DEPARTMENT OF ECONOMICS ECON 101 INTRODUCTION TO MICROECONOMICS 2003 Market Structures and Market Failure For more on the electricity reforms come to the tutorial for the week beginning May 19 Lecturer: Stephen Knowles Office: 7.25 in the Commerce Building Phone: 479 8350 Email: email@example.com Office hours: Mon 11-12, Wednesday 11-12 and Thursday 1:30-2:30 Lecture and Reading Guide Topic 1: Production and costs (April 29, May 1 and 2) Read: Wooding (2002) ch5 The Economist (1995) “The miracle of the sausage makers”, December 9, 1995, pp25-6 (supplementary reading #0 at the end of this handout). Topic 2: Perfect competition (May 6 and 8) Read: Wooding (2002) ch6 Topic 3: Imperfect competition and efficiency (May 9, 13, 15 and 16) Read: Wooding (2002) ch10 King and McDougall (2001) (supplementary reading #1 at the end of this handout). Topic 4: An introduction to market failure, including the funding of university education (May 20 and 22) Read: Wooding (2002) pp265-269 The Economist (1997): “Jam today, road pricing tomorrow” (pp13-14) and “Living with the car: no room, no room” (pp19- 22), December 6, 1997 (supplementary readings #2 and #3 at the end of this handout) Topic 5: Equity issues (May 23, 27 and 29) Read: Wooding (2002) chapter 12 Wolff (1996) chapter 5 (This book is on closed reserve in the Central Library. I recommend this chapter to anyone interested in reading more widely on ideas about what constitutes a fair distribution of income.) 2. Topic 6: Design of a tax system (May 30) Read: Mankiw (1998) pp243-59 (supplementary reading #4 at the end of this handout) Otago Daily Times (1999) “New Zealanders highly taxed by world standards - study”, December 4, 1999, p28 (supplementary reading #5 at the end of this handout) Sunday Star Times (1998) “Taxing times for all”, June 28, 1998, pD1 (supplementary reading #6 at the end of this handout) Topic 7: Course Summary (June 3) There is no reading for this lecture Note that the lectures on June 5 and 6 will be used for catch up or revision purposes. References The full bibliographical details for the reading sources listed above are as follows: King, A. and S. McDougall (2001) “A shocking tale of electricity prices”, EcoNZ@Otago: 7, pp1-4. Mankiw, N.G. (1998), Principles of Microeconomics, Dryden. Otago Daily Times (1999) “New Zealanders highly taxed by world standards - study”, December 4, 1999, p28. Sunday Star Times (1998) “Taxing times for all”, June 28, 1998, pD1. The Economist (1995) “The miracle of the sausage makers”, December 9, 1995, pp25-6. The Economist (1997) “Jam today, road pricing tomorrow”, December 6, 1997, pp13-14. 3. The Economist (1997) “Living with the car: no room, no room”, December 6, 1997, pp19-22. Wolff, J. (1996) An Introduction to Political Philosophy, Opus. Wooding, P. (2002) Introduction to Microeconomics, University of Otago. Lecture Notes Copies of the overhead slides used in lectures will be made available at the copy shop at the end of each week. Reading The lecture and reading guide tells you what to read for each lecture. Most of the readings are from Wooding (2002). Some other readings are included at the end of this handout. Wolff (1996) is on closed reserve in the Central Library. Some people prefer to do the reading before the relevant lecture and others find it more helpful to do the reading after the relevant lecture. The important thing is to make sure it’s done before the exam. What this part of the course is about Production and Costs In this section of the course we are going to lay the ground work required to analyse perfect and imperfect competition (the next two topics). We will study the production decisions made by firms, and the implications this has for costs. You will learn how an economists understanding of the term “cost” differs from that of an accountants. In Paul’s section of the course it was assumed that the supply curve was upward 4. sloping. In this section of the course you will develop a deeper understanding of why this is the case. Perfect Competition In these two lectures we are going to analyse the pricing and output decisions made by firms in perfectly competitive industries. In the real world, there are very few (or maybe even no) industries that meet the criteria to be considered perfectly competitive. You may be tempted to think that studying something that probably doesn’t exist is a waste of time, but this couldn’t be further from the truth. It is by understanding perfect competition that we can better understand the advantages and disadvantages of the real world industry structures we will study in the next section. Imperfect Competition In the last two lectures we have studied the characteristics of a perfectly competitive economy. Very few markets, if any, are perfectly competitive in the real world. However, the perfectly competitive model provides a useful point of comparison for other forms of market structure. In these lectures we will analyse monopoly, oligopoly and monopolistic competition. This will enable us to discuss issues like: Why does New World put out discount books? Why does Hoyts offer cheap movie tickets to students? What was the aim of the electricity market reforms in New Zealand? Are there any cases where monopoly is socially desirable? You should note that most of these applied questions will be addressed in the relevant tutorial, so if you don’t come to the tutorial, you will miss out on the more interesting part of this topic. Under the heading of oligopoly we will study something known as game theory. John Nash (who the film “Beautiful Mind” was all about) won a Nobel Prize in economics 5. for his work in this area. We will spend some time talking about Nash’s contribution to economics. Market failure and equity issues (the last few topics) The theme for this section of the course is to ask “what is the appropriate role for government in the economy?” Most of the material we have looked at so far in the course implies that a market economy is efficient and self-organising so there is little need for government intervention in the economy. However, there are many economic arguments that justify government intervention in the economy. Microeconomic justifications for government intervention normally fall under one of two headings: “market failure” (cases where the market will not deliver allocative efficiency) and “equity” (the distribution of income delivered by a market economy might be very unequal). This is what we will be focusing on for this last section of the course. As much economic debate in New Zealand focuses on the extent to which the government should intervene in the economy, these are important issues to analyse. We will begin by looking at cases where the market may fail and discuss why this provides a rationale for government intervention in the economy. One case study we will focus on is the funding of university education. We will then discuss different ideas about what constitutes a fair or just distribution of income, and how the distribution of income and poverty can be measured (this will be done with reference to New Zealand data). The final topic analyses different tax regimes in terms of efficiency and equity. At the end of this section you should be able to think in a structured manner about questions like: What can be done to relieve traffic congestion? Is it fair that some people earn a lot more money than others? Should New Zealand have a progressive income tax system or should we adopt a flat tax regime? Are university fees too high? 6. For some of these questions there are no right and wrong answers. What the lectures and tutorials aim to achieve is to provide you with a framework for analysing such questions in a systematic and logical manner. You should also note that many of these issues will be addressed in tutorials, rather than in lectures. Tutorial Exercises Tutorial for the week beginning May 5 Answer the following questions before your tutorial. 1. Suppose a bakery's short run production function is described by Q = 1000L where Q is the number of pies made and L the number of bakers employed. (a) What is the average product of labour? (b) What is the marginal product of labour? (c) Does this production process exhibit diminishing returns to the labour input? Why or why not? (d) Is this a realistic short-run production function? Why or why not? 2. A firm’s production function is described by Q = 3L + 2K, where Q, L and K represent output, labour and capital respectively. (a) Draw the isoquants and comment on their shape. What type of returns to scale does this production function exhibit? 7. (b) Assume that the firm has $6 to spend on hiring labour and capital. Labour costs $2 per worker and capital $1 per unit. Draw the isocost curve on the diagram you drew in (a). How much labour and capital will be employed? Work on the following tasks in your group. Make sure you read The Economist article before the tutorial. 1. Congratulations! You are now the proud owner/operator of a new coffee shop in George Street. The revenue generated by the coffee shop is $200,000. Your accountant informs you that the costs of running the coffee shop are $150,000. (a) What is the accounting profit of your firm? (b) If you didn't run this firm, you could get a job at the Dunedin City Council and earn a salary of $40,000 a year. When you set up your coffee shop you used $100,000 of your personal savings to set it up. The interest rate on your savings is 10%. What are your opportunity costs of labour and capital? (c) What is the economic profit of your firm? Explain in plain language the difference between this answer and that in (a). 2. Assume that the price of labour relative to capital is higher in New Zealand than in Fiji. Draw an isocost-isoquant diagram to show that New Zealand will use a more capital-intensive technique than Fiji to produce shirts. Assume that both countries have the same production function and that they each produce 1000 shirts. 3. Read The Economist “The Miracle of the Sausage Makers” (supplementary reading #0 at the end of this handout). Explain why it is that economic growth based entirely on adding more and more machines will not be sustainable (in the sense that growth rates will get lower over time). 8. Tutorial for the week beginning May 12 Answer the following questions before your tutorial. 1. “In the long run, it isn’t possible for firms in a perfectly competitive industry to earn super-normal (economic) profits.” Is this statement true or false? Give reasons for your answer. 2. Would a firm in a perfectly competitive industry; be expected to advertise, be expected to engage in Research and Development (R & D)? Why or why not? Work on the following tasks in your group. 1. Suppose that in 2003 the box industry is perfectly competitive. The lowest point on the long-run average cost curve of each of the identical box producers is $4, and this minimum point occurs at an output of 1,000 boxes per month. The market demand curve for boxes is: QD = 140,000 - 10,000 P, where P is the price of a box, and QD is the quantity of boxes demanded per month. The market supply curve for boxes is: QS = 80,000 + 5,000 P, where QS is the quantity of boxes supplied per month. (a) What is the equilibrium price of a box? Is this the long-run equilibrium price? (b) How many firms are in this industry when it is in long-run equilibrium? PTO 9. 2. Imagine that you have been sent the following letter. In your groups, draft a suitable reply. Dear Sir or Madam I am confused as to why economics text books draw the supply curve as being upward sloping. As I understand it, the supply curve is equal to the average cost curve. Average cost must surely fall as output increases because fixed costs are being spread over a larger quantity of output. Therefore, both the average cost curve and supply curve should slope downwards. You economists have got it wrong again. 3. The following table contains data on the total cost involved with producing a certain level of output of computer games. Complete the table. Q TC FC AFC VC AVC ATC MC 0 80 1 150 2 190 3 240 4 300 5 375 6 480 7 620 10. Tutorial for week beginning May 19 Prepare answers to the following questions before coming to the tutorial. 1. Explain why a monopoly might want to restrict output when it takes over what was originally a perfectly competitive industry. 2. What is the most likely economic explanation for Hoyts offering lower movie ticket prices to students? You may find it helpful to draw a diagram to help explain your answer. Work on the following task in your groups. Make sure you read the article before the tutorial. Read the article “A shocking tale of electricity prices” (supplementary reading #1 in this handout). (a) ECNZ has been split up twice (1995 and 1999). Why do you think the government did this? (b) In 1999 retail power companies were separated from lines companies. Why do you think the government did this? (c) Max Bradford (then Minister for Energy in the National Government) famously predicted that the 1999 reforms would reduce the price of electricity (and Paul Holmes constantly reminded him of this in the following months). However, in the first six months after the reforms, the price of electricity actually increased by 5%. What possible explanations are there for this. (d) What component of the electricity industry best represents a natural monopoly? 11. (e) What is meant by the “spot” price of electricity? Would an increase of 20% in the spot price, necessarily translate into a 20% increase in the average price paid for electricity? (f) Do you think price controls should be used to reduce the prices charged by electricity retailers? Give reasons for your answer. (g) Do you think price controls should be used to reduce the prices charged by lines companies? Give reasons for your answer. Tutorial for week beginning May 26 Prepare answers to the following questions before your tutorial. 1. What is a “pure public good”? Which of the following goods would you class as being pure public goods? Give reasons for your answers. (a) Lighthouses (b) The police force (c) A cure for cancer (d) Television broadcasts 2. Radio broadcasts appear to be non-excludable so we would expect the market not to provide radio broadcasts. What solution has the market found to this problem? 3. There have been accusations over the last few years that some cars imported from overseas have had their odometers wound back. What type of market failure is this likely to lead to? Show graphically why the allocatively efficient level of output will not be achieved. 12. Work on the following task in your groups. Make sure you read the articles before the tutorial. The question is based on two articles from the December 6, 1997 issue of The Economist “Jam today, road pricing tomorrow” (pp13-14) (reading #2 in this handout) and Living with the car: no room, no room” (pp19-22) (reading #3 in this handout). (a) Why are roads neither a public good nor a common property resource? (b) What are some of the external costs of driving a car? (c) “In New Zealand, road users pay directly for roads through vehicle-licence fees, a levy on gasoline [petrol] and weight-distance charges for heavy goods vehicles.” (The Economist, December 6, 1997, p19.) Why are these methods of charging for road usage a less efficient way of internalising the costs of congestion than tolls on heavily used roads? (d) Other than higher road-user charges, what methods can be used to reduce traffic congestion? Tutorial for week beginning June 2 1. What is meant by “diminishing marginal utility of income”? Do you agree that this is a realistic assumption to make? PTO 13. 2. The table below gives some data on the distribution of income in Brazil (a country with one of the most unequal distributions of income in the world). Quintile Share of total income first quintile (poorest 20%) 2.1 second quintile 4.9 third quintile 8.9 fourth quintile 16.8 fifth quintile (richest 20%) 67.5 Source: 1997 World Development Indicators, World Bank, Washington, p54. (a) Draw a Lorenz curve based on the data in the table. (b) The Gini coefficient based on the above data is 0.63. Explain how this figure can be derived from the Lorenz curve you have just drawn. (Note: you don’t have to do the number crunching, just explain the formula.) (c) Does a Gini coefficient of 0.63 represent a more equal or less equal distribution of income than a Gini coefficient of 0.7? 3. What is the “benefits principle” of taxation? How can it be used to justify charging the rich more tax than the poor? Work on the following tasks in your groups. Make sure you do the relevant reading before the tutorial. The first task is based on the Otago Daily Times article “New Zealanders highly taxed by world standards – study”, December 4, 1999, p28 (reading #5 in this handout) and the Sunday Star Times article “Taxing times for all”, June 28, 1998, pD1 (reading #6 in this handout). The second task is based on Taylor (1995) p.524 (reading #7 in this handout). PTO 14. 1. “The top tax rate in New Zealand is 39%, which is much lower than in many other countries. Therefore, New Zealand is a low tax country.” Do you agree with this statement? Give reasons for your answer. The following question was part of the Summer School 2003 Final Exam. As preparation for the Final Exam for this course, think about the key points you would raise in an answer to this question. Also, have a go at writing a conclusion to this essay question. Do this in your groups. 2. Do you think a negative income tax system should be introduced in New Zealand? Give reasons for your answer. (Note: as an economist, you should evaluate such proposals in terms of both efficiency and equity. Make sure you explain what a negative income tax is, and how such a tax regime would operate.) 15.