand depends on the price of its product, but also the availability of other products:

Di: qi = f(pi , availability of other products)

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The key feature of this demand curve is that if there are more “other products” available, each firm’s demand shifts to the left since they must share the market with more products. If there are fewer “other products” available each firm’s demand shits to the right. Short Run Equilibrium In the short run, can have profits (p > ATC) or losses (ATC > p > AVC) as usual. The figure below shows a firm earning positive economic profits.

qi

$

pi

qi

Di

MRi

MCi

SRACi

But with free entry/exit profits cause entry. When a new firm enters it brings its product. As discussed above, this will shift existing firms’ demand to the left. Similarly, losses cause exit. When a firm exits, it takes its product so that existing firms’ demand shift to the right. Long Run Equilibrium Therefore long run equilibrium satisfies the following:

1. must be a SR equ’m, i.e. MR(qi) = MC(qi)

2. firms must be cost minimizing, i.e. operating on LRAC

3. firms must be earning zero economic profits, i.e. pi = AC(qi)

If the short run equilibrium is as shown above, the profits earned generate entry. This shifts existing firms’ demands until the situation in LR equilibrium is as shown at point 1 in the diagram below.

qi

$

pi

qi

Di

MRi

MCi LRACi

11

2

3

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Characteristics of LR Equilibrium At point 1 in the diagram:

pi > MC(qi), (pricing power like monopoly)

pi = AC(qi), (π =0 like perfect competition) Monopolistic Comp. vs Perfect Comp. A perfectly comp. firm would be operating at 2 in the diagram. The differences are that under monopolistic competition:

pi > min LRAC, (“excess capacity theorem”) -society is not obtaining output at the lowest possible cost?

pi > MC(qi), (DWL like monopoly?) Is Monopolistic Competition Really Inefficient? The short answer is that we can’t really say. To see this consider some other possible production points. Force Firms to 3 This eliminates DWL in the firms’ production levels. However, the losses (p < AC) would require subsidies from the government to continue in operation. The taxes to fund these subsidies would cause DWL elsewhere in the economy. Force Firms to 2 This price would lie above the firms’ demand curves. Therefore for it to be sustainable would require the elimination of some firms (thus shifting existing firms’ demands until they go through 2). However, the elimination of some firms implies the elimination of some products, but product selection is valuable to consumers. So there is a tradeoff between standard efficiency and “product selection” efficiency (optimal number of products). This is difficult to resolve without making ad hoc judgments about the relative weightings of these two ideas. It is doubtful whether the government can do any better than what the market produces in terms of the tradeoff. Empirical Relevance of Monopolistic Competition There are many industries that have extensive product differentiation, but very few firms. Example include the industries that produce detergents and chocolate bars. Monopolistic competition is not relevant for these industries. However, there are many examples of industries that appear to be well described by monopolistic competition including books and music, restaurants, gas stations, hair salons, etc..

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Oligopoly and Game Theory An oligopoly is an industry that contains two or more firms, at least one of which produces a significant portion of the industry’s total output. In contrast to a monopolist firm (which has no competitors), and a monopolistically competitive firm (which has many competitors), an oligopolistic firm faces only a few competitors. Oligopolists are aware of the interdependence among the decisions made by the various firms in the industry — they therefore exhibit strategic behaviour. The Basic Dilemma of Oligopoly Because they are large, firms know that they are not price-takers – what they do affects market price. But neither is a firm a price-maker – what other firms do affects the market price and hence profits. The basic dilemma is the same as that found in a cartel. Do the firms cooperate (collude) to produce a monopoly-like outcome? Or do they engage in non-cooperative competition with one another? What a firm decides to do may depend on what its rivals do. Some Simple Game Theory

When game theory is applied to oligopoly, the players are firms, their game is played in the market, their strategies are the price or output decisions, and their payoffs are their profits. Consider two firms (a duopoly) who face the dilemma of deciding to cooperate or compete. In this simplified example, there are only two strategies for each firm:

$Produce an output equal to one-half of the monopoly output (yields low output and high price). $Produce an output equal to two-thirds of the monopoly output (yields high output and low price).

Refer to Figure 11-3. If both firms cooperate, they achieve the cooperative outcome and jointly produce the output of a monopolist. A Nash equilibrium is an outcome in which each firm is doing the best it can given what the other firm is doing. In this case, the Nash equilibrium is the non-cooperative outcome where both firms produce the higher level of output. The logic works as follows:

A’s Decision: -if B produces 1/2Qm, I should produce 2/3Qm since 22 > 20 -if B produces 2/3Qm, I should produce 2/3Qm since 17 > 15

-so Firm A has a “dominant strategy” to produce 2/3Qm

B’s Decision: -if A produces 1/2Qm, I should produce 2/3Qm since 22 > 20 -if A produces 2/3Qm, I should produce 2/3Qm since 17 > 15

-so Firm B has a “dominant strategy” to produce 2/3Qm

The Nash equilibrium is clearly {2/3Qm, 2/3Qm} The basis of Nash equilibrium is rational decision-making in the absence of cooperation. In Nash equilibrium, each player’s best strategy is to maintain its present behaviour given the present behaviour of the other players. If Nash equilibrium is established by any means whatsoever, no firm has an incentive to depart from it by altering its own behaviour.

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Oligopoly in Practice Cooperative Behaviour (Collusion) Collusion is illegal in most countries and is unenforceable across borders. So, explicit collusion is not usually possible. Firms must rely on tacit collusion. As we have seen, this is not a stable outcome whether attempted by small or large firms. Competitive Behaviours Oligopoly gives rise to competitive behaviours that are not seen, or at least are not as important in competitive markets.

Market Share Since p > MC in oligopoly markets then increases in market share lead to higher profits. So we often see excessive emphasis on market share in oligopolistic markets

Innovation The existence of profits in these markets gives an incentive for innovation that may not exist in more competitive markets. Entry Barriers and Entry Deterring Strategies The existence of profits in oligopoly attracts entry. Therefore firms may engage in entry deterring actions to forestall this. This applies to monopolized markets as well and is actually easier to see in that context.

Brand Proliferation By producing many brands the incumbent firm(s) may not leave enough “room” for an entrant. It may do this, even though its own profit would be higher in the short term if it produced fewer brands.

Advertising By engaging in excessive advertising the incumbent firm(s) makes it more costly for other firms to enter (since the entrant must also advertise a lot to get noticed). It may do this, even though its own profit would be higher in the short term with lower advertising.

Limit Pricing (or producing the “limit quantity”) By keeping the price below (quantity above) the monopoly level, the incumbent firm may not leave enough room in the market for an entrant. It may do this, even though its own profit would be higher in the short term with a lower quantity. However, the idea of limit pricing has been challenged since it may not be an equilibrium strategy in the face of actual entry.

Predatory Pricing This refers to the practice of lowering prices in the face of entry starting a price war. The idea is to make entry unprofitable for the entrant. If the firm can establish such a reputation entrants will be too scared to enter. However, as with limit pricing, the idea of predatory pricing has been challenged since it may not be an equilibrium strategy in the face of actual entry.

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Oligopoly and the Economy Temporary changes in demand lead to more price volatility in perfectly competitive markets than in oligopoly markets. Permanent changes in demand, however, lead to similar adjustments in both market structures. Oligopoly is an important market structure in modern economies because there are many industries in which the minimum efficient scale is simply too large to support many competing firms. The challenge for public policy is to keep oligopolies competing — rather than colluding — and using their competitive energies to improve products and reduce costs, rather than to merely erect entry barriers. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

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____________________________________________________

Chapter 12: Economic Efficiency and Public Policy ____________________________________________________

Learning Objectives:

• Explain and understand productive and allocative efficiency.

• Explain why perfect competition is allocatively efficient, whereas monopoly is allocatively inefficient.

• Understand the issues involved in the alternative methods of regulating a natural monopoly.

• Describe Canadian competition policy. Productive and Allocative Efficiency The full employment of resources is not enough to prevent the waste of resources. Here are three examples:

1. If firms do not use the least-cost method of producing their chosen outputs, they are being inefficient.

2. If the marginal cost of production is not the same for every firm in the industry, the industry is being inefficient.

3. If too much of one product and too little of another product are being produced, resources are being used inefficiently.

Productive Efficiency In order for production to be efficient, output must be produced at the lowest possible cost. That is, output must be obtained at the lowest possible opportunity cost to the economy.

Firm Level The firm must be cost minimizing, i.e. operating on its LRAC curve. If not, it is obviously not producing at minimum cost

Industry Level Firms in the industry must all be operating where MC is equalized across firms. If not, as shown in Fig 12-1, transferring production from the high to the low cost firm reduces total cost of the output. If all firms and all industries satisfy these conditions we are producing output at the lowest possible cost to the economy. We can then say that the economy as a whole satisfies productive efficiency.

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Productive Efficiency and the PPB All points on the PPB satisfy productive efficiency. As shown in Fig 12-2 the points B, C and D are all productively efficient. The slope of the PPB at any point is the ratio of the marginal costs of production (MCX/MCY) for the two goods and represents the opportunity cost of X. Points inside the PPB (like point A) imply that at least one of the goods is produced in an inefficient way. Either firms not cost minimizing and/or there are not equalized MC across firms in the industry or there are unemployed resources in the economy. Allocative Efficiency Allocative efficiency requires that goods are produced such that the price equals marginal cost. Price measures the willingness-to-pay or benefit to consumers at the margin, while marginal cost measures the opportunity cost of the resources used in the production of the good. Fig 12-3 shows the allocatively efficient production of goods in the economy. Market Structures and Efficiency Perfect Competition is both productively and allocatively efficient. Monopoly may be productively efficient, but is not allocatively efficient because pm > MC. Imperfect Competition market structures may be productively efficient but to the extent that market power allows p > MC they are not allocatively efficient. However, as we have already seen this is not as clear for monopolistic competition because of the product selection issue. Total Surplus Approach As we have seen in Chapter 5, we can use the total surplus approach for judging allocative efficiency.

Consumer Surplus Consumer surplus on a given unit is the WTP for the unit (height of D) less what is actually paid. Total consumer surplus is equal to the total WTP less what is actually paid on all the units that are sold in the market (the area below demand and above the price – see Fig 12-4).

Producer Surplus Producer surplus on a given unit is what is received for the unit less the smallest amount the firm would accept to produce the unit. Willingness-to-accept (WTA) for a given unit is the MC of producing that unit (height of S). Total producer surplus is equal to the total amount received by firms less the WTA on all the units that are sold in the market (the area above S or MC and below price – see Fig 12-4).

Total Surplus Total surplus is sum of consumer and producer surplus.

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Mathematically we can write out total surplus as (where Q units are sold in the market):

TS(Q) = CS(Q) + PS(Q) = Total WTP(Q) – Total Spent on Q + Total Received for Q – Total WTA(Q)

But in a market the total amount spent by consumers equals the total amount received by firms so:

TS(Q) = Total WTP(Q) – Total WTA(Q)

That is, total surplus is the area below D and above S (or MC) on all units that are actually traded in the market.

A social planner interested in maximizing total surplus would require production where the marginal total surplus would be equal to zero

∆TS(Q*) = WTP(Q*) – WTA(Q*) = 0 WTP(Q*) = WTA(Q*)

That is, efficiency occurs where the marginal benefit to consumers equals the marginal cost of production. Fig 12-5 illustrates. Output level Q* is efficient. Output levels below or above Q* imply DWL in the market.

At output level Q1 < Q* WTP(Q1) > MC(Q1). This is also true for all units between Q1 and Q* so there is DWL in the market equal to the areas 1 and 2.

At output level Q2 > Q* WTP(Q2) < MC(Q2). This is also true for all units between Q* and Q2 so there is DWL in the market equal to areas 3 and 4.

Perfect Competition (or supply and demand equilibrium) Equilibrium occurs at price p* where QS = QD Q = Q* allocatively efficient. See Fig 12-5. CS is the area below demand and above price and PS is the area below price and above supply. Monopoly (the simple or single-price monopolist) Equilibrium occurs where MR(Qm) = MC(Qm) Q < Q* allocatively inefficient. See Fig 12-6. CS is the area below D and above pm (area 1 in diagram). PS is the area below pm and above MC (the areas 2 and 4 in the diagram). There is DWL on all units between Qm and Q* (areas 3 and 5 in the diagram). Market Failure Any time the market outcome is such that Q ≠ Q* is referred to as an instance of market failure. Monopoly is an instance where the “market” output is too low relative to the social optimum. Pollution problems are instances where the “market” output is too high relative to the social optimum. This can occur when supply curves do not take into account the full social costs of production.

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Economic Regulation to Promote Efficiency Much of this section and the last section in the chapter are left for reading since the material is straightforward. It is well known that market power generally leads to deadweight loss in the economy. So policy is designed to minimize this DWL. Therefore policy seeks to:

1. Limit Entry Barriers and Entry-Deterring Behaviours -e.g. predatory pricing is forbidden as are other forms of “abuse of dominant position”

2. Encourage Competition Among Firms -e.g. price fixing is forbidden -e.g. merger policy reviews proposals for concentration issues

3. Regulate Natural Monopolies -used to do a lot of this -used to think that many more industries were natural monopolies -e.g. electricity generation as opposed to its distribution was once thought to be a natural monopoly as was phone service before the advent of cell phones, etc.

Regulation of Natural Monopolies Natural monopolies are those that have declining AC over the range of the market (the demand curve). Therefore we would only want one firm producing in this market since having more that one would involve paying the significant fixed costs twice. Fig 12-7 shows a natural monopoly.

Unregulated Outcome The unregulated outcome is not shown in the diagram but it would be the standard monopoly outcome (pm , Qm) which involves a large DWL.

Marginal Cost Pricing Regulation This would force firm to charge p1 = MC and serve any consumers at that price (p1=MC, Q=Q1). The problem with this solution that p1 < AC(Q1), which involves losses for the firm. These losses must be subsidized causing DWL elsewhere in the economy as the government raises the tax revenue.

Average Cost Pricing Regulation This would force firm to charge p2 and serve any consumers at that price (p2 , Q2). This solution involves no losses, but leaves DWL.

Two-Part Pricing Regulation? This would force firm to charge p1 = MC but would allow them to charge an access fee, say $A. If N is the number of consumers served then setting A such that NA = {c1 – p1}×Q1 covers losses on each unit sold, but does so in an efficient manner.

86

Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading. You should be submitting the Optional Assignment #2 at this point if you are going to do so. For the due date, see the course outline.

87

PART VI

THE GAINS FROM TRADE REVISITED

________________________________________________________

Chapter 33: The Gains from International Trade (pages 813-822) _________________________________________________________________

Learning Objectives:

• Explain the law of one price.

• Explain why countries export some goods and import other goods.

• Understand what is meant by the “terms of trade”. Trade is a critical part of Canada’s economy, and intra-industry trade is growing in importance. Fig 33-1 and 33-2 make it clear how important trade is to a country like Canada. We have studied the theory of the gains from trade through the pursuit of comparative advantage. This part of the chapter shows how trade patterns develop and shows the gains from trade in a supply and demand framework. The Determination of Trade Patterns “Law” of One Price If a good trades throughout the world, price differences in various national markets will reflect differences in transportation costs. In this sense there is a single “world” price for these goods Pattern of Foreign Trade In the absence of trade, suppose the domestic market is characterized by supply & demand as shown in Fig 33-5. In autarky, equilibrium would occur at (pd, Qd). The effect on the market when it is opened to trade depends on whether the “world” price is greater than or less than the autarky price. Countries export goods whose world price exceeds the autarky price and import those whose world price is lower than the autarky price. Exported Good If the “world” price pw > pd then the country has a cost advantage in this product if it is opened to trade. That is, the country has a comparative advantage in the production of this good, therefore the country will export this good. This is shown in Fig 33-5 and the diagram below where Sd and Dd represent the domestic supply and demand.

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Sd

Q

$

Qd

Dd

pd

pw

Q1 Q2

12 3 4

5 6

When the market is opened to trade the price rises to pw. Domestic consumption falls to Q1 and domestic production rises to Q2. The difference Q2 – Q1 is exported. The dollar value of these exports is pw(Q2 – Q1).

In addition we can perform a surplus analysis to show the gain in surplus that is generated by opening this market to trade:

Before Trade: CS = area 1+2+3 PS = area 5 + 6

After Trade: CS = area 1 PS = area 2 + 3 + 4 + 5 + 6

Gain from Trade = area 4 Imported Good If the “world” price pw < pd then the country has a cost disadvantage in this product if it is opened to trade. That is the country has a comparative disadvantage in the production of this good, therefore the country will import this good. This is shown in Fig 33-6 and the diagram below where Sd and Dd represent the domestic supply and demand.

Sd

Q

$

Qd

Dd

pd

pw

Q1

3

Q2

1

2 45

When the market is opened to trade the price falls to pw. Domestic consumption rises to Q2 and domestic production falls to Q1. The difference Q2 – Q1 is imported. The dollar value of these imports is pw(Q2 – Q1).

The surplus analysis is as follows:

Before Trade: CS = area 1 PS = area 2 + 5

After Trade: CS = area 1 +2 + 3 + 4 PS = area 5

Gain from Trade = area 3 + 4

89

The Terms of Trade The terms of trade (TT) for a country is the ratio of its weighted average export price to its weighted average import price, where the weighting is by the number of units or total value of goods traded. Changes in TT affects the country’s CPB relative to its PPB. The country’s terms of trade is most often expressed as an index number:

Terms of Trade = (Index of Export Prices/Index of Import Prices) × 100 An example of an improvement in the terms of trade is shown in Fig 33-7 where it is assumed that the country produces (and exports) only wheat, while it imports cloth. The text also shows how Canada’s terms of trade have changed over time (see Fig 33-8). Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

90

_______________________ Chapter 34: Trade Policy

_______________________ Learning Objectives:

• Explain the effects of common protectionist measures such as a tariff or quota on imported goods.

• Describe the various situations in which a country may rationally choose to protect some industries and understand the most common fallacious arguments in favour of protection and why they are fallacious.

• Explain why trade-remedy laws are sometimes just thinly disguised protection.

• Understand the institutional setting for trade policy in Canada including the North American Free Trade Agreement (NAFTA) and the World Trade Organization (WTO) and the issue of trade creation versus trade diversion.

We will examine the material in this chapter in a different order, starting with our analysis of common protectionist measures. It seems natural to discuss these before turning to the discussion of the arguments for and against protection. The last section of the chapter (on current institutional arrangements) is left for reading since the material is straightforward. Methods of Protection Tariffs Tariffs are a tax on imported goods. Examine Fig 34-1. Suppose that the government levies of tariff of $T per unit imported. This increases the “world” price in this market by $T from pw to pd = pw+T. Domestic consumption falls from Q1 to Q3 and domestic production rises from Q0 to Q1. Imports fall from Q1 – Q0 to Q3 – Q2.

Surplus analysis: Consumers Lose: area 1 + 2 + 3 + 4 Producers Gain: area 1 Gov’t Gains (tariff revenue): 3 Net Loss (DWL): area 2 + 4

Import Quota Under an import quota system the government allows only a limited number of units into the country Examine Fig 34-1. Suppose the government restricts imports to Q3 – Q2 units. The price in the domestic market is bid up from pw to pd. Domestic consumption falls from Q1 to Q3 and domestic production rises from Q0 to Q1. Imports (obviously) fall from Q1 – Q0 to Q3 – Q2.

Surplus analysis: Consumers Lose: area 1 + 2 + 3 + 4 Producers Gain: area 1 Importer Gains (profit to quota): 3 Net Loss (DWL): area 2 + 4

91

“Equivalence” of a Tariff and an Import Quota

If the quota amount is set such that the price increase is the same as it would be with a tariff, or to put it the other way, if the tariff is set such that the new level of imports is equal to the amount under the quota system we get basically the same solution with respect to change in imports and the effects on domestic consumers and producers. The only difference is who gets area 3. With a tariff it goes to the government while with the quota it goes to the importer. Voluntary Export Restraint (VER) Under this system the government negotiates with foreign producers to restrict their exports to the domestic economy to only Q3 – Q2 units. The analysis is identical that under the quota except for the fact that foreign producers receive area 3 rather than “quota holder”. Since this area of surplus leaves the domestic economy, it must now be counted as an additional deadweight loss. Free Trade or Protection? What is the appropriate trade policy to pursue? Is it to allow the more or less free flow of goods and services across borders (free trade)? Or should the government or use the tools of protectionism (tariffs, quotas, VERs, subsidies, or other forms of non-tariff barriers) to inhibit this trade? Case for Free Trade As we have seen, trading based on comparative advantage maximizes a country’s national income. Surplus analysis shows this in a different way but is making the same point. That is that the economy as a whole is better off by allowing free trade rather than trying to inhibit that trade.

This is so, even though it is well known that initially opening to trade, removing protectionist measures, or adjusting to terms of trade shocks will leave some individuals better off and some worse off. The argument would be that these effects are somewhat offset by the “shock absorber” of a flexible exchange rate or that there are more efficient ways of ameliorating adverse distributional effects rather than resorting to protectionism. Case for Protectionism Some of these arguments make some sense in terms of specific economic theories, some involve tradeoffs with other policy goals (therefore there are no “right or wrong” positive economics answers) and some don’t make much sense at all.

Objectives Other than Max National Income

Diversification of Production leaves the economy less vulnerable to terms of trade shocks even though national income will be, on average, lower. The question would then be into which industries should we diversify?

National Security Objectives might require that the country should encourage production in certain goods for national security reasons.

Protection of Certain Groups that best satisfy social and distributional goals, even thought average incomes will be lower. However, there may be policies that achieve the same goals but at a lower “national income” cost.

92

Protection Actually Maximizes National Income

Improving the Terms of Trade – It may be possible for large countries to affect the world price such that it changes the terms of trade in its favour. This more than makes up for the lost surplus due to protectionism. There is an economics literature on the “optimal tariff” that shows this is possible.

Infant Industry Argument holds that one should protect industries until they grow large enough (reap economies of scale) and experienced enough (learning by doing) to compete. The problem with this argument is to decide when the infants “grow up”.

Earn Economic Profit in Foreign Markets – The idea here is to protect an industry (through subsidies) that will earn economic profit in foreign markets. The economic profits earned there will more than make up for the losses to domestic consumers. This is the so called “strategic trade theory”. Again there is a literature that shows that this theoretically will work under particular conditions – but how do we recognize this?

Protect Against “Unfair” Trade – It is often argued that one should protect against dumping (selling below cost) by foreign firms. However, if the foreign firms “dumped” forever, we would be getting “cheap stuff”. The real worry is that after the domestic industry shrinks, the dumping will stop and the foreign firms will have market power in the domestic market. Similarly, some contend that one should use countervailing duties (tariffs) to protect against subsidized foreign competition. Fallacious Protectionist Arguments

Some of these are very common but turn out to have logical flaws.

“Keep the Money at Home” – This argument holds that buying domestically leaves the money here, and makes us richer. However, purchasing imports involves trading domestic currency for foreign currency first. The only reason(s) a foreigner would want the domestic currency is to buy domestic goods or assets – i.e. the money doesn’t actually leave!

Protect Against Low Wage Foreign Labour – This is the idea that since wages are lower in some other countries, they will eventually produce everything leaving us impoverished. However, it ignores the notion of comparative advantage. Just ask yourself, can a rich person not gain from trading with a poor person?

Exports are Good – Imports are Bad – Exports earn income domestically, imports earn income for foreign residents as recognized in the definition of national income (Y = C + I + G + EX – IM). However, consumption is what matters for standard of living and imports form part of domestic consumption.

Create Domestic Jobs – Here the idea is that discouraging imports creates domestic jobs. But in reality this just redistributes employment throughout the economy and leaves average incomes lower because we are no longer reaping the gains from trade. Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

93

PART VII

INPUT MARKETS

__________________________________

Chapter 13: How Factor Markets Work ________________________________________

Learning Objectives

• Describe the size and functional distributions of income.

• Explain a profit-maximizing firm's demand for a factor.

• Explain the role of factor mobility in determining factor supply.

• Distinguish between temporary and equilibrium factor-price differentials.

• Show how economic rent is related to factor mobility. Income is earned in the factor markets. Therefore it is important to know how factor markets work in order to understand the sources of income and to understand something about its distribution Income Distribution -Smith, Ricardo, and Marx were primarily concerned with the functional distribution of income. That is how much income was accruing to various factors of production (labour, land, capital). This was because income classes were highly correlated with the social classes of the time. Today we are more concerned with the size distribution of income. That is, how much income accrues to different individuals in society. Reports from Statistics Canada (and other similar agencies around the world) rank individuals by income and show the percentage of income earned by “quintiles” of the population. As shown in Fig 13-2, the Lorenz Curve measures cumulative percentage of income as the cumulative percentage of the population rises. Therefore the area between the Lorenz curve and a straight line (complete equality) is a measure of income inequality. The Gini Coefficient = 2×area is a commonly used measure. It summarizes the distribution into a single number. Fig 13-2 shows the Lorenz curve for market income for Canada from the 2001 census. After taxes and transfers the Lorenz curve moves closer to the “equality line” showing that Canada’s tax and transfer programs do some redistribution of income.

94

The Demand for Factors Firms demand factors of production not for themselves but for what they do: produce output that the firm sells. So factor demands are referred to as derived demands – derived from the demand for the goods that are produced. Firm Demand for a Factor

Profit Maximization

As profit maximizers, firms hire a factor until the marginal benefit of doing so is equal to the marginal cost of doing so. We will assume that firms are “factor price takers” in the input (factor) markets If we focus for now on labour, then the marginal cost of labour to the firm is the market wage w. What is the marginal benefit to the firm? The firm gets output from the worker (MP), then sells that output for revenue (MR). So the marginal benefit to the firm is referred to as the marginal revenue product (MRP). Profit maximization requires that the firm hire labour until:

MRP = w

MR×MP = w

For a firm operating in a competitive output market MR = AR = p, so profit max implies:

p×MP = w

The expression p×MP is often referred to as the value of the marginal product (VMP) Profit max in input markets is really the same decision as profit max in output markets. These are not really separate decisions but rather two sides of the same coin:

p×MP = w

MPwp =

-but LqMP

ΔΔ

=

-so qLwp

ΔΔ

=

-or qwLpΔ

Δ )(=

-but wL is variable cost, so ∆(wL)/ ∆q = MC

-so p = MC

This is simply the profit maximizing output decision for a competitive firm.

95

Firm Demand Curve for Labour

Firm hires labour until p×MP = w. By varying the wage we trace out the firm’s demand for labour. Since MP is downward sloping then so too is its demand for labour. This is shown in Fig 13-3. Shifts in firm demand stem from:

1. changes in the output price 2. changes in the firm’s use of other factors 3. technological change

Elasticity of a Firm’s Demand for a Factor Depends on:

1. Diminishing MP -the less steeply diminishing is MP, the more elastic is firm demand

2. Importance of Labour -the more important is labour in total costs the more elastic is firm demand

3. Substitutability of Factors -the more easily that factors can be substituted (LR), the more elastic will be firm demand for any particular factor

4. Elasticity of Output Demand -the more elastic is output demand, the more elastic is firm demand for factors

Market Demand for a Factor Market demand for a factor is the horizontal summation of firm demands. Therefore anything that shifts firm demands for a factor will shift market demand for the factor, including shifts of demand for the products produced by that factor The Supply of Factors We have studied the labour supply and saving supply (capital supply) decisions of individual households (Supplement Chapter). Here we will look at the supply of factors at three levels of aggregation, to the economy as a whole, to a particular industry, and to a particular firm within an industry. Supply of Factors to the Economy Physical Capital (machines or dollars tied up in machines)

Even with depreciation the “capital stock” usually grows slowly over time. The substitution and income effects of an interest rate change go in opposite directions for individuals, so the economy-wide supply of capital tends to be fairly price (interest rate) inelastic. Land

The total area of land in an economy is fixed. However, useable land is not. Improvements or neglect can change it over time.

96

Labour

Population changes fairly slowly over time but labour force participation can change slowly (demographic and social change, tastes) or rapidly (wages rise above “reservation wages”). Hours per person change in response to (among other things) wage changes. However the substitution and income effects of a wage change go in opposite directions for individuals so the economy-wide supply of labour tends to be fairly price (wage) inelastic. Supply of Factors to a Particular Industry This depends on “factor mobility”. Some factors are mobile in the short run, some in the long run, but for all, factors are more mobile over longer periods of time Mobility of Capital

Capital may be immobile in the short run (SR fixed factor) but is very mobile in the LR. In a small open economy r = rw, that is there is a horizontal supply in the LR. Mobility of Land

Land is obviously immobile in location but is certainly mobile in use in the LR. Mobility of Labour

Some may be tied to a location or occupation, but overall the labour force is highly mobile (so are many individuals over time). Supply of Factors to a Particular Firm In most cases, firms are “factor price takers”. Therefore, as discussed above, there is horizontal factor supply for the firm. Factor Market Equilibrium This is simply the usual supply and demand equilibrium for the various factors, as shown in Fig 13-5. Labour Market Equilibrium -wage w* such that LS = LD

We can perform the usual comparative static exercises that shift S and/or D and generate changes in equilibrium wages and the quantity of labour. Other Factors

The wage rate determined above is the rental price of labour. In the same way we can determine the rental prices of land and capital (RP and r).

Unlike labour, land and capital (the machines themselves) can be purchased outright. The purchase price would be the discounted value of the stream of future benefits.

97

Factor Price Differentials If all units of a factor were identical and freely mobile then there would be no differentials in prices across industries. As shown in Fig 13-6 factor prices would be the same in both industries. Temporary Differentials

Suppose that the factor is mobile across these industries but only over time. Then an increase in demand in one will lead to a temporary wage differential across industries (w’A > wR). The differential disappears over time as supply adjusts between markets. Equilibrium Differentials

Equilibrium differentials are differentials that persist over time with no forces that move to eliminate them. These can be based on:

1. Intrinsic Differences in the factors themselves 2. Acquired Differences due to costly improvements to the factor (e.g. land irrigation,

education and training) 3. Compensating Differences paid to compensate for non-monetary difference in jobs

(e.g. risk pay for firefighters, lower wages for academic researchers) Factor Earnings and “Economic Rent” Total factor earnings are often divided into:

-transfer earnings – payments necessary to get the factor into this use (i.e. its opp cost) -economic rent – payments in excess of transfer earnings (i.e. the factor market equivalent of producer surplus)

As shown in Fig 13-7 the division of factor earnings into transfer earnings and rent depends on the elasticity of factor supply.

Practice Problems At this point you should complete the Exercises in the Study Guide and do the Practice Problems posted on the website (http://qed.econ.queensu.ca/walras/custom/100/firstyear/). The Practice Problems for this chapter are taken from old assignments and examinations and suggested solutions are given. They are for practice and to see if you understand the material and are NOT to be submitted for grading.

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The personal information on this form is collected under the legal authority of the Royal Charter of 1841, as amended. The information collected will be used to return your correspondence assignment to you. Unclaimed correspondenceassignments are retained for one year after the end of the course and then destroyed. If you have any questions or concerns about the information collected or how it will be used, please contact Continuing & Distance Studies.

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* Attach this cover sheet to each assignment including tests. * Print legibly – this page will be used to return your assignment. * Please indicate your name and phone number on each page. Student # _________________________ * Please check appropriate box for return of assignments Phone # (day): ______________________ PLEASE CHECK ONE: I’m enrolled in one or more day course so I’ll pick up my assignment E-mail Address: ____________________ (fill in only your last name & first four digits of your student # below) I’m enrolled exclusively in correspondence or evening courses so mail Session: Winter 2009 my assignment to me (fill in your last and first name along with your mailing address below) Course: ECON 111*S Name: _____________________________________________ (Last) (First name or last 4 digits of your student number) Assignment #: __________ Address: ___________________________________________ No. of pages: __________ (including this Cover Sheet) ___________________________________________ City Province/State ______________________________________________________ Country Postal / Zip Code _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Drop Off/ Pick Up/ Fax/ Mail Assignments to:

Continuing and Distance Studies Faculty of Arts and Science

F200, Mackintosh-Corry Hall 68 University Avenue

Queen’s University Kingston, Ontario

K7L 3N6 PHONE: (613) 533-2470

FAX: (613) 533-6805

The personal information on this form is collected under the legal authority of the Royal Charter of 1841, as amended. The information collected will be used to return your correspondence assignment to you. Unclaimed correspondence assignments are retained for one year after the end of the course and then destroyed. If you have any questions or concerns about the information collected or how it will be used, please contact Continuing & Distance Studies.

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* Attach this cover sheet to each assignment including tests. * Print legibly – this page will be used to return your assignment. * Please indicate your name and phone number on each page. Student # _________________________ * Please check appropriate box for return of assignments Phone # (day): ______________________ PLEASE CHECK ONE: I’m enrolled in one or more day course so I’ll pick up my assignment E-mail Address: ____________________ (fill in only your last name & first four digits of your student # below) I’m enrolled exclusively in correspondence or evening courses so mail Session: Winter 2009 my assignment to me (fill in your last and first name along with your mailing address below) Course: ECON 111*S Name: _____________________________________________ (Last) (First name or last 4 digits of your student number) Assignment #: __________ Address: ___________________________________________ No. of pages: __________ (including this Cover Sheet) ___________________________________________ City Province/State ______________________________________________________ Country Postal / Zip Code _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Drop Off/ Pick Up/ Fax/ Mail Assignments to:

Continuing and Distance Studies Faculty of Arts and Science

F200, Mackintosh-Corry Hall 68 University Avenue

Queen’s University Kingston, Ontario

K7L 3N6 PHONE: (613) 533-2470

FAX: (613) 533-6805

The personal information on this form is collected under the legal authority of the Royal Charter of 1841, as amended. The information collected will be used to return your correspondence assignment to you. Unclaimed correspondence assignments are retained for one year after the end of the course and then destroyed. If you have any questions or concerns about the information collected or how it will be used, please contact Continuing & Distance Studies.

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ACADEMIC CHANGE FORM

(Current Year)

If complete withdrawal fromprogram please check (U)

STUDENT NUMBERStudent card returned (mayaffect fees)

TITLE SURNAME GIVEN NAMES FACULTY or SCHOOL

Current Degree Program

eg. BA EXAM CENTRE CODE

The personal information on this form is collected under the authority of the Royal Charter of 1841, as amended,the Ontario Ministry of Training, Colleges, and Universities Act, and the Federal Statistics Act. The informationcollected will form part of your student record at Queen's. It will be shared with the Faculty, School, ordepartment and reported to Statistics Canada and the Ministry of Training, Colleges, and Universities. Inaddition to those external reporting requirements, the information will be used for updating your academicrecord, for determining fee assessment, internal statistical analysis, and for communicating with you. If youhave any questions, please contact the Office of the University Registrar, Gordon Hall, Queen's University.

REQUESTED CHANGE IN DEGREE PROGRAM OFFICE USE ONLY

DEGREE PROGRAM TYPE CONCENTRATION(S)

eg. BA eg. MIN eg. PSYC

CONCURRENT PROGRAM OF STUDY EXPECTED GRADUATION DATE

(Check if applicable) Spring 20 Unknown

B.Ed. BPHE Fall 20 Not Applicable

(Continued on following page)

ADD SECTIONCourse Code andSection

Course Title Correspondence ? Fall U

Winter U

Spring U

Summer U

Weight

eg. Writ 075* S Effective Writing I U X 0.5

DROP SECTIONCourse Code andSection

Course Title Correspondence ? Fall U

Winter U

Spring U

Summer U

Weight

eg. Writ 075* S Effective Writing I U X 0.5

TOTAL COURSE LOAD FOR THE YEAR (AFTER CHANGES) TOTAL ___________

STUDENT’S SIGNATURE DATE ADVISOR’S APPROVAL / SIGNATURE DATE

Send to: Division of Continuing & Distance StudiesF2, Mackintosh-Corry HallQueen’s University,Kingston ON K7L 2N6Phone: (613) 533-2470Fax: (613) 533-6805 rev. 03/07

BIOGRAPHIC CHANGE FORM

STUDENT NUMBER FACULTY or SCHOOL

TITLE SURNAME GIVEN NAMES

The personal information on this form is collected under the authority of the Royal Charter of 1841, as amended,the Ontario Ministry of Training, Colleges, and Universities Act, and the Federal Statistics Act. The informationcollected will form part of your student record at Queen's. It will be shared with the Faculty, School, or departmentand reported to Statistics Canada and the Ministry of Training, Colleges, and Universities. In addition to theseexternal reporting requirements, the information will be used for updating your academic record and forcommunicating with you. If you have any questions, please contact the Office of the University Registrar, GordonHall, Queen's University.

REPORT CHANGES ONLY

NAME CHANGE

TITLE SURNAME GIVEN NAMES

Any change to a name must be accompanied by supporting documentation (photocopy acceptable) or change WILL NOT be processedREASON (marriage, divorce, court order etc.)

(Continued on following page)

PERMANENT HOME ADDRESS

AREA CODE PHONE NUMBER APT. NO., HOUSE NO. and STREET

CITY PROVINCE COUNTRY

POSTAL CODE

MAILING ADDRESS DURING TERM

AREA CODE PHONE NUMBER APT. NO., HOUSE NO. And STREET

CITY PROVINCE COUNTRY

POSTAL CODE EXAM CENTRE CODE

STUDENT SIGNATURE DATE

Send to: Office of the University Registrar (Records and Services) Queen's University Gordon Hall, 74 Union St.Kingston, Ontario, K7L 3N6

rev. 03/07

TRANSCRIPT REQUEST FORM

Send to: Transcript Clerk Cost: $10.00 per copy of Official Transcript Office of the University Registrar Make cheque payable to Queen’s UniversityGordon Hall, 74 Union St. Complete separate forms for each different Queen’s University Person or institution requiring a transcript.Kingston ON K7L 3N6

The personal information on this form is collected under the authority of the Royal Charter of 1841, as amended. The informationcollected will be used by the Office of the University Registrar to process your request as identified on this form. For moreinformation, please contact the Office of the University Registrar (Records and Services), Queen's University, Gordon Hall, 74Union St., Kingston, Ontario, K7L 3N6, (613) 533-2040.

PLEASE PRINT

Queen’s Student Number Date

Title Surname

Given Names

â ã ä åYear of Program (circle)

Former Surname (if applicable)

Faculty or School Graduation Year Birth Date

(Continued on following page)

Apt. No. House No. Street Name

City Province Postal Code

Student’s Signature Area Code Telephone Number

Transcript to be sent - Check one only1. Immediately ____2. After Fall Term Final Marks ____3. After Winter Term Final Marks ____4. After Spring Term Final Marks ____5. After Summer Term Final Marks ____6. After Degree Conferred ____7. After Date _________________________8. Before Date _________________________

I am a degree candidate “ Yes “ No

I am currently registered “ Yes “ No

Please forward my transcript to:____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

No. OfCopies tobe sent

Remember: include a cheque payable to Queen’s University; each official transcript costs $10.00 rev. 03/07