Whenever a firm increases the number of units it sells, this will affect the firm's revenue, because the quantity sold is higher and revenue is equal to the number of units sold times the price they were sold. In a perfectly competitive market, each firm acts as a price taker and can sell as much as it wants to at the market price. This implies that the marginal revenue in a perfectly competitive market is equal to the market price. For example, if a firm is selling orange juice at €2 per glass (and it can sell as many glasses as it wants to at this price), then any additional glass of orange juice that the firm sells increases total revenue (TR) by 2 and thus, marginal revenue is equal to 2. That is, if the firm increases quantity from 10 to 11 glasses, total revenue increases from 20 to 22 and the change in total revenue is equal to 2: MR = TR (11 glasses) – TR (10 glasses) = 11 * 2 – 10 * 2 = 22 – 20 = 2. If the market is not perfectly competitive, the marginal revenue is not necessarily equal to the market price. Consider a monopolist who faces the entire market demand. In order to sell more units, the monopolist would have to decrease the price for all units (not only for the additional unit that it wants to sell). This means that total revenue could increase by less than the market price if the next unit lowers the sales price by too much. To be more precise, selling one more unit will increase total revenue by the price at which the good is sold minus the revenue that the monopolist loses from selling all units at a lower price. Total revenue is a quadratic function which is maximized at the point where marginal revenue is equal to zero (at quantity q *). Mathematically the marginal revenue is the derivative of total revenue with respect to quantity, i.e. \begin{equation*} \mathit{MR} = \frac{\mathit{dTR}}{\mathit{dq}} = \mathit{p(q)} + \mathit{q}*\frac{\partial\mathit{p(q)}}{\partial\mathit{q}} \end{equation*} where TR is total revenue <m:omath><m:r>TR </m:r><m:r>= </m:r><m:r>p</m:r><m:r>(</m:r><m:r>q</m:r><m:r>)</m:r><m:r>q</m:r></m:omath>. The first part of this derivative p(q) is positive, because when the quantity sold rises total revenue increases by the price at which the extra unit is sold. The second term of the derivative will be negative, because to sell more units, the price per unit must decrease. Multiplied by the total number of units q, this measures the total loss in revenue due to the lower price. The figure shows the marginal revenue curve and the total revenue curve for a monopoly with linear market demand. The left panel (a) shows the marginal revenue curve (MR) and the demand curve (D). In the case of linear demand, marginal revenue is also a linear function, and its slope is twice as steep as the slope of the demand function. This means that if inverse demand takes the form p = a - bq, then the marginal revenue function is MR = a - 2bq. The right panel (b) shows marginal revenue (MR) as well as total revenue (TR) (and average revenue (AR)) in the case of a linear demand function (D). Total revenue is a quadratic function that reaches its maximum where marginal revenue equals zero (at quantity q^*). Keep in mind that marginal revenue is not the same as average revenue AR, which is the revenue per unit, i.e., \begin{equation*} \mathit{AR} = \frac{\textit{Total revenue}}{\textit{quantity}} = \frac{\textit{TR}}{\textit{q}} \end{equation*} Marginal revenue is an important concept in economics, because together with marginal costs it determines the equilibrium quantity and price in a perfectly competitive market. A firm maximizes its profits when it produces the quantity at which the marginal revenue of the last unit produced is equal to marginal costs of that unit. That is, profit maximization requires MR = MC . If marginal revenue exceeds marginal costs <m:omath><m:r>(</m:r><m:r>MR </m:r><m:r>> </m:r><m:r>MC</m:r></m:omath>), selling one additional unit increases total revenue more than total costs. Therefore, profit will increase if it sells this unit. (Remember that the profit of the firm is total revenue minus total costs). Consequently, a profit- or utility-maximizing firm will produce this additional unit. If marginal costs exceed marginal revenue <m:omath><m:r>(</m:r><m:r>MR </m:r><m:r>< </m:r><m:r>MC</m:r></m:omath>) total costs increase more than total revenue for the next unit produced, and it is better for the firm not to sell this unit. When <m:omath><m:r>MR </m:r><m:r>= </m:r><m:r>MC </m:r></m:omath>the firm has no incentive to either increase or decrease its quantity as both would lead to a reduction in profits. Therefore, firms stop producing where MR = MC, but before MR < MC. Further reading In economics, we usually assume that the firm's objective is to maximize profits. But, some economists following Baumol (see e.g. “Business Behavior, Economics and Growth”, 1967) argue that under certain conditions firms seek to maximize revenue rather than profits. Baumol argues that the managers of a firm, in contrast to the owners and shareholders, are more interested in maximizing sales than profits because there is a direct link between the salary and reputation of a manager and total revenue. Good to know What determines the wage that you can earn? According to economic theory, your salary will depend on how much the total revenue of your employer increases by hiring you. This theory can be used to explain why some football clubs are willing to pay huge sums for players that they expect to contribute considerably to the success and fame of the club. For example, in Summer 2019 Eden Hazard transferred from Chelsea to Real Madrid for €150 million. This large sum reflects not only Eden's expected contributions on the field, but also new merchandising opportunities and brand recognition for Real Madrid. Test whether you understood the concept of marginal revenue... Take a quiz <use xlink:href="/themes/custom/venice/images/icons.svg#launch-18px"></use> Exercises for you <use xlink:href="/themes/custom/venice/images/icons.svg#launch-18px"></use>
Marginal revenue (MR) measures the change in total revenue that occurs when a firm increases output by one unit, i.e., it is the extra income (or revenue) generated by selling one additional unit.
Government intervention helps women. We need more of it
These aren’t easy questions, the rancorous nature of current American politics evidence of their polarising nature. Nevertheless, as social expectations are raised, they require constant reappraisal, for certain injustices necessitate government intervention. Research has shown that gender equality, especially, is reliant on an active, intervening state to provide things the market has historically failed to offer and that are vital to progress - namely parental leave and childcare. The case for placing both in the custody of the state is compelling, and ultimately, if gender inequality is to be taken seriously, necessary. Here’s why. Historic prejudice The labour market has rarely been a friend to women. Reflecting regressive social mores, it has, for most of its history, viewed the female condition as unsuitable for the dog-eat-dog world of work - too sensitive, too fragile - while pregnancy itself carried great disruptive potential, an ever-present, ticking time-bomb. These sentiments continue to find expression in the hiring process - men preferred to women in a phenomenon economists call ‘statistical discrimination’. The preference presumes that women are more likely to quit work on account of starting a family. And being ‘more likely’ to quit, they are paid less - globally women earn 24% less than men according to Oxfam - as businesses safeguard themselves against future losses. In turn, unfair remuneration makes women actually more likely to quit, and the circle is complete. A similar logic makes women less likely to get promoted, explaining their relatively few numbers in positions of high authority. The material ramifications of this are dire, to say nothing of the ethical injustice. UN unemployment and poverty statistics are all skewed unfavorably towards women, and mothers have it particularly bad. Despite progress having been made - 39% of the global workforce are women and there’s been a haphazard re-examination of caregiving roles in society - the restrictive breadwinner/homemaker dichotomy generally persists, economic prejudice feeding social expectations and vice versa. It’s possible for politics to help disrupt this stubborn feedback loop; intervention can check female economic prejudice and address outmoded social norms - if the will is there. America provides a cautionary tale of when the opportunity is passed up. The American experience The self-styled home of freedom and opportunity - along with Suriname, New Guinea and the Marshall Islands - doesn’t have a national law on paid parental leave, preferring instead for the market - rarely known for its compassion - to adjudicate. As a result, in 2013, it was estimated that just 12% of American workers were covered by paid parental leave policies. Forbes recently reported that 25% of women in the US return to work just 2 weeks after giving birth. And many others, left overwhelmed and with little recourse, simply leave their jobs rather than return when expected. In the words of the legal team, A Better Balance, while still thought of a the primary caregivers women are effectively ‘forced to choose between their job and a healthy pregnancy’. Those who do return to work post-pregnancy then encounter further problems. As ethnographer, Kristen R. Ghodsee, has observed, ‘many professional women get completely derailed after taking time out of the labour force’ - the quickening pace economies change, and the absence of any mechanism to help ease the return, makes it increasingly difficult to re-enter the workforce after a period of inactivity. Child care then poses further problems, for in the US it costs, on average, $15,000 per child per year. Federal provision does not exist. This means that for a large number support is unavailable, and an oftentimes a career-damaging return home is left as the only option. An American Progress study found that in 2016 alone, an estimated 2 million parents made career sacrifices due to problems with child care, and mothers were 40% more likely than fathers to report that child care issues had a negative impact on their career. It’s perhaps unsurprising, therefore, that a New York Times survey recently revealed 64% of Americans had fewer children than they would like, citing the prohibitive cost of childcare - so much for the benevolent invisible hand. The Swedish model Sweden, so often a beacon of progressiveness, offers an alternative. Witnessing American plight, it was clear to Swedes that the key to this fight was comprehensive governmental intervention, specifically, intervention on behalf of young families. One mooted solution was state-sponsored paid maternity leave that guaranteed job protection. Although certainly a positive step, some were left unconvinced it went far enough, and actually feared it may further incentivise businesses to overlook women when hiring. To ward against this, Sweden has legislated that parents of both sexes are entitled to 480 days of paid parental leave at 80% of their salary, plus bonus days for twins, and, most significantly, they must share it - each partner must take at least 90 days of those 16 months. Click here to browse our economics job listings Not only is this offer more generous, it addresses the social and economic issues that conspire to straitjacket women. It reframes the traditional expectations of both mothers and fathers, equalising the roles they’re presumed to adopt in parenthood. This, by extension, also encourages a more fundamental reassessment of societal gender roles which, regardless of identification, many find restrictively narrow. And financially speaking? Well, it’s just a better deal for both parents. Given toddlers are far from self-sufficient, and workplace pressure can be unremitting, Sweden also recognised further measures to protect the careers of young parents - particularly mothers - were needed. They guaranteed affordable childcare for all. The Education Act of 2011 confirmed that parents need only ‘spend [between] one to three per cent of the family’s income on childcare’, depending on income, with the state footing the rest of the bill. The results have been clear: 80% of Swedish 1-5 year olds now attend preschool, mothers (and fathers) are able to continue their careers unencumbered, and the country itself has been ranked the best place for women to live by U.S. News. The irony apparently lost on them. Generous parental leave and quality child care will not end structural injustices faced by women, but they’re imperative first steps. Their imposition directly targets the so-called ‘statistical discrimination’, and removes key obstacles that discourage the hiring of and investing in women. They are a start, a basis from which a broader program of reform can be built that mitigates the free market’s prejudice - gender quotas, improved education, and further legislation all have parts to play. If government intervention can be called upon in other moments of perceived crisis - not least to prop up banks - why not also for the crisis of gender inequality? As America has proven, parental leave and childcare are not safe without government enforcement. Their provision needs to be taken in-house, guaranteed and made accessible to all. For any further advice - just ask the Swedes.
The jostling between market and state, and the territory that each occupies, lies at the heart of political discourse. It's the major fault line around which political parties form and debates rage. Despite their uneasy relationship, between them they generally make available all that we need, be it food, a home, healthcare, employment, or education, at varying - and often questionable - quality and cost. The demarcation between the two, rarely ever static, differs widely across states, and speaks to the values of the society in question. What, for instance, can be said of a country whose privatised higher education is financially off limits to its poorer citizens? Is it right to leave the market responsible for people’s health? And what of the provision of childcare?
Public Economics & Economic Policy (JEL H)
Some resources are plentiful while others are rare. We tend to think less about the air that we breathe than about how we are going to spend our time on any given day. That is because breathable air is in apparent abundance while the number of hours in a day is clearly limited. Our decision to breathe is not a conscious one and is thus somewhat uninteresting for an economist. On the other hand, a whole branch of economics exists to understand and explain our choices of time allocation: how many hours we choose to work and how many hours we choose to play are of fundamental importance to the labor market. It is not just people’s time but also their skills that are in limited supply. Economists are typically concerned with the efficiency of any allocation: how can the most be made of such scarce resources? While mainstream economics focuses on the preferences and decisions of individuals in society, evaluating the fair allocation of scarce resources requires aggregation of preferences in order to judge the utility of an allocation to society as a whole (see welfare economics). Thus, not only the efficiency of an allocation but also its equity, or distributive fairness, is relevant to the study of scarcity and choice. Indeed, the issue of equity is central to the debate on free-market versus planned economies. The scarcity of a resource in a particular context can be quantified and hence judged objectively. Traditionally, economists have also studied people’s choices over scarce resources as though they were taken through simple, objective and rational calculation. Of course, people’s decision-making is not purely rational; it is affected by emotion too. The fast-developing subfield of behavioral economics applies insights from human psychology to enrich economists’ understanding of choice at a more subjective level. <11an>limit:3;categories:Master's Programs;disciplines:Economics</11an> The basics of supply and demand tell us that the price of a rare item will be higher than that of a common one. Marketing teams often apply the concepts of scarcity and choice along with ideas from psychology to make money. If marketers can create the impression that an item is in scarce supply, then some people will be willing to pay more for it, or to bring forward their purchases. Mind games about scarcity are played out through campaign statements such as “Buy it while it lasts!”, “Last chance to order!” or “Limited offer!” precisely in order to influence consumer choice. Further reading For an interesting discussion about the scarcity of a clear definition of economics and how economists have chosen to present their discipline over the years, see Backhouse and Medema's “Retrospectives: On the Definition of Economics” (Journal of Economic Perspectives, 2009). Good to know Perhaps the most important and pressing issue of our time, that of climate change, is essentially a problem of scarcity and choice. As the very air we breathe comes under threat and our rivers begin to run dry there has never been a greater urgency to consider economics in the search for practical solutions. The subfield of environmental economics deals with emissions targets and permits, carbon taxes, and subsidies for renewable sources of energy. It will surely be one of the most in-demand areas for economists to work in the years to come.
Where there is scarcity, choices must be made! Scarcity refers to the finite nature and availability of resources while choice refers to people’s decisions about sharing and using those resources. The problem of scarcity and choice lies at the very heart of economics, which is the study of how individuals and society choose to allocate scarce resources.
The theory of comparative advantage states that as long as countries have access to resources in different proportions (i.e. at differing relative cost) then they will all gain from engaging in international trade with one another. To realize these gains from trade, they each need to simply devote resources to the industries where domestic production is most efficient and then trade to receive other goods that satisfy domestic demand. Seen in this light, limiting trade between economies results in a deadweight loss. Economists, ever in search of efficiency, therefore tend to agree that free trade agreements are a good thing and that trade barriers are to be avoided. Nevertheless, trade barriers are becoming commonplace around the globe as many governments take a protectionist stance to their economies. While countries as a whole do tend to gain from free trade, as more countries participate in the world economy, competition in production intensifies, leading to losses for certain groups within countries. Wages and jobs in particular industries can come under pressure. In theory, this loss of a less efficient industry at home can be ameliorated by retraining and reallocating people and jobs to more productive areas of the economy. Yet trade barriers can have a more immediate effect because retraining takes time. Trade barriers are hence favored by many citizens and politicians looking for a quick fix. Over time, this results in countries propping up inefficient domestic industries with subsidies and tariffs, creating yet more deadweight loss. <11an>limit:3;categories:Master's Programs;disciplines:Economics</11an> A prime example of this is the trade dispute that began in June 2018 between the US and China and their governments’ discussions regarding tariffs on imports. The decision by the British electorate to leave the European Union can also be explained in part by an aversion to the free movement of people; exiting the bloc effectively erects a non-tariff barrier to trade on labor as a factor of production. Within the European Union there are no tariffs on goods and services exchanged. Even so, non-tariff barriers to trade persist through variations in the national rates of tax, differing technical standards of production, as well as the bias of national governments in favor of local firms. The European Union also maintains strict food and drugs safety standards, imposing licenses for the import of non-EU products in these sectors. The arguments for and against trade barriers typically boil down to a classic discussion about economic efficiency on the one hand and distributive justice on the other. Reducing barriers improves efficiency and thus creates a larger economic “pie”. But, distributive justice may justify keeping some barriers or rules in place to ensure the pie is shared in a fair way. Further reading Paul Krugman was awarded the Nobel Prize in Economics in 2008 for his work on New Trade Theory, which explains why trade intervention can make sense when markets are imperfect. For a refreshingly critical view of economists’ unequivocal advocacy of free trade, see his article, “The narrow and broad arguments for free trade” (American Economic Review, 1993). Good to know Trade barriers within the discipline of economics itself are few and far between. Students of economics have a comparative advantage over their peers in more traditionally national subjects such as law and medicine, as legal and health systems tend to be specific to each country. Indeed, economic principles can be applied virtually anywhere. This facilitates international student exchange between economics departments during studies. And as a graduate of economics, the international job prospects are good, not least in import and export industries, where a sound knowledge of trade barriers is a must! Video Summary Want more examples? Watch our short video on Tariffs and Trade Barriers:
Trade barriers refer to the obstacles that are put in place by governments to limit free trade between national economies. Trade barriers are thus essentially interventions in markets that happen to operate internationally. Trade barriers include tariffs (taxes) on imports (and occasionally exports) and non-tariff barriers to trade such as import quotas, subsidies to domestic industry, embargoes on trade with particular countries (usually for geopolitical reasons), and licenses to import goods into the economy.
Macroeconomics and Monetary Economics (JEL E)
Dress Code for Economic Conferences: What to Wear and What to Avoid
Having previously helped thousands of INOMICS users find the right economics conference for them, it seemed only polite to give some general guidelines about what’s appropriate to wear once there - we know you economists are a particular bunch! Hopefully this advice will allow you to check one small thing off your (very long) checklist, and allow you to focus on the more important aspects of attending an academic conference: the networking, presenting, and possibly - fingers crossed - even having fun! So, let's get serious. Check out our conference listings The basics It’s quite likely that you’ll be traveling prior to the conference and might not have access to an iron. This one should keep in mind. Moreover, remember to pack clothes that work for both standing and sitting (there will be a lot of both, economists really can talk) and won’t be completely wrinkled after a few hours. With this in mind, avoiding linen is probably a good idea, unless, perhaps, your conference is taking place on a tropical island. In which case, lucky you! Bringing some back-up options is always a good idea in case one of your items of clothing gets a wee bit dirty or, god forbid, you have an accident. Wearing dark colours is normally a good idea as they are universally flattering and hide wrinkles and spillages well. Finally, pack some layers; you might be in a room with an air conditioner for one talk and in a veritable sauna the next, and you don't want to be distracted by being too hot or too cold. Smart is better than casual Broadly speaking, it’s always better to dress up rather than down. While “business wear” can mean a full suit for some folks and jeans and a nice top for others, it’s better to be the only guy with a tie than the only one without. No matter what time of year, shorts are never a good choice, as they come across as too casual. For women, skirts and dresses are fine, but nothing too tight or short, as this can seem unprofessional. A nice blazer or scarf can dress up a plain outfit. Be aware of what you’re wearing on top though – as a general rule you shouldn’t show any cleavage, as it can be distracting or even offensive, and it’s better just to err on the conservative side. Dressing for presenting If you’re presenting for the first time, remember that your presence can be nearly as important as your presentation. In order to seem professional and poised, avoid large jewellery or busy prints, and make sure your hair is not hiding your face. Women can wear heels, but make sure you’re comfortable walking and standing for an extended period of time. Aside from this, whatever you're wearing you should try and be as confident as possible when presenting. Squaring your shoulders, standing straight and having your legs at shoulder width apart is a body position that suggests confidence and authority. Doing something like this makes you look assured and assertive, which is just as important as looking smart. Do some practice runs with some economists friends in the days leading up to build up confidence. It's always a good idea. Simply ask Finally, if you’re unsure of the basic dress code for a conference, don’t be afraid to ask. Some disciplines are generally more formal than others (finance versus computer programming, for instance), so generalities only go so far. The conference organisers should provide you with guidelines, but it’s perfectly fair to bring it up if it’s unclear. Moreover, don’t feel pressured to completely let go of your personality in favour of a professional wardrobe. As long as you feel comfortable, you’re more likely to come across as confident. Interpret our suggestions as they make sense for you, and just remember to bring a few extra options for surprise occasions like extra dinners, unexpected weather changes or other unforeseen circumstances. Go on. Knock 'em dead.
While you may be used to the daily routine of graduate school or teaching, presenting at a conference, or even just attending one, can be a whole different activity. The preparatory checklist is long enough as it is, without having the added conundrum of worrying about your appearance. If you’re in business school, perhaps you’re used to ironing your button-down shirt and slacks every day, but most academics cringe when they hear the term 'business casual'. But fear not. We, the gracious folks at INOMCS, are here to help.
But what of people's lives? With records being broken, and figures heralded as ‘the best ever’, you'd be forgiven for presuming people’s lives were improving in parallel, that the numbers translated into more than just useful soundbites. For most this is yet to happen. In explanation, economist, Joseph Stiglitz, has denied that the nation’s economic health has experienced a marked improvement, claiming ‘neither GDP nor the Dow is a good measure of economic performance, for neither tells us what’s happening to ordinary citizens’ living standards’. Indeed, if one looks to more tangible metrics - life expectancy (falling and among the lowest in the developed world), disposable income (on the decline), and household debt (skyrocketing) - a vastly different picture of American life emerges: one of stagnation, uncertainty and strife. It’s with this picture that young Americans, in particular, most identify. Instead of prosperity, millennials (Americans born between 1981 and 1996) anticipate economic future of precariousness, Trump’s creation of ‘the greatest economy… in the history of the country’ having no recognisable bearing on their reality. Optimism, the characteristic for which they were once known, is fading, and in its place has grown a shrewd pragmatism, accompanied by an acceptance that the US economy, regardless of its supposed merits, is deeply flawed. Whoever is experiencing its much touted ‘improvements’, it’s not them. <11an>limit:2;categories:Graduate / Traineeship|Internship|Junior Industry Position|PhD Candidate;countries:united states;disciplines:Economics</11an> Broken promises Remember, this was the generation that were told a college education was everything, the ticket to a comfortable life. Having held up their end of the bargain - becoming the most educated generation ever in the process - they’re now finding out the social contract to which they committed was sold on false pretences. High on the list of grievances are tuition fees - they are eye-watering. Having risen a further 25% in the last decade, they average $48,510 and $21,370 per year for private and public institutions, respectively. No one, of course, can afford this outright, and as a consequence, student loan debt has become the second highest consumer debt category, behind only mortgage debt. Added to the stagnating real wages graduates face when entering work - median purchasing power has been static for 40 years - and the rising cost of living, and you have a demographic cohort with a collective debt in excess of US$1 trillion, the highest in history. With respect to tuition at least, the accumulation of debt is not inherently bad, presuming the interests that stand to be gained are of appropriate size. Primarily, and rather obviously, this interest has typically been a job - ideally, one that's fulfilling and well paid. Nowadays, though, these are in short supply. The problem isn't an actual lack of jobs, although figures on this are nothing to celebrate; it’s the quality of jobs relative to the skills of the applicant. Millennials have been struck by underemployment, ‘the underuse of economic capacity’, or, in other words, lots of history grads working in Starbucks. According to data from the New York Fed, in September 2019, 34% of college graduates were underemployed, working in jobs that do not require a college degree. Among those more recently graduated, aged between 22-27, the rate was as high as 41.3%. And this is no post-recession fallout, either. In fact, these figures have remained relatively stable over the past 25 years. No cyclical fluctuations, as one may expect, and no identifiable long-term trends. It’s perverse. Students spend billions of dollars every year to earn degrees, and over a third of them add no value to the workforce. Ambition blocked Underemployment is also by no means the sole preserve of graduates, as the 2019 GenForward Survey, conducted by the University of Chicago, has shown. Using a nationally representative sample of 18-34 years olds, the survey reported the extent to which young people feel their aspirations are stymied. Many, for instance, believe they’re denied ‘access to good jobs, either because they are unavailable in their area or because they cannot get to them by driving or using public transportation’. A full 44% of Latinxs, 39% of African Americans, 31% of Asian Americans and 29% of whites subscribed to this sentiment, claiming that decent employment existed inaccessibly elsewhere. Moreover, those working were commonly found to dislike their jobs, large numbers citing ‘just to get by’ as their reason for being there, despite a majority strongly desiring a career-driven path. Even then, second jobs for around 25% was still needed to actually ‘just get by’, given inadequate pay. Far from exploiting the gig economy for its flexibility - its supposed redeeming quality - the data strongly suggested participation was the result of necessity, of the lack of an alternative. Candidates must listen Relative to their parents, the future for millennials is one of ‘lower earnings, fewer assets, and less wealth’, so concludes research from the Federal Reserve. The median income for 25-34 year olds has fallen in every major industry but healthcare since 2008, contributing to millennials owning just 4% of real estate value, when at the same age baby-boomers owned 32%. This is far from the picture Donald Trump describes. It’s a picture populated by physicist waiters, engineer baristas and sales people who boast an extraordinary knowledge of international relations. Ultimately, it’s picture in which talent is being squandered. With millennials on the verge of overtaking baby-boomers in number, and thus becoming a potentially election-defining voting block, candidates for President should really be taking note. Header Image Credit: Alvaro German Vilela on Shutterstock (licensed image - copyright)
The US economy is improving, so we are told. With the financial crash receding into the distance, almost out of sight, things are looking up, the future is finally brightening. Unemployment reached a 50-year low in 2019, falling to 3.5%, while US employers have added almost 5 million jobs in just two years. These are ‘the best economic numbers our country has ever experienced’, the President declared at Davos, with characteristic humility. And bombast aside, his sentiment is not without foundation, the US economy is posting some good numbers. In addition to jobs, GDP has been growing at close to 3 percent annually, and the Dow Jones has increased by 49% is the last 3 years - all of which is great election fodder for the coming campaign. Democrats should be wary.
Economic Development, Innovation and Growth (JEL O)
\begin{equation*} \eta_A = \frac{\Delta\mathit{q}_{A}}{\Delta\mathit{p}_{A}} = \frac{\frac{d{q}_{A}}{\mathit{q}_{A}}}{\frac{d{p}_{A}}{p}} \end{equation*} Price elasticity of supply is generally positive because firms are motivated to supply more (less) of an item as its price rises (falls). Precisely how sensitive supply is to changes in price depends on several factors. The most important is how long it takes sellers to adjust the amount of the item they can offer for sale. This is not just about the ability to ramp up production when more of the item is demanded. It is also about how feasible or costly it is for the seller to store items when demand falls. The more complex the production process, the greater the dependence of sellers on other markets. Greater interdependence also increases the seller’s responsiveness to price changes. In markets for physical goods and the local provision of services, public infrastructure is also a significant factor in the price elasticity of supply. The supply curves for five standard theoretical cases are shown in the graph below. In the first case, the supply curve S1 starts at the origin (0,0), and is linear and upward-sloping. This implies that any change in price is met with a proportional change in quantity supplied. Therefore the price elasticity of supply is unitary η1 = 1. If the item’s price increases by 10%, so too does its quantity supplied. As with the price elasticity of demand there are two extreme cases for the price elasticity of supply: perfect elasticity and perfect inelasticity. The horizontal supply curve S2 represents perfectly price-elastic supply: the elasticity tends towards (positive) infinity η2 → ∞. In theory, this means that if its price increases above p2 then an infinite amount of the item will be supplied. But, if its price drops below p2 then none will be supplied. Clearly, this is unlikely to happen in practice. However, in industries with flexible production and factor markets with spare capacity, the price elasticity of supply can be very high. One example is the market for coffee-to-go. In this market, new entrants are very quick to take advantage of increased consumer willingness to pay, and leave the market quickly when conditions deteriorate. Figure 1: Various price elasticities of supply At the other extreme, the vertical supply curve S3 indicates that supply of the item is fixed at a quantity of q3, whatever its price: supply is perfectly price-inelastic η3 = 0. This is the case, at least in the short-term, for items with longer, less flexible production processes. Indeed, producers of such items are unable to react quickly to price changes. The remaining two cases are the supply curves S4 and S5. The former represents relatively price-inelastic supply 0 < η4 < 1. This can be seen by interpreting the graph: as the price increases, quantity increases only slightly. The latter shows a price elasticity of supply greater than unity η5 > 1. In contrast to S4, as the price increases, the quantity according to curve S5 increases by much more. Economists distinguish between short-run and long-run supply curves due to the difference in their price elasticities. In the short run, supply is often assumed to be price-inelastic because the short run is defined by there being at least one fixed factor of production. In the long run, all inputs are variable and therefore supply tends to be more price-elastic, reflected in a flatter supply curve. Further reading The market for housing is a good example to gain an understanding of what can influence the price elasticity of supply. Using urban variation across the United States, Green, Malpezzi and Mayo uncover some key determinants of supply price elasticity in their article, “Metropolitan-specific estimates of the price elasticity of supply of housing, and their sources” (American Economic Review, 2005). Good to know The combination of price elasticity of demand and price elasticity of supply is what determines the respective sizes of consumer surplus and producer surplus in a market. In general, the less price-elastic demand (supply) is, the greater the consumer (producer) surplus. This is particularly relevant information when it comes to market interventions because it allows one to calculate which side of the market stands to gain most (or, more commonly, lose least) through a tax or other regulation on supply.
The price elasticity of supply for an item A ηA measures how the quantity of the item supplied qA changes in response to a change in the item’s price pA
Markets for goods and services have varying numbers of sellers, ranging from one (monopoly) to infinitely many (perfect competition). Oligopoly lies somewhere in between. In practice, industries with between two (duopoly) and six major players are considered to be in oligopolistic competition. Examples of oligopoly include the markets for mobile telephone networks such as Deutsche Telekom, Orange, Telefónica and Vodafone in Europe, the market for large passenger aircraft like Airbus and Boeing, and the market for soft drinks like Coca Cola and PepsiCo. The theory of oligopoly originated in 1838. French polymath Antoine Augustin Cournot observed a market for mineral water, which had two firms competing for market share. Realizing that neither firm could ignore the other’s supply of water in the market, Cournot analyzed the market as a game in which the quantity supplied by one firm q1 is a direct function of the quantity supplied by the other q2, i.e. reaction function q1*(q2) as shown in the graph on the left. Assuming that each firm sells an identical or homogenous product, faces identical costs and that the firms act simultaneously, equilibrium quantities supplied in the market are determined where the reaction functions cross q1*(q2*) = q2*(q1*). This was the first formal representation of a Nash equilibrium. It was over a century before John Nash published his general proof. In Cournot equilibrium, both firms make a positive profit and the market is supplied with more of the item at a lower price than in monopoly, but less of the item and at a higher price than in a perfectly competitive market. Figure 1: Nash equilibrium comparison between Cournot and Bertrand market scenarios Forty-five years later in 1883, another French professor, Joseph Louis François Bertrand, contended that Cournot’s analysis of oligopolistic competition was unrealistic since firms more commonly compete not on quantity but on price in the real world. Under the same assumptions of identical products or services, identical costs and simultaneous decision-making, Bertrand demonstrated how price competition in an oligopoly would instead result in zero profits for the firms, where prices would be set equal to marginal cost, just as in perfectly competitive markets. For this reason, firms in an oligopoly have an incentive to differentiate their products to a certain extent in order to profit from different buyers’ individual preferences. Some buyers will then not consider the products offered by each firm as perfect substitutes, rather they will be imperfect substitutes in consumption. The graph on the right shows the reaction functions of two firms in a duopoly where they offer similar but not fully identical products and compete on price. Note how in this situation, if one firm increases (decreases) its price, this prompts the other firm to raise (lower) its price as well. This contrasts with the Cournot case, where if one firm increases its market share (quantity), the other responds by reducing its supply in the market. As with Cournot, the Nash equilibrium in the Bertrand duopoly with product differentiation is at the point where the reaction functions cross and prices are set at p1*(p2*) = p2*(p1*). In real oligopolies, firms compete both by varying price and by varying quantity supplied. It may be argued that firms with long production processes, as in the case of passenger-aircraft manufacturers Airbus and Boeing, make strategic decisions about quantities supplied in the market rather than their prices (which can be adjusted later) and thus come closer to Cournot competition. On the other hand, market leaders that can vary their production at short notice, such as drinks manufacturers, are more likely to compete directly on price and hence fit the Bertrand competition model better. And in order to avoid suffering from zero profits, Coca Cola and PepsiCo do their utmost to convince us that their drinks are not identical! Further reading Jean Tirole won the Nobel Prize in Economics in 2014 for his for his analysis of market power and regulation. For a comprehensive treatment of oligopolistic competition, see chapter 5 of his text book, “The theory of industrial organization” (MIT Press, 1988). Good to know Rather than slaying each other in vicious price wars, firms competing in oligopolistic markets are often tempted to collaborate in pricing strategy and to coordinate supply in the market, in some cases merging their operations into a single entity. While this can sometimes benefit the industry and lead to better products, market concentration, the formation of cartels and price-fixing can be detrimental to the consumer. See the article on antitrust policies for further details.
An oligopoly is a market in which there are only a few sellers of the item being traded. The decisions of one seller thus affect the decisions of the other sellers in the market. Sellers compete strategically in the market by taking each other’s interests and actions into account.
\begin{equation*} \epsilon_A = \frac{\Delta\mathit{q}_{A}}{\Delta\mathit{p}_{A}} = \frac{\frac{d{q}_{A}}{\mathit{q}_{A}}}{\frac{d{p}_{A}}{p}} \end{equation*} Price elasticity of demand is generally negative because people tend to demand more (less) of an item as its price falls (rises). Precisely how sensitive demand is to changes in price depends on many things. Some factors include the type of item being sold, the availability of substitutes, the type of buyer, and the time period considered. For example, basic food items such as bread tend to be price-inelastic: people adjust their demand in response to changes in price less than proportionately to the changes -1 < ϵbread < 0. This means that if the price of bread goes up 10%, quantity demanded will fall by less than 10%. On the other hand, let’s consider the rise in price of a particular type of bread (“special bread”). If other types of bread that represent good substitutes for it do not change in price, then people may respond by reducing consumption of special bread. This could happen in (potentially greater) proportion to the change in price, i.e. ϵspecial_bread ≤ -1, or result in the purchase of other bread to replace it (see cross elasticity of demand). Demand for special bread would then be said to be price-elastic. Whenever the quantity of an item demanded changes by at least as much, or disproportionately more, than a change in its price ϵA ≤ -1, the item is price-elastic. Tourism is one sector of the economy where items (transport, accommodation, food) tend to be very price-elastic: if holidays reduce (increase) in price then more (fewer) people will go on holiday. Indeed, the demand for any goods and services that are not necessary for daily life tends to be price-elastic. Of course, what is considered a necessity for one person may not be necessary for everyone else in the economy. This is relevant for sellers of items in the market who often try to group their customers by price sensitivity and practice price discrimination (offering different prices to different groups) wherever it is profitable. The demand curves for four standard theoretical cases of price elasticity are shown in the graph below. In the first case, the demand curve D1 is linear and downward-sloping. This implies that the price elasticity of demand for the item is negative ϵ1 < 0. However, note how price elasticity itself is not the same all the way along the curve. At high prices and low quantities, any change in price is small relative to the current price. Meanwhile any change in quantity demanded is large relative to the current quantity demanded. Demand is then price-elastic ϵ1 < -1. But at the other end of the curve where prices are low and quantities high, any change in price is large relative to the current price, while any change in quantity is small relative to the current quantity demanded. Thus demand is price-inelastic -1 < ϵ1 < 0. It is not unreasonable to expect that the price elasticity of demand for an item depends in part on where the current market equilibrium lies. This in turn is determined by supply too and is therefore not shown in this graph. The remaining three cases are less realistic but they form important benchmarks for demand theory. The second demand curve D2 is horizontal at a price of p2. In other words, the item is only demanded at a fixed price of p2. Any quantity of it is demanded at this price. The idea is that buyers are so sensitive to any change in price that quantity demanded will suddenly reduce to zero should the price go up. Inversely, demand will become infinite should the price go down. This is known as perfectly price-elastic demand ϵ2 → -∞. In practice, perfect price elasticity is improbable for any item. The third and vertical demand curve D3 represents the other extreme: quantity q3 is always demanded, irrespective of the item’s price. People simply do not react to price changes: demand for the item is perfectly price-inelastic ϵ3 = 0. Finally, demand curve D4, the only nonlinear example here, is special in that quantity demanded evolves exactly in proportion to any change in price. In this case, demand for the item is unitary price-elastic ϵ4 = -1. If the price decreases by 5%, quantity demanded rises by 5% such that total revenues from sales remain unchanged. Another key feature of cases 2 to 4 is that price elasticity of demand is constant in all of them, i.e. ϵA is the same at any point on the corresponding demand curve. Unrealistic perhaps, but music to the ears of theoretical economists! Figure 1: Various price elasticities of demand In rare cases, demand for an item can increase in response to a price rise. For such items the demand curve will slope upwards and the price elasticity of demand will be positive ϵA > 0. The phenomenon of conspicuous consumption is one such case: goods or services that are bought in part to display the wealth of the owner or user. More wealth can be shown off at higher prices! For more on this, see the article on normal and luxury goods. Another case is where price is a signal of quality, particularly for luxury items. If a higher price means the item has improved in quality then more of it may be demanded. Naturally, this only holds as long as buyers can distinguish between true and false signals of quality. Price elasticity is a static theoretical concept. Therefore there is no time dimension in the definition of price elasticity. However, in practice, it is important to consider the time frame for responses to changes in price. People may not change their purchasing behavior in the short term; if they simply fill the supermarket shopping trolley with the same goods every week, then short-term demand will be price-inelastic. In the long term however, demand for items is more sensitive as people become aware of price changes and are better able to adjust their buying decisions accordingly. <11an>limit:2;categories:Jobs|Courses|Programs|Conferences;disciplines:Financial Economics (JEL G)</11an> Further reading For a good appreciation of why price elasticity matters and an empirical overview of consumer sensitivity by food category in the United States for the entire period 1938 to 2007, see the study by Andreyeva, Long and Brownell, “The impact of food prices on consumption: a systematic review of research on the price elasticity of demand for food” (American Journal of Public Health, 2010). Good to know Governments have a keen interest in price elasticity of demand in order to judge where they can raise revenue through consumption taxes. In most economies, the government taxes tobacco products quite heavily. Some argue that this is done to discourage smoking for a healthier society. But the reality is that demand for cigarettes is price-inelastic: most smokers are addicted and will continue to purchase their regular dose regardless of price hikes through tax. The more price-inelastic an item, the greater its potential to provide juicy tax revenues. Of course, this introduces deadweight loss into a market, but it can be worth it if there is also a reduction in negative externalities (for example).
The price elasticity of demand for an item A ϵA measures how the quantity of the item demanded qA changes in response to a change in the item’s price pA.
The economic theory of production divides costs into two main categories, fixed and variable. Fixed costs, or overheads, cover expenses that do not depend on the level of output in the short term: the cost of purchasing or renting land, buildings and machines, and the cost of running them. Variable costs depend directly on the level of output and include the cost of inputs that vary with output, such as raw materials and hours of labour. Figure 1: Returns to scale as quantity increases Average costs, or unit costs, are simply the total of all fixed and variable costs, divided by the level or units of output. As shown in the graph, unit costs are relatively high at low levels of production, which is due to fixed costs. As output increases, average costs fall as the outlays for land, buildings and machines are spread over more units. The entity is said to be experiencing increasing returns to scale: it is good for it to grow (between 0 and q1 output in the graph). However, unit costs will not decline indefinitely as machines suffer wear and tear and need to be repaired or replaced, and more buildings and land are required for greater production. Unit costs may settle at a minimum amount for a range of output levels. No further cost savings can be made simply by varying output: the returns to scale are then constant (between q1 and q2 output in the graph). Eventually, it becomes difficult to manage very large levels of output and unit costs start to rise: the entity is now experiencing decreasing returns to scale (beyond q2 output in the graph). Economies of scale may not be due solely to production costs. Insofar as the entity is producing items for sale, conditions in the market for the items also determine economies of scale. It will only be profitable to increase production as long as there is sufficient demand for the item and/or the competition allows for it. This interdependence with the market makes it difficult to pinpoint the optimal size of an entity for efficient production. Although economies of scale make intuitive sense in theory, they are difficult to measure and judge in practice. A degree of risk is involved in decisions made by individuals and organisations about growing capacity through new investments in capital (i.e. fixed costs). Investments can increase production at a lower unit cost but whether or not positive returns (and thus true economies of scale) are achieved also depends on sales and revenue. It is seldom easy to know whether “small is beautiful”, “big is better” or “too many cooks spoil the broth”. Further reading George Stigler won the Nobel Prize in Economic Sciences in 1982 for his contributions to the study of market processes and industry structures. In “The Economies of Scale” he contends that an organisation’s optimal size can be deduced most easily by observing an industry over time, classifying each organisation in the industry by market share and determining within the distribution where market share is increasing and where it is decreasing (Journal of Law and Economics, 1958). Good to know In the digital era of the Internet and Big Data, increased computing power and lower data-processing costs create plenty of opportunities to achieve economies of scale. The emergence of Big Tech (firms such as Amazon, Facebook and Google) is clear evidence of this. Yet even the scale of these giants is limited by demand in their respective markets and, increasingly, by government regulations aimed at constraining their power.
Economies of scale are the savings that occur when an entity grows in size and can produce output more efficiently or at lower cost. Here, the word “entity” can refer to individuals, organisations or even entire nations.
\begin{equation} \mathit{YED}_{A} = \frac{\Delta\mathit{q}_{A}}{\Delta\mathit{Y}} = \frac{\frac{\partial{q}_{A}}{\mathit{q}_{A}}}{\frac{\partial{Y}}{Y}} \end{equation} In the market for any good or service, how much of it is demanded depends to a large extent on its affordability to buyers. An item’s affordability is determined both by the price at which it is offered and by the buyers’ available budgets. While price elasticity of demand gauges the sensitivity of buyers to changes in the item’s price (it measures pricing sensitivity), income elasticity of demand considers the relationship between budgets and quantity demanded. The concept of income elasticity is used to classify goods and services into two main types: normal and inferior. A normal good or service is one whose demand moves in the same direction as income. That is, if the buyer’s income increases (falls) then the buyer will demand more (less) of the product. In this case, YEDA > 0. On the other hand, an inferior good or service is one whose demand moves in the opposite direction to income, YEDA < 0. Examples of normal items include consumer goods and services such as clothes, electronic goods, general transport services and theatre and concert tickets. Consumers generally want more as they become better off. Normal goods and services can be subdivided further into the categories of basic necessities and luxury items. Basic necessities are items whose income elasticity of demand is inelastic, 0 < YEDA < 1. That is, demand does respond positively but it does not rise or fall by as much as income in response to any change in income. As its name suggests, demand for a basic necessity is less sensitive to a change in income: the buyer needs it! In contrast, a luxury item is one whose demand increases as soon as it becomes affordable; its income elasticity of demand is said to be elastic, YEDA > 1. Inferior goods and services include food staples such as bread and shared transport such as public bus services. When income rises and thus demand falls for an inferior good or service, its consumption is typically replaced by an alternative item with a higher income elasticity of demand. For example, consumers may switch their income away from bread in order to consume more meat, or they may purchase a private car or other, more comfortable form of transport to substitute for their public-bus journeys. Figure 1: Various income elasticity of demand depictions Income elasticity of demand is often described graphically using an Engel curve (named after the German statistician Ernst Engel). This is a plot of quantity demanded graphed against income (not to be confused with a demand curve, which shows the relationship between prices and quantity demanded!). In the graph, the 45° dashed line through the origin represents proportionate responses of buyers to changes in income, i.e. unit income elasticity of demand, YEDA = 1. Along this line, if buyers’ income increases by 10% then their demand for the item also rises by 10%. The special cases of normal goods, necessity and luxury, are easily discernible in relation to this dashed line; inferior goods are recognisable by the negative relationship between income and quantity demanded. Further reading Aitchison and Brown provide further forms of Engel curves in their article, “A Synthesis of Engel Curve Theory” (The Review of Economic Studies, 1954) and point out that what constitutes a necessity for one income group in the economy may in fact represent a luxury for another income group. Hence their thesis is that Engel curves should be curves rather than straight lines! Good to know Economists are often criticized for assuming that more is always better. This may be an unfair claim. Economists tend to focus on the maximization of individual utility (read: happiness!), which need not always rise with income and consumption. At some point, consumption is saturated. This is manifested through the large gifts and donations that the rich often make to others in the form of charity. Income elasticity of demand is also very relevant in Development Economics; income elasticity tends to be higher at lower levels of economic development.
The income elasticity of demand formula YEDA is a measure of how the quantity demanded of an item A qA in a market is affected by a change in income Y on the demand side of the market:
Common examples of adverse selection include the market for insurance and the labour market In the insurance market, providers know less about their customers’ risk levels than the customers themselves, and riskier customers have a greater interest in purchasing insurance. Risky customers then dominate the insurance market, increasing the cost to providers because there are more claims from such customers. The price of insurance (the insurance premium) then rises, which also affects less risky customers, who may then choose not to purchase insurance coverage at all. Adverse selection thus leads to a smaller, less efficient market than a market in which insurance companies knew everything about their customers In the labor market, employers know less about job candidates than the candidates themselves, and unsuitable candidates are attracted to job descriptions and job adverts promising good salaries and working conditions. When such candidates apply for jobs they dilute the pool of potential employees and, in the absence of a mechanism for employers to screen candidates for their suitability, this reduces the value of employees to the employers, who in turn offer lower wages and benefits. Suitable candidates are then less attracted to the jobs. Again, adverse selection leads to a less efficient market than one in which employers had full information about job candidates. Adverse selection is potentially very harmful as it can mean that some people obtain jobs where they will do serious damage to others. A particularly dark example of this is child molesters being attracted to jobs which grant them access to children, such as schools and clubs providing activities for children. Not only do unlucky children then suffer, but trust in the market is eroded and the “right” people stop participating in the market. This is why the teaching profession is highly regulated and laws exist to enforce a thorough screening of applicants for such roles. Further reading George Akerlof is one of three economists to have won the Nobel Prize in Economics in 2001 for analyses of markets with asymmetric information. In “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (Quarterly Journal of Economics, 1970) he analyzes adverse selection in the used car market where sellers of used cars have superior information about the cars’ true quality than buyers. Akerlof demonstrates how sellers of low-quality cars (“lemons”) flood the market, lowering prices and thus preventing owners of high-quality cars (“peaches”) from obtaining a fair price for their cars. Good to know The problem of adverse selection can be mitigated through the design of appropriate mechanisms to discourage unwanted players from entering the market and/or to encourage favorable players to enter the financial market. In the case of health insurance or any type of insurance, providers practice price discrimination, offering lower premia to customers who provide evidence of being low-risk, and they may also charge excess fees in the case of claims in order to share risk with the customer. In the case of the labor market, employers may initially offer a period of probation with poorer conditions (lower salary and benefits) to new employees such that only suitable candidates who are sure of passing probation apply for the job in the first place.
Adverse selection occurs as a case of asymmetric information whenever a more well-informed market player uses information to take advantage of another player in the market who does not hold that information. In turn, this adversely affects participation in the market.
In classical economic theory, information is assumed to be complete and evenly distributed among market players: each player knows how the other players value the items being traded in the market. This simplifies the analysis of the market because the players’ actions will be certain and predictable. Market outcomes (prices and quantities) can then be easily calculated. However in reality, market players tend not to know everything about each other. That is, information in the market is asymmetrically distributed. Information is valuable, and better informed market players can take advantage of their superior information to achieve better outcomes than less informed players. For example, sellers of goods typically hold more information about the goods they are selling than do prospective buyers. Sellers can reveal information that makes the goods seem more valuable to buyers, while not disclosing any information that would reduce their value to buyers. The price of the good will then be higher than it would have been in a market with complete information. This is one reason why firms spend so much money on marketing and advertising! Other asymmetric information examples include if a homeowner wanted to sell their house, they would have greater information about it than the buyer. Asymmetric information refers to this unequal knowledge between buyers and sellers. Asymmetric information can also be present in financial markets, where insiders or large investors have access to information that is not available to the general public, giving them an unfair advantage in making investment decisions. In all of these cases, one party has more information than the other party, which can create an imbalance. Understanding the structure of information in a market (i.e. how the information is distributed: who knows what about whom) is crucial for predicting what will happen in that market. This can be more important for predicting outcomes than holding the information itself. Where there is asymmetric information, it is often useful for the less informed player to elicit information from the better informed player. A whole branch of microeconomics is devoted to the design of mechanisms (protocols, sets of rules) to reveal information about valuations that would otherwise be hidden, in order to increase efficiency in the market. An example of this is the public licensing of airwaves for mobile telephone networks. In the advent of mobile telephony, governments claimed the rights to the airwaves under their jurisdiction but they did not know how much telecommunications firms were willing to pay for them. Economists were commissioned to design auctions that would give the firms an incentive to bid up to their reservation prices (i.e. be truthful about their valuation of the airwaves). This raised billions of dollars for the public purse that may otherwise have remained within the profits of the private telecommunications firms. What was important was that governments had recognised their own ignorance and the nature of the information asymmetry, and acted accordingly. Further reading on asymmetric information Joseph Stiglitz is one of three economists to have won the Nobel Prize in Economics in 2001 for analyses of market failures with asymmetric information. For a good and very readable overview of how information affects economic outcomes, see his working paper, “The Revolution of Information Economics: The Past and the Future” (National Bureau of Economic Research Working Paper No. 23780, 2017). Good to know The labor market is full of information asymmetries. Employers usually know more about the jobs they need done than potential employees, while candidates who are applying for jobs know more about their own strengths and weaknesses than potential employers. The recruitment and selection process is geared towards revealing hidden information about candidates in order to achieve the best match for the employer. Candidates too have an interest in assessing potential employers and learning more about the jobs on offer before signing up to them. Understanding and applying the theory of asymmetric information can help you to find the job that is right for you!
Asymmetric information in economics refers to a state where market players have different levels of information about each other’s valuations of the market. As such, their information is asymmetric, or asymmetrically distributed.
Ceteris is Latin for “other things” and paribus means “equal”, so the literal translation is “other things being equal”. The concept of ceteris paribus in economics it is generally understood to mean that all other things remain equal or are held constant while dealing with the issue at hand. Video Note: In the video, “ceteris” is pronounced with a "ke". However, in many other places it will be pronounced “se". Our research says either is fine. Our narrator just found it more natural in their accent to say the former. But if you have strong feelings about Latin pronunciations do let us know. As an example of ceteris paribus analysis, one may wonder what the impact of introducing a minimum wage will be on the level of employment in an economy. A basic economic analysis of the labor market, as shown in the graph just below, might consider employers’ demand for labor D and (potential) employees’ supply of it S, quantified in hours worked per period for a particular hourly rate of pay. Demand for labor increases as the hourly wage falls since it becomes cheaper to hire workers. On the other hand, the supply of labor increases as the hourly wage rises because it is more attractive for people to work at higher wages. In this free labor market, equilibrium is where demand meets supply and h* hours are purchased by employers at the hourly wage of w* (the market-clearing rate of pay). Figure 1: Involuntary unemployment in the labor market All else equal, ceteris paribus, if a minimum wage Wm is introduced that is higher than the market-clearing rate of pay w* then employers will demand less labor and there will be a reduction in employment (total hours worked decrease from h* to hm), creating involuntary unemployment. Although there are workers in the labor market who would like to supply more hours’ work than hm at the minimum wage Wm employers are unwilling to pay for more than hm hours at the new rate. Note how this basic analysis ignores other effects of the increase in wages, such as what happens to the workers who remain in employment. Because we specified ceteris paribus, we would not be concerned with those other effects. However, extending our analysis, those still in employment now earn more per hour and may spend their extra earnings, increasing their demand for goods and services. This could end up creating more employment than the graph suggests. The workforce could also become more productive if employers choose to shed less productive employees first. This would normally make the economy more competitive with other economies, leading to greater exports. In turn, (domestic) employers will again increase their demand for labor. The above example of ceteris paribus analysis with its conclusion that “a minimum wage creates unemployment” also ignores the effects of other things that are potentially happening simultaneously. The supply of labor might be growing or shrinking due to demographic changes, or the effects of a new income-tax or child-benefit policy introduced at the same time. A more realistic economic model might attempt to incorporate some of these complexities. But, one of the core reasons we specify ceteris paribus is to simplify an analysis and focus on the effects we’re interested in. A ceteris paribus approach thus typically involves partial equilibrium rather than general equilibrium analysis and focuses on the short term rather than the medium or longer term. While this may not seem satisfactory from a practitioner perspective, there is an advantage to simplifying the world through ceteris-paribus modelling: it allows the analyst to concentrate on one mechanism at a time and to try to understand and explain causal relationships. As long as the economic analyst is careful not to overstate claims, a ceteris-paribus analysis often offers more insight than do ambitious attempts to explain everything that is happening at once throughout the whole economy. Further reading The philosopher and economist Daniel Hausman provides a critical account of deductivism in economics and how ceteris paribus has been (mis)used by economists over the years in “Economic Methodology in a Nutshell” (Journal of Economic Perspectives, 1989). Good to know Although the real world is generally too messy to test economic theories that rely on ceteris-paribus assumptions, there are ways to get around this. Behavioral economists design experiments that essentially create ceteris paribus conditions within a controlled laboratory setting. Participants in the experiments are asked to make decisions under certain conditions. The experimenter is then able to isolate the direct effects of policy changes by altering one condition at a time while holding all else equal: ceteris paribus!
When economists say “ceteris paribus” they are talking about the direct effect of X on Y while assuming that the rest of the world stands still.
Econometrics, Statistics and Quantitative Methods (JEL C)
In economic theory, free markets are beneficial to society because they allow consumers and producers to exchange goods and services for money according to their own maximization of personal utility. Both sides of the market gain at the equilibrium price; we call these gains consumer surplus and producer surplus. In a simple economy with just one market, the sum of consumer and producer surplus equates to social welfare: the market is then understood to be doing something good for society. If the government decides to intervene in a market, for example by levying a tax on an item which is being sold by producers to consumers, then this will force a new equilibrium in the market. Consider the market in the graph below, with producer supply S, consumer demand D and a free-market equilibrium of q* units sold at p* per unit. If the government introduces a simple unit tax (a certain amount of tax per unit of the item sold) to be collected from the producers, this forces a parallel shift of the supply to the left and an effective new supply curve of S’. This shift occurs because the tax increases the cost of selling the item, which reduces the amount of the item that producers wish to sell as they make less profit off of it. The new equilibrium point is where D crosses S’ at a quantity q’ and a retail or consumer price of p’cons. Although the item is sold at price p’cons this new price includes the tax and the producer only receives the price p’prod per unit. The government then receives (p’cons – p’prod)q’ in tax revenue. Figure 1: Deadweight loss produced from a tax on a competitive market Note how the new quantity q’ is less than the original quantity q* (since less of the item is bought at a higher price). Therefore both consumer surplus and producer surplus are reduced. Some of the original consumer surplus and producer surplus has been transformed into tax revenue for the government. However, the government is not able to recoup all of the reduction in total surplus from the original free-market equilibrium. This is because the tax induces less of the item to be exchanged in the market. Some of the benefits to market participants from the original equilibrium have simply vanished as some units are no longer traded at all. This is represented by the gray shaded triangle in the graph and it is known as the excess burden of the tax, or a deadweight loss. The size of the deadweight loss is determined by the elasticities of supply and demand. A deadweight loss is a loss in economic efficiency: before the unit tax, social welfare was higher than after its introduction. Deadweight losses, which are caused by market interventions, are often cited by proponents of a free market economy when arguing for smaller government, less regulation and lower taxes. However, such arguments tend to be somewhat simplistic. In reality, economies are made up of many markets and the actions of participants in one market often have implications for individuals elsewhere in the economy. Government interventions can be very practical responses to market failure. If the market in the example above were that for cigarettes and it were left unregulated and untaxed, cigarette producers and smokers would benefit from their respective surpluses. A unit tax on cigarette packs would reduce those surpluses and there could be a deadweight loss in the market. Yet smoking causes illness and in a society where healthcare is publicly provided, the treatment of smokers’ conditions has to be financed. In addition to the smokers’ potential health problems (the care of which must be funded by taxpayers), they produce another negative externality - secondhand smoke - that may cause health problems for other individuals who are not participating in the cigarette market. Externalities like this one often require taxes to force the market to achieve the socially optimal level of trade. In this case, the unit tax on cigarette packs would reduce the number of cigarettes sold as well as the amount of negative externality produced. Thus, it may be beneficial to society as a whole to have a unit tax on cigarette packs. This shows how a deadweight loss in one market, while still an irrecoverable reduction in efficiency in that particular market, can sometimes be compensated by gains elsewhere in the economy. Further reading Some economists claim that the act of gift-giving is economically inefficient since the giver is typically not perfectly informed about the recipient’s preferences. Logically, a transfer of money that allows the recipient to choose items for themselves would be more efficient than a guess by the giver as to what items the recipient likes. Projected to whole markets at festive times of the year when (non-monetary) gifts are exchanged, this can invoke deadweight losses in the economy. See Joel Waldfogel’s provocative article, “The Deadweight Loss of Christmas” (American Economic Review, 1993). Good to know Some governments restrict the supply of knowledge, e.g. through book-burning, the blocking of internet sites or excessive control of school curricula. This generally results in a significant deadweight loss for society. While such acts may allow governments to achieve certain short-term aims, reducing knowledge in society will stymie progress and growth, making the economy less competitive in the long run. Reinventing the wheel is always inefficient! <o:p></o:p>
A deadweight loss is the cost to society from economic inefficiency that occurs when a free-market equilibrium cannot be reached. This can be due to a market intervention like a price ceiling, the dominance of a monopoly, or some other shock to supply and/or demand.
For example, the production of fruit and vegetables requires sufficient land of the appropriate type with water and sunlight. It also requires labor and machinery to plant, cultivate and harvest the crop, as well as packaging and people or machines to present the produce for sale. Similarly, the production of a school education requires trained teachers and administrators, books and other learning materials, as well as buildings and/or other space to host the education. Applied to the first example of producing fruit and vegetables, the law of diminishing marginal returns implies that increasing the input of one factor such as land, while holding the input of the other factors (labor and machinery) constant, will increase the amount of the fruit and vegetables produced at a decreasing rate as more land is added. That is, each additional square meter of land, for fixed levels of the other factors, will yield smaller increases in output of fruit and vegetables. Applied to the second example, the first teacher or the first book will add much to the education provided. But, each subsequent teacher employed without increasing the availability of learning materials, administrators, or physical space, will expand education at a decreasing rate. The law of diminishing marginal returns can be represented graphically in two dimensions with the (total) return R as a concave function of the input i of a single factor of production (while the inputs of other factors are held constant). As more of this single factor of production is employed, for the same unit increases in input Δi, the additional (i.e. marginal) return diminishes ΔR” < ΔR’ < ΔR: Figure 1: Law of diminishing marginal returns for a revenue function At first glance, the law of diminishing marginal returns might seem to contradict the concept of economies of scale whereby increasing inputs should generate increasing, not diminishing, returns. Note however that the law of diminishing marginal returns relates specifically to varying the input of a single factor of production while holding all other factors constant. As such, it implies that different factors of production are not perfect substitutes for each other; instead, there is a degree of complementarity between input factors. You might be able to bake a larger cake by adding a bit more flour but if you do not also increase the quantities of eggs, sugar and oil the cake is liable to become dry and tasteless! Its description as a “law” makes the law of diminishing marginal returns sound grand and as indisputable as a law of physics. In fact, it can be considered more of an assumption of the theory of production. As with all assumptions, it is open to challenge. Indeed, some economists argue that marginal returns to input factors are increasing at low levels of production. The law of diminishing marginal returns thus may not apply to all forms of production and therefore should be treated with caution. Further reading The economist Stanley Brue presents a critical history of the law of diminishing marginal returns in economic thought, highlighting the lack of empirical evidence to support it, in “Retrospectives: The Law of Diminishing Returns” (Journal of Economic Perspectives, 1993). Good to know The law of diminishing marginal returns does apply to learning, and in particular to exam preparation: the first hour spent cramming for an exam is generally more productive than subsequent hours. It is important to balance individual learning with dialogue, discussing and questioning the content with others. Experimentation with different input quantities can help you to maximize the returns to your education!
The production of goods and services requires the input of various factors of production. The law of diminishing marginal returns states that as the input of a factor of production increases, ceteris paribus, the additional output from each additional unit of that input decreases.
The following graph shows the demand curve for a typical good or service. As the item’s price (vertical axis) falls from pD1 to pD2 to pD3, the quantity demanded (horizontal axis) rises from qD1 to qD2 to qD3, and vice versa. As price rises, quantity demanded falls. Figure 1: A linear demand curve Note how the demand curve shown might be representing the preferences of a single individual for the item: the individual decides to buy more (less) of the item as its price falls (rises). This movement along the demand curve shows the inverse relationship between price and quantity demanded, which is known as the law of demand. Alternatively, it represents the quantities of the item demanded by all participants in the market at various prices, i.e. the market demand curve. The market demand curve is simply the sum of all individual demand curves for the item in the economy. In general, firms will be interested in estimating market demand rather than individual demand for their products and services. A demand curve need not be linear (hence the name “curve”!) and its slope at each point represents (but is not the same as) the price elasticity of demand. This shows how sensitive the individual is or consumers in the market are to changes in price. Demand curves are drawn at a given level of income for the individual or consumers in the market. Should the income level change, the demand curve will shift inwards (shift to the left) or outwards (shift to the right), depending on whether income has risen or fallen and the item’s income elasticity of demand. For “normal” consumer goods and services, greater quantities will be demanded at every price if income rises and the demand curve shifts outwards to the right. For so-called “inferior” consumer goods and services, lower quantities will be demanded at each price if income rises. The demand curve will shift inwards to the left, as consumption of such goods and services is replaced by consumption of other goods and services that have become affordable due to the rise in income. A special case arises when people buy goods and services in order to display their income or wealth to others, so-called “conspicuous consumption”. In this case the demand curve can be upward-sloping because the item’s value to the individual rises as price increases. This is because the show-off, social-status power of the item rises, the higher its price. Such items are typically branded as “luxury” and are known by economists as “Veblen” goods or services due to the economist and sociologist Thorstein Veblen who first studied them. In practice, demand curves can be estimated by experimentation with price changes, observing consumer behavior for similar products or by surveying consumers about hypothetical changes in prices. Economists will generally choose to observe actual behavior rather than rely on hypothetical claims, i.e. revealed preferences are more meaningful than stated preferences. Market research is a huge industry but it essentially boils down to understanding the relationship between price and quantity and calculating demand curves. Further reading Most introductory economics text books cover the theories of demand and supply extensively. Often, the supply curve is discussed alongside the demand curve, and together these determine equilibrium price and quantity in a market. For a more in-depth understanding of the demand curve, a neat critique of Alfred Marshall’s original theory of demand is presented by the free-market economist and 1976 Nobel prize winner Milton Friedman in “The Marshallian Demand Curve” (Journal of Political Economy, 1949). Good to know Many firms today conduct real-time analysis of customer demand and engage in “dynamic pricing”. Understanding how willingness-to-pay changes at different times of the day, week or year and differentiating prices accordingly allows producers to capture some of the consumer surplus for themselves. The markets for electricity and air travel are examples where dynamic pricing has become standard practice. As a consumer it is, therefore, often worth observing how prices change over time before making important purchases.
A demand curve shows the relationship between the price of a good and the quantity of the good demanded, either by an individual or by all participants in the market. Demand curves are downward-sloping for most items as greater quantities are demanded at lower prices.
A basic economic idea is that the price for a good or service will eventually settle at a point when quantity demanded and quantity supplied are equal (assuming all other factors remain equal). This is referred to as the equilibrium. Our article on market equilibrium describes how this process works in the economy. The consumer side of market equilibrium is demand. Quantity demanded depends, with all other factors being equal, on the price of the commodity. Of course, all other factors are never constant: other goods in the market, the preferences of consumers, and many other things influence the demand for a good. The demand curve generally slopes downward, showing that consumers want more of a product when it is cheaper, and less when it is more expensive. Demand is also dependent on many other factors: whether complements or substitutes are available, the amount of income the consumer has, the elasticity of demand, and more. Meanwhile, the supply curve typically slopes upward. This shows that firms like to sell goods that have higher prices, and will offer to sell a large quantity of a good if the price is high. But when the price is low, firms offer less of the good for sale. Other factors that influence supply include production costs, the difficulty of competition, the presence of taxes or subsidies, and more. For more about supply and demand, and how they interact, see our article about Market Equilibrium.
“Supply and demand” is probably one of the first things people learn about economics. Supply refers to the quantity of a product or service that producers are willing to supply at each price, while demand refers to the quantity consumers are willing to buy at each price at a given point in time.
A simple example of this: the opportunity cost of using a machine to make and sell one product (call it Product A) is the lost potential revenue from selling another product (Product B) that could have been made using the machine instead. That is, Product B cannot be produced, and its unrealized revenue is the opportunity cost of using the machine to make Product A. If Product A is worth €50, and Product B is worth €35, then this opportunity cost for making Product A is €35 - €50 = -€15. For Product B, it is €50 - €35 = €15. This might seem confusing at first, but it makes logical sense. A suboptimal choice (Product B) should have a positive opportunity cost, because it eliminates the chance for a higher return by choosing the better alternative (Product A). Meanwhile, Product A’s opportunity cost is negative because the “cost” of choosing Product A is the “opportunity” to make a worse choice and lose money. To extend this example, if the machine involved in production is specialized to only make Product A, it may seem like there is no opportunity cost involved in the production process. Since the machine couldn’t produce anything else anyway, no “sacrifice” of other products is needed. However, this is not correct. The resources used as inputs for Product A have an opportunity cost of whatever next-best purpose they may have been used for. This opportunity cost is known as an implicit cost, since money is not actually exchanged. On the other hand, explicit costs are simply the money given out. In this case, the explicit cost is the price to buy the specialized machine. Opportunity cost considers both explicit and implicit costs, which is a key difference between opportunity cost and how cost and profit are typically measured in accounting or business contexts. You might be wondering where we stop counting additional opportunity costs. If this company sold Product A for €50, what is the opportunity cost? The lost chance to sell Product B for €35 instead? Or is it the lost chance to make and sell Product C for €15? When we count opportunity cost, usually we only consider the “next-best” option. In this ongoing example, the opportunity cost of selling Product A is the profit from Product B that could have been made instead. We do not consider Product C or other alternatives. This is because those other alternatives are worth less than Product B. If selling Product A was suddenly impossible, the rational, utility maximizing choice would be to sell Product B instead. Opportunity cost is concerned only with the next-best option, not every possibility under the sun. Thus, we do not need to consider Product C or other options less valuable than Product B. A further application of opportunity cost is in international trade. The theory of comparative advantage states that it is most efficient for different countries to specialize their production in the goods that they have the lowest opportunity cost of producing. Then, they trade with other countries to acquire the other goods they need. In this way all countries benefit, and economic efficiency is achieved. Good to Know A good manager should always be considering business decisions in the context of the next best alternative. Even if a business move is profitable (in an accounting sense), without considering opportunity costs, it might not be the best choice available. As an example, opportunity cost can be used in tandem with return on investment (ROI) and risk analysis to analyze business decisions. Risk measures the potential (expected) outcomes of a choice, while ROI measures the expected return of a choice compared to its cost of implementation. These are common methods used to compare options, choosing a low-risk, high-ROI option, ceteris paribus. Opportunity cost adds context to this analysis by including a different perspective. Unlike risk analysis and ROI, it compares the actual outcomes of different choices to one another. Thus, the best choice is one with the lowest opportunity cost after accounting for the potential risk of each option, and the relative cost of implementing them. Of course, it is impossible to know the actual cost or the actual risk of a decision before it is made. Thus, these analyses are never perfect unless they examine decisions or events that already took place. So, it is often quite difficult to know the actual opportunity costs before they occur! Now, what was the opportunity cost to you for reading this article?
Opportunity cost refers to the loss of the next-best positive outcomes of a choice when an alternative decision is made. In other words, the next best alternative that is given up is the opportunity cost. This cost does not only refer to money, but any lost benefits that the other choice could have bestowed. Opportunity costs are involved in every decision that is made, even if they are not obvious at first.
\begin{equation*}\epsilon_{AB} = \frac{\Delta\mathit{q}_{A}}{\Delta\mathit{p}_{B}} = \frac{\frac{{dq}_{A}}{\mathit{q}_{A}}}{\frac{{dp}_{B}}{p_B}}\end{equation*} In microeconomics, individuals' utility (or material well-being) is assumed to depend on their access to, or consumption of, bundles of items. It is also contingent on individuals seeking to maximize their utility. The precise relationship between the consumption of particular items and an individual’s utility is determined by the person’s preferences. Individuals are constrained in their consumption by their budgets and by the prices of the items. If the price of an item increases, then the individual’s ability to obtain utility through consumption of that item is reduced. It may be possible to obtain utility more efficiently through consumption of a different item instead. The extent to which this is possible depends on the substitutability of other items with the item whose price has increased. For example, an individual may like to consume hazelnuts and peanuts. Ideally the individual likes to consume both types of nuts (due to diminishing marginal utility). However, if the price of one nut type – say peanuts – increases, then the individual can afford fewer peanuts. This would lead them to reduce peanut consumption and replace some of this product with hazelnuts. Hazelnuts and peanuts are thus substitutes in consumption. Note that the reverse is also true if the price of peanuts falls and becomes more affordable. The individual will then obtain utility more efficiently by reducing hazelnut consumption and increasing peanut consumption. This means that in the case of substitutes, the cross elasticity of demand is positive ϵHazelnutsPeanuts > 0. The interrelationship between items is key in the cross elasticity of demand. Some items are consumed together as complements rather than as replacements or substitutes. For example, fuel is required to power vehicles. If the price of either one of these items changes, demand for both goods will move in the same direction. If the price of vehicles increases then demand for the vehicles will fall. Because of this the demand for the fuel that powers the vehicles will also fall. Likewise, if the price of fuel rises then demand for both fuel and vehicles will fall. So, in the case of complements, the cross elasticity of demand is negative ϵFuelVehicles < 0. Other items have conceivably very little to do with each other. For example, if the price of yogurt changes then this would not be expected to affect the demand for smartphones. The cross elasticity of demand between these items should be close to zero ϵSmartphonesYogurt ≈ 0. However, note that if an item that makes up a large or necessary part of individuals’ budgets becomes less affordable, people might buy fewer goods in general because they are relatively poorer. This will then lead indirectly to change in the demand for other seemingly unrelated items. For example, if smartphones triple in price, people might decide they need smartphones but end up buying much less yogurt because they have less leftover money to spend. But, this still doesn’t mean that smartphones and yogurt are truly substitutes; there’s a different effect at play. See income elasticity of demand for details about this type of effect. As with the standard price elasticity of demand for a single item, a cross elasticity of demand can be elastic (IϵABI ≥ 1), unit elastic (IϵABI = 1), inelastic (IϵABI < 1), perfectly inelastic (IϵABI = 0) or (in theory) perfectly elastic (IϵABI → ∞). This reflects the extent of the change in quantity demanded relative to a change in price. Further reading To better understand the difference between substitutes and complements and its importance for policy makers, read “Marijuana and Alcohol Evidence Using Border Analysis and Retail Sales Data” (2018). This paper from researchers Baggio, Chong and Kwon from the University of Connecticut and Georgia State University reflects on the effect of legalizing cannabis on the consumption of alcohol. More generally, it has recently been reported that current cross-price elasticities are lower than previously estimated (Auer and Papies, Journal of the Academy of Marketing Science, 2019). The median estimate of ϵAB is about 0.1, implying typically only a small degree of substitutability between items. The authors mention firms’ focus on the development of brand loyalty as one reason why consumers may switch less between items than traditional economic theory would predict. Good to know The United States Department of Agriculture Economic Research Service provides a data tool to access estimates of price elasticities. This includes cross elasticities of demand, both for major commodities and countries (particularly the USA and China). The estimates are derived from research published by US academic and government sources.
The cross elasticity of demand (or cross-price elasticity of demand) ϵAB refers to the sensitivity of the demand for item A qA to changes in the price of item B pB: