1. © The McGraw-Hill Companies, 2002 Week 7 Issues in Microeconomics

2. © The McGraw-Hill Companies, 2002 The labour market

3. © The McGraw-Hill Companies, 2002 2 Demand for factors in the long run The optimum mix of capital and labour depends on the relative prices of these factors –This helps to explain why more labour-intensive means of production are used in some countries where labour is relatively abundant. A change in the price of one factor will have both output and substitution effects A rise in the wage rate leads to –substitution towards more capital-intensive techniques –but also leads to lower total output

4. © The McGraw-Hill Companies, 2002 3 The demand for labour in the short run Under perfect competition, with diminishing marginal productivity: the firm maximizes profit when the marginal cost of employing an extra worker equals the MVPL... The marginal value product of labour is the revenue obtained by selling the output produced by an extra worker W0W0 MVPL Employment Wage, MVPL

5. © The McGraw-Hill Companies, 2002 4 The demand for labour in the short run W0W0 MVPL Employment Wage, MVPL L* Employment is L*. This decision is consistent with the MR = SMC rule for maximizing profit under perfect competition. Below L*, extra employment adds more to revenue than to labour costs. Above L*, the reverse is so. …this occurs at E where wage = MVPL. E

6. © The McGraw-Hill Companies, 2002 5 The supply of labour The LABOUR FORCE: –all individuals in work or seeking employment Labour supply –for an individual, the decision on how many hours to offer to work depends on the real wage –an individual’s attitude towards leisure and income determines if more or less hours of work are supplied at a higher real wage rate.

7. © The McGraw-Hill Companies, 2002 6 Labour supply in aggregate If we consider the economy as a whole, or an industry a higher real wage rate also encourages a higher participation rate so labour supply is likely to be upward- sloping

8. © The McGraw-Hill Companies, 2002 7 Labour market equilibrium for an industry The industry supply curve S L S L slopes up –higher wages are needed to attract workers into the industry For a given output demand curve, industry demand for labour slopes down Equilibrium is W 0, L 0. Quantity of labour Wage DLDL DLDL SLSL SLSL W0W0 L0L0

9. © The McGraw-Hill Companies, 2002 8 A shift in product demand Quantity of labour Wage DLDL DLDL SLSL SLSL W0W0 L0L0 Beginning in equilibrium, a fall in demand for the product also shifts the derived demand for labour to D' L D' L The new equilibrium is at W 1, L 1. L1L1 W1W1

10. © The McGraw-Hill Companies, 2002 9 A change in wages in another industry Quantity of labour Wage DLDL DLDL SLSL SLSL W0W0 L0L0 Again starting in equilibrium, An increase in wages in another industry attracts labour, so industry supply shifts to the left – S' L The new equilibrium is at W 2, L 2. L2L2 W2W2

11. © The McGraw-Hill Companies, 2002 The information economy

12. © The McGraw-Hill Companies, 2002 11

13. © The McGraw-Hill Companies, 2002 12 Welfare indicators by country group

14. © The McGraw-Hill Companies, 2002 13 e-products An e-product: –can be digitally encoded then transmitted rapidly, accurately and cheaply áe.g. music, films, books, sport … Fixed costs of producing e-products are huge … … but marginal costs of distribution are tiny implying vast economies of scale

15. © The McGraw-Hill Companies, 2002 14 Network externalities Suppose D 1 represents the demand curve for a product exhibiting network externalities £ Quantity D1D1 P1P1 Q1Q1 With price at P 1, demand is limited. If price is reduced to P 2, more people find the network attractive so not only is there a move along the demand curve, but there is a shift in demand. P2P2 D2D2 Q2Q2 Long-run demand is more elastic (DD). D D

16. © The McGraw-Hill Companies, 2002 15 Information: the supply side Given substantial economies of scale, we expect monopoly suppliers of information products: Dominant firm with competitive fringe áe.g. Microsoft Niche market monopolies

17. © The McGraw-Hill Companies, 2002 16 Pricing information products Strategies for pricing information products: –two-part tariff an annual charge to cover fixed costs, and a small price per unit related to marginal costs –versioning the deliberate creation of different qualities to facilitate price discrimination –bundling the joint supply of more than one product to reduce the need for price discrimination

18. © The McGraw-Hill Companies, 2002 17 Competition vs. collaboration A strategic alliance is a blend of co- operation and competition, in which a group of suppliers provide a range of products that partly complement one another –e.g. Microsoft and Intel –airline alliances: One World, Star

19. © The McGraw-Hill Companies, 2002 18 Understanding the e- economy 1 The information revolution is changing our lives –but few of its activities or market tactics are unprecedented 2 The revolution in technology has not required a corresponding revolution in economic theory

20. © The McGraw-Hill Companies, 2002 Government spending and Revenue

21. © The McGraw-Hill Companies, 2002 20 Government spending

22. © The McGraw-Hill Companies, 2002 21 Private and public goods A private good –if consumed by one person, cannot be consumed by another person. áe.g. dental treatment A public good –even if consumed by one person, can still be consumed by other people. áe.g. street lighting The strong externalities associated with public goods, mean that government intervention may be justified to ensure appropriate provision.

23. © The McGraw-Hill Companies, 2002 22 Merit goods and bads Merit goods (bads) –goods (bads) that society thinks everyone ought to have (ought not to have) regardless of whether they are wanted by each individual. áe.g. Education, health services, cigarettes –The government may spend money on compulsory education or compulsory vaccination because it recognizes that otherwise individuals act in a way they will subsequently regret.

24. © The McGraw-Hill Companies, 2002 23 Varieties of taxes Direct taxes –taxes on earnings from labour, rents, dividends and interest. áe.g. income tax, corporation tax Indirect taxes –taxes levied on expenditures on goods and services áe.g. VAT, duty on alcohol Wealth taxes –capital transfer tax, tax on property

25. © The McGraw-Hill Companies, 2002 24 Employers pay the blue area, and workers the green. A tax on wages Hours worked Wage L W DD SS With no tax, the labour market is in equilibrium at wage W, hours L. The orange area is a welfare loss for society. L' SS' W' W'' With a tax, labour supply is effectively at SS', workers receive W'', but firms pay W', the difference being the tax.

26. © The McGraw-Hill Companies, 2002 25 The incidence of a tax Who pays a tax depends upon the elasticity of demand and supply for the product. This also affects the size of distortion caused by the imposition of a tax.

27. © The McGraw-Hill Companies, 2002 26 The Laffer curve shows how much tax revenue is raised at each possible tax rate. Beyond t*, higher tax rates reduce revenue because of disincentive effects. t* 100% Tax rate Tax revenue

28. © The McGraw-Hill Companies, 2002 Industrial policy and competition policy

29. © The McGraw-Hill Companies, 2002 28 Industrial policy and Competition Policy Competition policy –aims to enhance economic efficiency by promoting or safeguarding competition between firms Industrial policy –aims to offset externalities that affect production decisions by firms

30. © The McGraw-Hill Companies, 2002 29 Industrial policy Inventions and the patent system –designed to provide a sufficient incentive for invention without suppressing competition for ever Research and Development (R&D) –the social return on risky projects may exceed the private return Dynamic change –coping with sunset and sunrise industries

31. © The McGraw-Hill Companies, 2002 30 Consumer surplus Consider the demand curve D and suppose price is at P with quantity demanded being Q. P represents the value placed on the good by the marginal consumer so D can be seen to represent marginal social benefit D Q P Quantity Price A E With all consumers paying the same price P for the good, the triangle APE represents consumer surplus – benefit received by consumers in excess of the amount they need to pay.

32. © The McGraw-Hill Companies, 2002 31 – as shown by the rectangle. Producer surplus D LAC = LMC Quantity Price Q P Producer surplus is the excess of total revenue over total costs

33. © The McGraw-Hill Companies, 2002 32 Consumer surplus is the area of the big green triangle. The social cost of monopoly: comparing perfect competition and monopoly For simplicity, suppose as industry with horizontal long-run average and marginal costs. Under perfect competition, long-run equilibrium would be with industry output Q c selling at price P c. D LAC = LMC QcQc PcPc Quantity Price

34. © The McGraw-Hill Companies, 2002 33 and the red triangle shows the welfare loss – the social cost of monopoly The monopoly receives producer surplus (profit) of the blue rectangle. Consumer surplus is now the smaller green triangle. The social cost of monopoly: comparing perfect competition and monopoly D LAC = LMC QcQc PcPc Quantity Price MR QmQm PmPm If taken over by a monopolist, profit maximization is at the lower output Q m and higher price P m.

35. © The McGraw-Hill Companies, 2002 34 Perfect competition and monopoly under differing cost conditions Suppose that monopoly enjoys lower cost conditions than under perfect competition QcQc PcPc LRSS pc Under perfect competition equilibrium is at P c, Q c. LAC = LMC MR PmPm QmQm Compared with P m, Q m under monopoly D Quantity Price

36. © The McGraw-Hill Companies, 2002 35 Welfare implications In comparing the two situations, the loss of consumer surplus under monopoly (the red triangle) must be balanced against the gains from efficiency (the blue rectangle)

37. © The McGraw-Hill Companies, 2002 36 Counting the cost of monopoly The size of the social cost of monopoly is difficult to evaluate –in part it depends upon the elasticity of demand –which influences the size of the ‘red triangle’ of welfare loss