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Capital and interest P. 1

Capital and interest

Concept of capital and interest
Capital
Capital is anything that can generate future income over time. Traditionally, we classify factors of production into four categories: land, labour, capital and entrepreneurship. , :

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According the new definition of capital capital including anything that can generate income in future, all factors of production are therefore capitals. ,

Interest
Inter-temporal decision: Consumers always prefer earlier consumption to future because future is less certain. , Hence, a good of tomorrow is different from of today. Or say, present good is more preferred to the same good in future. , ,

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Capital and interest P. 2

In Economics, it is claimed that people have positive time preference. Hence, a good today is worth more than a same good in future that a premium has to be paid for earlier availability. , , ,

Thus, to scarify present consumption, people will ask for compensation. Therefore: , , : To lender, interest is the compensation for deferred consumption. , To borrower, it is price of earlier consumption. ,

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Existence of transaction cost If transaction cost does not exist, there would be no difference between the interest paid by the borrower and the interest charged by the lender. , However, transactions costs often incurred in the process of lending and borrowing; such as, collecting information about borrowers, assembling savings for loan purpose, bargaining and negotiation, etc. , ; : As a result, the interest rate charged to borrowers is not the same as that paid to lenders. Financial intermediaries provide services in facilitating borrowing and lending is paid by the difference in borrowing and lending interest rate. , ,

For deferred and earlier consumption to be possible, market must available for exchange to happen. Let r be the interest rate, then 1+r is the relative price of present goods. The exchange rate of present goods to future goods reflects interest. , r , 1+r:

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Capital and interest P. 3

Nominal and real interest rates In an economy with inflation, interest is not only the premium for earlier consumption, but also involves the compensation of decrease in purchasing powerWith a high rate inflation, nominal interest can be regarded as: , , , , :
P i = r+ P e

i = nominal interest rate () r = real interest rate () P = expected inflation rate () P e

This equation is called ex-ante Fisher equation. Since in monetary economy we often use money as a mean for credit agreements, the loss brought by decrease in purchasing power of money during inflation will be counted when calculating interest; as such, the expected inflation rate is included in above equation. It reflects the expected dropping rate of purchasing power. , , ,

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Nonetheless, inflation is uneasy to be forecasted in real world. Unexpected inflation will bring deviation to nominal and real interest rate. Thus, wealth redistribution effect will occur that makes creditor get loss and debtor gain. , , ;

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Capital and interest P. 4

Think more! !
Without money exists, there will be no interest exist. Is it right? , ?
Interest exists with or without money. When no money is involved, interest is the extra amount of goods offered by the borrower in exchange for the lenders deferring consumption. , , For example, I borrow one apple from you today will give two apple to you tomorrow. The extra one apple is interest paid to you. : ,

http://www.examwai.blogspot.com/ Present value / discounted value

Discounting is a method of computing future income in terms of todays income. Present value/discounted value (PV) is the value of future income measured in terms of todays value. For example, a person put an amount of P in bank for t years and the interest rate is r, he can got Y in future: Y = P(1+r)t (PV)P, t, r, Y: Y = P(1+r)t

PV =

Y (1 + r )t

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Capital and interest P. 5

PV of annuity
Annuity is a series of fixed income generated over time.

PV =

Y Y Y Y + + + ...... 2 3 (1 + r ) (1 + r ) (1 + r ) (1 + r )t

For example, the wage (annually) of a person is $1 million, he has worked for 3 years and the interest rate is 10%: $100 , , 10%:
PV = $1m $1m $1m + + 2 (1 + 0.1) (1 + 0.1) (1 + 0.1)3 = $0.909m + $0.826m + $0.751m = $2.486m

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Perpetuity is infinite fixed income generated over time.

PV =

Y r

For example, a person earns $1 million per year for his whole life: $100 :

PV =

$1m = $10m 0.1

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Capital and interest P. 6

Four properties of PV
1) The higher the interest rate, the lower the present value. , 2) The longer the time distant the future income, the lower the present value. , 3) The higher the future income, the higher the present value. , 4) The longer the life-span of an asset, the more sensitive its present value in response to change in interest rate. , ,

Applications

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1) The price of machine According to the Law of Demand, the price of a machine increase, the quantity demanded decrease. , , How to determine the price of a machine? ? For example, a machine generate an income of Y per year and has 3 years of life. , Y , 3 Y Y Y + + 2 (1 + r) (1 + r) (1 + r) 3

PV of the machine ( PV) = If Price > PV, not worth to buy. > PV, If Price PV, worth to buy. PV,

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Capital and interest P. 7

2)

Depletion rate of nature resources The higher the interest rate, the lower the present value; and, the longer the life-span of an asset, the more sensitive its present value in response to change in interest rate. , ; , , , Hence, increases in interest rate will speed up the depletion rate of nature resources (e.g. petroleum). , (: ) Also, higher the interest rate, shorter the storage time of red wine. , ,

Investment

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Investment is viewed as the use the unconsumed income to create more income in future. , It is also the sacrifice present consumption for future consumption.

Marginal efficiency of capital (MEC) (MEC)

MEC is also known as the internal return rate of investment (IRR). MEC (IRR) For example, we decide to buy a capital good (K). Assuming that the good can generate an amount of income (R) every year, PK would be the price of that good: (K); R, PK :

PK =

R R R R + + + ...... 2 3 (1 + MEC) (1 + MEC) (1 + MEC) (1 + MEC)t

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Capital and interest P. 8

If the market interest rate (r) > MEC, i.e. the PV of K < PK, we will NOT buy K. (r) > MEC, K PV < PK, For r < MEC, i.e. PV of K > PK, we will buy K. r < MEC, K PV > PK, To determine the optimal size of investment, we should buy the number of K at the point where r = MEC. , K r = MEC

r*

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MEC 0 K* K

Marginal efficiency of investment (MEI) (MEI)

If r decreases, the number of capital good purchased will rise; thus the increase in demand for the capital good will drive up the price (PK) too. r, ; , (PK) When PK increases, MEC will fall and it would be a leftward shift of MEC curve then. PK, MEC; MEC

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Capital and interest P. 9

MEC1 MEC2

MEI 0 Hence, the difference between MEC and MEI is: , MEC MEI : MEC is about the short run situation and investment of individual firm before PK adjusted. Hence, MEI is about the long rum market situation after PK adjusted. MEC PK, MEI PK K

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Capital value (CV) (CV)
Capital value (CV) is the present value of the total future income generated by capital. (CV) Price of capital = CV = = CV =

Y . r

Y . r

When all expected future income of a capital is discounted into present value and then reflected by its market value, the process is called the capitalization. , , As capital includes anything that can generate income in future, such as reputations, licenses, franchise, singing talentetc, all capitals have market value and can be capitalized through market transaction. , : , ,

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Capital and interest P. 10

Wealth, income and interest

Income
Income is the maximum consumption in a given period of time. , It is also the expenditure without reducing of wealth. Income is regarded as a flow concept.

Wealth

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Wealth is the value of stock of economic goods at a particular time. It is a stock concept. Wealth can be regarded as the sum of all incomes discounted. Suppose we own a capital asset, then the wealth generated from the asset would be: , :
Wealt () = Y + Y Y Y Y + + + ...... 2 3 (1 + r ) (1 + r ) (1 + r ) (1 + r )t

As capital value refers to the discounted value of the future incomes only: :
CV = Y Y Y Y + + + ...... 2 3 (1 + r ) (1 + r ) (1 + r ) (1 + r )t

Then, wealth = Y + Capital Value , = Y +

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Capital and interest P. 11

Since the present income (Y) would be assumed to be an income of an absolutely short period and therefore approaches zero. Thus, wealth can be regarded as equal to capital value: , (Y) , , :

W = CV =

Y r

Then, Y = W r , Y = W r If a person deposits all his wealth (W) in a bank, at the rate of interest r, the interest payment is: (W), r , : Interest ()= Wr

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Therefore, Wr = Y = Interest , Wr = Y = So, interest is the whole of income, not part of it, i.e. , , , :

Income () = Interest ()

Remember! !
Without market, interest rate cannot be determined and therefore wealth cannot be determined too. , ,

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Capital and interest P. 12

Wealth maximization VS income maximization VS

Income can be a value as well as a stream of value. As a flow concept, income fluctuates over time. Maximizing the income of the second year is different from maximizing the income stream of two years. Thus, it is difficult for a person to maximize something uncertain. ; Hence, the concept of income maximization is not clear enough to explain human behaviour. The postulate of wealth maximization is used instead. , ; , However, given a constant interest rate and a perpetual annuity, maximizing income Y is the same as maximizing wealth because in this case: W = . For Y is maximized, r

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Separation theorem
Fishers Separation Theorem states that under competitive conditions, the decisions on production to earn income is made separately from the consumption decision. , A person can consume more or less than his current income by borrowing or lending. , To maximize his/her consumption over time, a person will select a stream of future income which has the highest prevent value. ,

W will be certainly maximized too. , , : Y W = Y , W r

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Capital and interest P. 13

For instant, a girl can choose to work as a singer, a clerk or a doctor. , Works as a singer, she can earn high income in the early years but the income will fall when she is getting old. , , For a clerk, the income is very steady over time. , To be a doctor, she has to study university and earn no income when she is young. But after graduate, her income will get rising. , ; According to the postulate of wealth maximization, she will choose the job giving her the highest present value. ,

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If the interest is very high, she would more likely to become a singer. Since the PV of income a doctor earned in the later years will be lowered by the high interest rate. Or, as a singer, she can invest the early high income earned to generate higher return of interest in future. , ; , , , ,

If the interest rate is zero or extremely low, she will choose to be a doctor since it provides her the highest total sum of income. , ,

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Costs and Rents P. 1

Costs and Rents

Nature of cost
In Economics, when we talk about cost we always talk about opportunity cost: , , :

The highest valued option forgone. , A person is said to face a choice when there are more than one option available to him, with a given quantity of resources. ,

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Under constrained maximization, the best option is the value of the choice while the second-best option is its cost. Therefore, costs arise only when we have to make choice. , , ,

More about cost

1) Only the highest valued option forgone counts as a cost.

Under constrained maximization, only the highest valued alternative will affect the decision making. ,

2) No choice, no cost. ,

No choice means nothing to forgo, therefore cost does not exist. ,

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Costs and Rents P. 2

3) Cost will change only if the highest-valued option forgone is changed. ,

As cost is the highest-valued option forgone, it will not change if the value of this option remains unchanged. , , For example, if you choose to have a lunch at a restaurant, no matter how bad the quality of food provided, it makes no change on your cost. , , ,

4) Time itself is not a cost

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It is meaningless to measure the amount of time sacrificed in making a choice. What counts as the cost is the alternative activities that can do within the time sacrificed.

The value of times varies between individuals, depending on the use to which they put it. For example, the retired are more willing to queue for the out-patient services ( ) of public hospitals than the youths. , : ,

5) Concept of full cost

Cost refers to the full cost. The highest valued option forgone means all the highest valued alternatives have to forsake at the same time while making a choice. That means, cost can involve more than one item of alternatives. , , For example, the cost of watching a movie involves not only the price of the ticket but also the highest valued activities forsaken during the time you watch movie. , ,

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Costs and Rents P. 4

Historical cost (Sunk cost)

Think about it! !

The longer we have been waiting in line at a bus stop, the more costly it would be for us to leave the line. Is it right? , , ? Opportunity cost measures what are going to give up while making a decision. Once a decision maker has made a choice, the highest valued alternative becomes a past option and cannot be changed. Therefore, it cannot be regarded as opportunity cost. , , ; In Economics, it is called historical cost; i.e. those options we gave up in the past decisions. , : As past forgone options are no longer available now, historical cost is not a current alternative. Hence, , ; ,

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Bygone be bygone! Historical cost (sunk cost) is NOT a cost that has NO influence on current decision making. ! ,
As such, no matter how long we have been staying in the line at a bus stop, the time we had sacrificed is a kind of historical cost, irrelevant to our current decision of leaving the line. , , ,

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Costs and Rents P. 5

Think More! !
In reality, can we get all perfect information before make a decision? Absolutely NOT! , ? ! Information is an economic good and costly to acquire; i.e. we always live in a state of uncertainty. Then, historical cost can somehow affect current decisions. ; , Historical cost can serve as a date to assist decision makers in forming expectation about current benefit and cost. , For example, the history of stock prices often serves as investors main reference in buying stock currently. Although sometimes it is very misleading, it is a way to minimize information cost. , , ,

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Explicit and implicit (imputed) costs ()

Think about it! !

The cost of using a flat gets lower if the flat is owned by the user instead of being rented by him. Is it right? , ?

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Costs and Rents P. 6

A person renting a flat has to pay rent and its use involves a cost; however, it does not mean that an owner can use his flat without cost! So, what is the cost then? The owner forgoes the rental income from leasing it. , ; , ! , ? Hence, the cost of using the flat to the owner and to the renter are the same. What makes the differences are that the renter has paid the rent explicitly (explicit cost) while the owner has forgone the rent implicitly (implicit / imputed cost). , : (); (/)

Explicit costs are those costs which actually involve a transfer of funds from one to another.

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/ ;
,

Implicit / imputed costs are costs of using the assets. They are measured at values reflecting what the one could earn if he/she shifted these assets to their highest valued alternative use.

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Costs and Rents P. 7

Transfer earning and economic rent

Transfer earning
The transfer earning of a factor (e.g. labour) is the minimum amount that that the factor must earn (e.g. wage) in order to prevent it from transferring to another use. (: ) (: ) Hence, it is the minimum amount that must be paid to a unit of any factor to hold it in its present use or to keep it in existence. , , Or say, it is the cost of alternative use of the factor. , For example, a teachers monthly salary is $10 000. If this $10 000 is his transfer earning, it means that he will quit and find another job if his salary is reduced. , $10 000 $10 000 , , ,

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Economic rent
The economic rent is the part of return to a factor which is unnecessary to keep a factor in existence. ; Hence, the increase or decrease of that part of return will not affect the quantity supply or supply of the factor in a particular usage. ,

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Costs and Rents P. 8

Or say, it refers to the excess factor earnings over the transfer earning; i.e. , ; :

Economic rent = Actual earning Transfer earning =

Take the same example, if the teacher has an rise in month salary to $12 000, with the same transfer earning $10 000, the economic rent will be $2 000. , $12 000, $10 000, $2 000 That means, this $2 000 is the excess part of return over the transfer earning that does not make any influence on the decision making of whether being a teacher or not. , $2 000 ,

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Price (e.g. wage rate) (: ) S (labour ) Transfer earning Economic rent

Graphical illustration of transfer earning and economic rent

D (labour ) 0 Units of factor (labour) ()

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Costs and Rents P. 9

The supply curve of a factor is usually upward-sloping, and it reflects the cost of using the factor; that is the alternative returns the factor can earn elsewhere. , ; The intersection of the factor demand curve and the factor supply curve determines the market-clearing price of the factor. , Given the market-clearing price, all units of the factor except the last one would earn economic rents for remaining in the industry. , ,

Some special cases: :

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If the factor supply curve is horizontal, i.e. the individual firm or an industry is faced with a perfectly elastic supply of a factor of production. It can be able to obtain all units of the factor it wants at a fixed factor price. , The whole income earned by the factor represents transfer earning. No economic rent can be earned by any units of factor in this case.

All earnings are transfer earnings

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Costs and Rents P. 10

Price (e.g. wage rate) (: )

S (labour )

Transfer earning

D (labour ) Units of factor (labour) ()

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If a factor of production is fixed in supply and has no alternative use, it will be in perfectly inelastic supply; e.g. land. , ; : The quantity supplied of factor is fixed no matter the changes of factor price. , The whole of the factor income in this case is economic rent since the factor has no alternative use even its price is zero. That means there is no cost of keeping it in the particular usage. , , ,

All earnings are economic rent

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Costs and Rents P. 11

Price S

P1
Economic rent

D 0 Units of factor

Hence, whether a factor payment constitutes economic rent or not depends on the elasticity of its supply and on its alternative uses. , , ,

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The more elastic the supply curve of a factor, the smaller the proportion of its earnings ascribed to economic rent and the larger the transfer earnings. , ,

Ricardian Rent While each unit of the factor has the same cost but is earning different economic rent, that rent earned is called that Ricardian Rent. , , For example, two doctors with same qualifications, Dr. A and Dr. B, both of them have the same opportunity costs. They are providing same quality and are charging the same fee of medical services to patients. However, Dr. A is twice as productive as Dr. B; i.e. within the same working hours, Dr. A can provide twice the number of treatments to patients as Dr. B. Hence, Dr. A can earn twice as Dr. B can. , , A B ,

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Costs and Rents P. 12

, , A B ; , , A B , A B Since both of Dr. A and B will have the same cost, they have the same transfer earnings. For Dr. A can earn more, he gain more rent then Dr. B. Thus, the rent earned by Dr. A is called Ricardian rent, which is due to his higher productivity. A B , A , B , A , The below diagrams illustrate the case of Ricardian rent. Both Land A and Land B have the same cost (both are zero), but Land A has higher marginal productivity than B (i.e. higher MRP than Land B). Hence, Land A can earn Ricardian rent and B cannot. A B (), A ( MRP B ), A , B

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Price Price S S

Ricardi an rent

D = MRP Land A A

0
D = MRP

Land B B

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Costs and Rents P. 13

Differential Rent Differential rents of various units of the same factor are factor payments beyond their values of use elsewhere. , That means, the each unit of the same factor earns the same income but the costs are different for various units of the same factor. , , For example, a tutorial school increases the salaries paid to the tutors in order to attract an additional tutor away from other competitors. The one who is attracted to make the shift will simply be receiving what he or she can earn elsewhere. However, those tutors who are already teaching in the tutorial school will find their salaries have increased and for them the increase in their salaries is a higher differential rent. , ; ,

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Price (e.g. wage rate) (: ) S Increase in differential rent of the tutors

D2 D1

Units of factor (Tutor) ()

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Costs and Rents P. 14

Think more! !
1. High rent lead to high cost of living. Is it right? ! ? High land rent in Hong Kong is often believed to make the cost of living, or the cost of doing business, higher in Hong Kong. , , However, similar to all factors of production, the demand for land is a derived demand. That means, the increase in demand for residential flats (product market), will push up the price of residential flats and therefore bloom up the lend rent. Hence, high rent is a result of demand NOT a cause! , , , ( ), ,

, !

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2. Rent is a cost or not? ? Cost is the highest-valued option forgone. Options are available everywhere; if all available options are considered, rent is a cost. , ; , For example, the options available for an operator of a firm include a transfer of ownership (e.g. selling out the business). If the owner chooses to stay in business, he has forgone the rent which can be captured from selling out the business. Thus, rent is also the cost. , , () , , For the same token, a monopolist, can sell out his monopoly right and captures the monopoly rent. If he forgoes to do so, the monopoly rent become his cost. , ,

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Costs and Rents P. 15

3. Change in rent causes no change in factor supply? ? By definition, economic rent refers the excess return that will not affect the quantity supply or supply of the factor no matter how it changes. , Put into real world, however, the change in rent indeed will cause a certain change in factor supply. , , For example, a cut in teacher salaries would not cause most of the teachers to quit as the new salaries are still higher than the transfer earnings; but, the behaviour of some teachers may change after the salary cut; such as some teachers may not willing to work overtime, or even more shirking behaviour may be found. , , , ; ,

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As such, change in rent would in some dimensions would change the factor supply. ,

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Costs and Rents P. 16

Rent, Profit and Loss ()

Profit exists when the actual income comes at a rate higher than the rate of interest, or say, when there is an unexpected increase in wealth. (), , Thus, Prof. Steven Cheung regards profit as an income that cannot be discounted and capitalized. Besides, as it cannot be captured by a transfer of ownership, it is not a cost too. , (), , Rent is an anticipated income that can be discounted and capitalized; thus rent is a cost. However, profit can only be revealed after a choice is made, it is useless in analyzing choice. Hence, rent is relevant to resource allocation and human choices, but profit is not. , ; , () , , , While profit is a windfall gain, loss is a windfall shrink in wealth. (),

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According to Prof. Steven Cheung, a person enters a business and suffers an accounting loss due to a lack of experience is not a loss in economic sense. His loss is only an investment expense on the knowledge of running the business. For loss in Economics, it refers only to a result of unexpected events. , , , , ,

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Cost and Production functions P.1

Production and Cost Functions

Production
Production is a process and takes time, i.e. it is a flow of output per unit of time. , It refers to the physical or technical relation between the inputs and outputs.

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Definition of short-run and long-run
Fixed Factors
Factors that cannot be changed with the output level are called fixed factors, e.g. factory buildings, land, capital tools etc.

Variable Factors
Factors that can be changed with the output level are called variable factors, e.g. raw materials, labour, fuel, electricity etc.

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Cost and Production functions P.2

Short Run
It is the production period that at least one factor is fixed.

Long Run
It is the production period that all factors are variable.

Input-output relationship in short run

Let labour (L) be the variable factor and capital (K) be the fixed factor. (L)(K) Total product (TP) (TP)

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Total product is the total amount produced over a certain period of time by all the factors of production employed. , TP = = = Average product () (AP) L MP MP1 + MP2 + MP3 + MPN

Average product (AP) (AP) Average product is the total product divided by the number of variable factors used; i.e. the per unit product of the variable factor. ; AP =

TP L

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Cost and Production functions P.3

Marginal product (MP) (MP) Marginal product is the change in total product resulting from the use of one more unit of the variable factor.

TP L MPL = TPL TP(L1)

MP =

Numeral example of input-output relationship in short run Labour () (L) TP (=APL) (=MP) AP (=

TP ) L

MP (=

TP ) L

0 1 2 3 4 5

0 10 22 33 40 45

0 10 11 11 9

10 (= 100) 12 (= 2210) 11 (= 3322)

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10 7 (= 4033) 5 (= 4540)

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Cost and Production functions P.4

TP

TP

0 AP/MP

L (variable factor )

AP

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0 MP L (variable factor )

When MP is positive, TP is rising. MP , TP While MP is negative, TP begins to fall. MP , TP MP curve cuts the maximum point of the AP curve. MP AP AP

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Cost and Production functions P.5

The Law of Diminishing Marginal Returns

When one factor is added successively to another factor (or group of factors) which is held fixed, the marginal product (MP) of the variable factor will eventually decrease.

, (MP)
The law of diminish marginal returns is an empirical law; that means, it is based on generalization from our observations of facts. ,

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If the law of diminishing marginal return did not hold, what would happen to the use of resources (e.g. farm land)? , (: )?

Think More! !

If the law did not hold, a farmer with a small plot of the best soil could, by adding successive increments of fertilizer (variable factor) to the soil, could infinitively increase the crops that were able to feed the whole world. , , , , The land price will be very close to zero as the demand for farmland was extremely small while the supply of it was abundant.

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Cost and Production functions P.6

Cost of production
The total costs of production include all factor payments, which may be explicit of implicit. , The production costs can also be regarded as the production of other highest valued goods forgone when producing a given kind of good. ,

Short run costs

Production costs can be conceptually divided into at least two categories: : 1) Fixed costs

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NOT vary with the change of outputs.

Sunk costs, have no influence on decision making. ,

2)

Variable costs

Increase as amount of outputs increase.

Total cost () ( (TC)

Total cost (TC) = Total fixed costs (TFC) Total variable costs (TVC) (TC) = (TFC) (TVC)
Average cost () (AC)

Average cost () (AC) =

TC Q TFC Q
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Average fixed costs () (AFC) =

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Cost and Production functions P.7

Average variable costs () (AVC) =

Margin cost () (MC)

TVC Q

Margin cost () (MC) = As

TC Q

TFC TVC = 0 ; therefore , MC = Q Q

Short run cost curves

Assuming there exists only ONE variable factor, labour (L) and wage is constant; therefore (L), ; wage () L MC = Q L = wage () Q 1 = wage () Q L 1 = wage () MP AVC = TVC Q wage () L = Q L = wage () Q 1 = wage () Q L 1 = wage () AP
Q

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AP MP 0 Cost MC L

AVC

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Cost and Production functions P.8

Since MC =

TVC , that means MC is the slope of TVC; and according to the U-shape MC Q

curve, the shapes of TC and TVC curves would be TVC MC = , MC TVC ; MC U , TC TVC Q

Cost TC

Slope = MC = AC
TVC

Slope = MC = AVC

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TFC

Cost

AC = Wage
MC

1 AFC AP

AFC =

TFC Q

AC AVC

AFC

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Cost and Production functions P.10

Long run costs

Cost

LRAC

0 Increasing returns to scale Optimal firm decreasing returns to scale

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(1) Increasing return to scale

Economy of scale
increasing speed of output > increasing speed of factor input >

(2) Decreasing return to scale

Diseconomy of scale
increasing speed of output < increasing speed of factor input <

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Cost and Production functions P.11

(3) Optimal firm

increasing speed of output = increasing speed of factor input =

Alchians rate effect and volume effect (1) Rate effect

Faster the rate at which a given volume of output is produced, higher the AC and MC. , , AC MC Have to pay more for producing faster. ,

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(2) Volume effect

For constant rate of production, larger the volume of output, lower the AC and MC. , , AC MC Two reasons for AC and MC falls with increasing production volume: AC MC : i. variety of technique machines can be uses more economically for a larger volume of output than for a smaller volume.

ii. Learning by doing Larger the volume of output, more chance for learning the skill and hence lower the per unit cost of production. ,

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Cost and Production functions P.12

(3) Increase in both rate and volume

As increase in rate will higher the production cost whereas increase in volume will bring the costs lower, the ultimate effects will be uncertain. , , However, for the AC to be lowered, the volume effect must dominate the rate; otherwise, the production costs will rise then. , AC, ; ,

Efficiency in production

Production is efficient if we can maximize the output level with the minimized costs. ,

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If one can produce with lower marginal cost, he will increase the output level, otherwise the output level will drop and the resources will shift to the one who can produce at lower cost. , ; , , Finally, different producers will produce different amount of outputs with the same marginal costs; i.e. MCA = MCB , , MCA = MCB,

Numeral example of efficiency in production

For example, Mr A and Mr B are two furniture producers producing tables and chairs. Their production possibilities are shown as below: , A B :

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Cost and Production functions P.13

Mr A Table Chair MC (in term of chair) Table Chair

Mr B MC (in term of chair)

0 1 2
3

10 9 7
4

0 1
2

16 15
12

1 2
3

1
3

3 4

7 0

5 7

Suppose they are requested to produce totally 5 tables. If MCB > MCA, Mr B have to sacrifice more chairs to produce one table; thus, he will stop to produce. MCB > MCA, B ; , Finally, Mr A will produce 3 tables and Mr B will produce 2; where MCB = MCA = 3, the efficiency in production is reached. , A 3 B; MCB = MCA = 3

http://www.examwai.blogspot.com/ 40 Efficiency in production:

:
We may define efficiency in production as:

:
MCA = MCB
Since the marginal costs of producing the same good are the same

for all producers, we cannot reallocate the resources so that increasing the output of ONE good without the output decrease of another good. An increase in output of one good can be achieved only by reducing the output of the other goods. , ,

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Market competition P.1

Market Competition and Mechanism (I) (I)

Price-taking ( Perfect Competition ) Market ()
Basic assumptions :
There are so many potential buyers and sellers that none of them can affect the market price which is determined by the interaction of demand and supply. They are all price-takers. , Goods are homogeneous, at least in the eyes of the consumers. Any one good is a perfect substitute of any other so that buyers are indifferent to any one of them. (), Perfect information exists in the market Zero transportation cost. There are free entry and exit of firms. Each individual supplier faces a horizontal demand curve; i.e. the price elastic of demand is infinite (Ed = ). ; : (Ed =)

http://www.examwai.blogspot.com/ 41

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Market competition P.2

D (Ed =)

Qd

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For example, the per-unit price of apple is $5. Seller A sold 4 units; therefore, his total revenue (TR) is $20, AR is $5. If he sells one more apple, he can get another $5, i.e. his MR of selling that extra unit of apple is also $5. After that, he has totally sold 5 apples; then, his TR is $25 and AR is $5 again. Hence, P = MR = AR =$5. , $5 A 4 , (TR)$20, (AR)$5$5; MR $5 , 5 , TR $25, AR $5 , P = MR = AR =$5

For every supplier, the price is equal to marginal revenue and also equal to average revenue (P = MR = AR). , , (P = MR = AR)

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Market competition P.3

Derivation of the short-run supply curve of a price-taking firm

For a firm to survive, the price has to be larger than or just equal to the average cost; thus, if the price is lower than the minimum point of the average cost curve (AC), the firm will shut down. , , , Hence, the minimum AC is called the break-even point in traditional economics. Since there is no better alternative to current production, the price taker would stay in the industry. , , ,
P MC

AC

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P = MR = AR
0 Q

A firm always has the option of producing nothing. If it produces nothing however, it will have an operating loss equal to its fixed costs. So long as the price is above average variable costs (AVC), the firm will continue to produce, at least in the short run. , , , (AVC), Any income over the variable cost is better than immediately shutting down, the price at least covers a part of fixed costs. , ,

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Market competition P.4

According to the equi-marginal principle, every price taker will maximize his wealth by supplying the quantity at the point marginal revenue equals to marginal cost (MR = MC). , , (MR = MC) As each individual supplier faces a horizontal demand curve, every seller in the price taking market can only takes the market price that is also equal to the marginal revenue and average revenue (P = MR = AR); thus the firm supplies at , ; (P = MR = AR), :

P = MC
Hence, the short run supply curve of a price-taking firm is its marginal cost curve starting from the minimum point of its AVC curve. , AVC

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P MC = S

AVC

P1

D = MR =AR

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Market competition P.5

Criticism of wealth maximization

The main criticism of the price-taking model is on its assumption of wealth maximization. Whether the firm is really maximizing or not in reality is NOT important to economists. What matters is that the firms in acting as if they do maximize, could survive in the long run. , ; , For example, three idiots operate petrol stations. They all know nothing about business and choose the sites of the petrol stations at random. One chooses in a rain forest, another chooses at a desert and the last one sets his petrol station along a main road. Finally, the other two idiots go out of business, only the last one with his petrol station setting along a main road finds his business prosperous. , , , , Hence, only the one who can survive is consistent with what we predict based on the assumption of wealth maximization. , ,

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Price-takers equilibrium
The market demand and market supply determine the market clearing price of a good. Each consumer will consume up to the point where P = MUV. , P = MUV A price-taker would take the market price and produce the quantity up to the point P = MC , P = MC

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Market competition P.6

Thus, the equilibrium for price taking market is at the point: , :

P = MC = MUV

S = MC

SMarket

PM

DMarket
0 Q 0 Q 0

D = MUV
Q

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Market Individual supplier Individual consumer

Efficiency in Allocation
Pareto condition: : It refers to the condition that there is not possible to reallocate the use of resources so that one will gain without the loss of another. , ,

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Market competition P.7

In the short run any firm may earn an excess over its total cost or a loss. With free entry and exit, over the long run, every firm is in an optimal state: P = MR = MC = AC. , , : P = MR = MC = AC If P < MC, that means MR < MC, Qs will decrease. P < MC, MR < MC, Qs If P > MC, that means MR > MC, Qs will increase. P > MC, MR > MC, Qs A firm producing at an output level of P = minimum AC is said to be in optimal scale of production. The plant size is the most efficient one with the existing level of technology. P AC , For consumers, every buyer is willing to buy until P = MUV, i.e. the consumption optimal point. , P = MUV, If P < MUV, Qd will increase. P < MUV, Qd If P > MUV, Qd will decrease. P > MUV, Qd Hence, the Pareto condition will be reached at the point while the production optimal is equal to consumption, i.e. , , ; :

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P = MUV = MC
In price taking market each individual cannot affect the market but when all individual choose at the optimal point the market will come to optimum then; thus the market mechanism is just like a invisible hand that help to adjust the efficiency of resources allocation. , , , ; ,

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Market competition P.8

Rent/Economic Rent /
In Economics, rent/economic rent is regarded as the surplus income, i.e. unnecessary income to affect decision. , / In short run, entry of supply is restricted and that lead to economic rent. After large amount of new entry firms, no rent can be gained at all. , ; , Dissipation of rent

As there is free entry of price-taking market, the rise of supply makes price go down and all rent will be dissipated in long run. , ; ,
P

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P

SMarket

MC

AC

Pe
Economic rent

D=AR=MR

DMarket
0 P

Qe S1

0 P

Q1
MC

S2
AC

Pe1 Pe2 DMarket

0 D=AR=MR

Qe1 Qe2

Q2Q1

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Market competition P.9

Marginal firm, intra-marginal firm or extra-marginal firm

Marginal firm

When a firm is just covering its total costs, it is on the margin of leaving or entering the industry. , If the market price falls later, the firm is the first one to leave and shut down - so-called marginal firm. ,
P MC AC

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Pm D=MR=AR
0 Q

Intra-marginal firm

If a firm can earn an amount of rent excess of the total cost, it is called intra-marginal firm. , Its lower cost in the industry, permits it to remain in the industry even at a lower price. ,

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Market competition P.10

MC AC

Pm

D=MR=AR

Extra-marginal firm

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The firm has a higher cost, so it would not enter the industry. ,

An extra-marginal firm is one which has an average cost higher than the price in the industry. ,

MC AC

Pm

D=MR=AR

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Market competition P.11

Long Run Industry Supply Curve

Long run supply curve connects all long-run equilibrium points after the demand and supply are being changed.

Constant Cost Industry

In the long run, any increase in the market demand will induce a corresponding increase in the market supply with free entry of other firms into the industry. , , If the output of the whole industry expands without any change in its factor prices, the long run market supply curve is horizontal, i.e. a constant cost industry. , , For example, the newspaper hawkers :

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P MC AC P

S1 S2

Pm

LRS D2 D1

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Market competition P.12

Increasing Cost Industry

In general, the expansion of output by a firm requires more factors of production. If this situation prevails among other firms, the increase in demand for this factor of production will bid up the factor price. The long run supply curve is upward-sloping. , ; For example, near Lunar year, the rise of demand for flowers at the Flower Market Street derives the demand for shops to increase and that the rental payment increases as well. : ,

MC2 P MC1 AC2 AC1 P

S1

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LRS D2 D1
0 Q 0 Q

S2

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Market competition P.13

Decreasing Cost Industry In long run, owing to the economies of scale, factor costs would decrease as supply increase. As factor costs going down, the long run supply curve would be downward-sloping. , , , For example, the technology improvement of mobile phone industry lead to the market expansion and fall of production cost; thus, the price decrease as well. : ;

MC1 MC2 AC1 AC2

S1 S2

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D2 D1
0 Q 0 Q

LRS

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Price searching P.1

Market Competition and Mechanism (II): (II)

Price-searching (Imperfect Competition) Market ()
When the assumptions required by a price-taking market no longer hold, the market is said to be a price-searching market. , The reasons for a price-searching market to exist may be: : 1. There are barriers to entry into the industry with a result that potential sellers remain a few, or even one. , ,

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2. For the purpose of wealth maximization, each price-searcher will search the best price. , 3. Each price-searcher has some degree of market power to affect the market price and faces a downward-sloping demand curve. , P

D 0 Qd

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Price searching P.2

4. Products are heterogeneous or differentiated. They are different in quality, the terms of sales, services provided, availability and location etc. ; 5. Information is not perfect but bears cost! , Consumers bear costs in collecting pre-purchase information on goods and sellers. One example of pre-purchase information is the familiar brand name which is to give reliable quality, consumer confidence and taste. : Consumers are willing to pay more because the extra payment is approximately equal to the information cost saved as a result. ,

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The market is dominated by one potential single seller or price-searcher - the monopolist. () The products are heterogeneous and with no close substitutes. , The monopolist is a rational wealth-maximizer. There is competition also : Competition for the monopoly right as well as competition with suppliers of similar substitutes; e.g. MTR and Bus services. ;

Monopoly ()

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Price searching P.3

Given the downward sloping demand curve facing the monopolist, under the simple pricing, the price will be equal to its average revenue and greater than its marginal revenue (P = AR, AR > MR). , , (P = AR, AR > MR) For example: : P 10 9 8 7 6 Q 1 2 3 4 5 TR 10 18 24 28 30 MR 10 8 6 4 2 AR 10 9 8 7 6

http://www.examwai.blogspot.com/ 56 Under the simple pricing the marginal revenue gets smaller than the market
price (except for the first unit). As a result the marginal revenue schedule lies below the price line (demand curve and average revenue curve). , (); , ()

P 2AB = AC

MR

D = AR = P Qd

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Price searching P.4

The horizontal distance between the vertical axis and MR curve cuts into halves of that between the vertical axis and the demand curve (AR curve). MR (AR )

Simple monopoly pricing

The condition of supply and equilibrium is still based on the equi-marginal principle: MR = MC. , MR = MC Unlike price taking market, the monopolist facing a downward sloping demand curve will not charge the price equal to MC. Since P = AR, AR > MR, , , MC P = AR, AR > MR,

P > MC

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As the monopoly simply pricing is not a marginal-cost pricing, it does NOT have a supply curve. By definition, a supply curve shows the relationship between market price and quantity supplied; however, it is impossible for a monopolist to find a curve linking up the quantity supplied with market price. , , ; , , In general, at MR = MC, the monopolist gains an amount from total revenue in excess of total cost. It is NOT treated as profit because profit is an unexpected gain in income but this gain is expected. Otherwise the supplier would not be willing to compete for the monopoly right. , MR = MC , , ; , ,

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Price searching P.5 P MC Monopoly Rent

AC P1

AR = D = P MR 0 Q

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Marginal revenue and demand elasticity
P Ed >1 Ed =1

This amount is in fact the return of anyone holding the monopoly right. A monopolist can simply sell this right to someone else. Therefore he incurs an opportunity cost of the foregone income if the right is sold. This amount is in fact a cost. ; , ,

Ed <1

MR

D = AR = P Qd

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Price searching P.6

Demand elasticity Elastic (Ed > 1) Unitarily elastic (Ed =1) Inelastic (Ed < 1)

Marginal revenue MR > 0 MR = 0 MR < 0

Based on the production equilibrium: MR = MC; given MC > 0, MR > 0. Hence, a monopolist often chooses to produce along the elastic (Ed > 1) demand segment under the simple pricing. : MR = MC; MC > 0, MR > 0, (Ed > 1)

Allocation of Resources: Is monopoly efficient? : ?

http://www.examwai.blogspot.com/ 59 When price is greater than the marginal cost, the monopolist is under
produced leading to a misallocation of resources, i.e. more resources should be used by the monopolist to increase its level of output. Is it right? , , ; ?

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Price searching P.7

P MC

deadweight loss

P1

MUV=D 0 Q1 MR Qe Q

According to the above diagram, the optimal point is at MUV = MC where Qe should be produced but the monopolists only produce Q1 at the point MR = MC. , MUV = MC , Qe; MR = MC Q1

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If the monopolists produce more, there is more gain from the social point of view. , All potential gains are enjoyed by the consumers when output reaches Qe where price is equal to MC. Qe, MC, Under simple monopoly pricing, the price-searcher stays at Q1 so that it is criticized as socially inefficient. The shaped triangle area is regarded as deadweight loss of society caused by the practice of simple monopoly pricing. , Q1 The recent argument on monopoly mainly lies on a consideration of transaction cost as a constraint affecting the behaviour of both the consumers and the price-searcher. ,

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Price searching P.8

In theory, a price-searcher may use any pricing methods to capture any existing potential gain of the economy. The output level could easily be set at Qe with the potential gain (the shaped triangle area) captured. , Qe () If the transaction cost is zero, the allocation of resources is still socially optimal at Qe and the price-searcher can also act as efficiently as the critics requires with MC = MUV. , Qe , MC = MUV

A monopolist may well be efficient by using simple monopoly pricing if he finds that the transaction costs in using other pricing methods are significantly high.

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Price searching P.9

Price Discrimination
Price discrimination refers to the practice of any price-searcher by which different consumers paying different prices but are given the same goods or services produced at the same cost. , Or, the same consumer paying different prices for different amount of the same goods or services produced at the same cost. , , This practice by the price-searchers aims at the extraction / capture of the consumers surplus. /

http://www.examwai.blogspot.com/ 62 Conditions of Practising Price Discrimination

Stiglers View: : 1. The price-searchers have a certain degree of monopoly power on sale. As a result, it faces a downward-sloping demand curve. ; The market can be distinguished/separated into sub-markets according to different elasticities of consumer demand by the price-searchers. Consumers is unable to resell the product. (Whenever the transaction costs of separating consumers and policing procedures to prevent resale are greater than the extra revenue earned from price discrimination, the practice will not be used.) ( , )

2.

3.

Steven Cheungs View

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Price searching P.10

: 1. In reality, imperfect information always exists, i.e. the consumers may not even know that they are charged differently. , , A same group of consumers with the same elasticity of demand may still be charged differently within the same market, provided that they are not aware of this. , , Information costs are too high that the customers are difficult for finding places to resell. ,

2.

3.

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This practice also called perfect price discrimination, aims at capturing the entire consumers surplus. , Sellers charge each unit of output at different price according to each individual demand (MUV). (MUV),
P MC

First Degree Price Discrimination : To Capture All Consumers Surplus :

D=MUV 0 Q

Constrains: :

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Price searching P.11

Sellers have perfect information about each buyers MUV. MUV Resale practice is forbidden.

Result: : Sellers can capture all consumer surplus. Under the first degree price discrimination, the social optimal point is reached; i.e. MC = MR. , , MC = MUV

Third Degree Price Discrimination

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Sellers will charge a higher price to the consumers with an inelastic demand and charge a lower price to the consumers with an elastic demand. , A standard example is the fares charged on adults and students by the Mass Transit Railway Corporation (MTRC) in Hong Kong.

This practice is to distinguish the consumers into different groups (sub-markets) according to the demand elasticities. ()

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Price searching P.12

MC

PA PB

DB MRA 0 DA Q 0 MRB Q 0 Q*

DA+B MRA+B Q

MC = MRA+B = MRA = MRB PA =DA = ARA; PB = DB =ARB As EdA < EdB, therefore, PA > PB

http://www.examwai.blogspot.com/ 65 However, according to Steven Cheungs view, price discrimination is nothing

concerning with demand elasticity; it is only due to the existing of high information cost for consumers to acquire market information. , , ,

For example, selling tangerines, customers do not know the price of others as they are purposely separated by the sellers. , , ,

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Price searching P.13

Price Discrimination Or Not : Some Misconceptions ?

The following cases seem to be examples of price discrimination but actually they are not. : 1st round (run) and 2nd round (run) movie charges; ; 1st class and economy class airline tickets; ; tuition fee to students and scholarship to some bright students; discounts on hotel rooms for frequent travellers; ; discounts given to wholesalers; ;

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same goods and services served in hotels and in street-stalls; ; peak-hour pricing : by MTRC, telephone company, electricity company. :

If the goods and services provided are different in costs, or they are differentiated in nature and/or quality;, it is not an example of price discrimination.

, /;

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Price searching P.14

Other Pricing Method for Extracting Consumers Surplus

All-or-nothing pricing Two-part pricing There is a minimum charge together with a per unit price on the goods provided. For example, the minimum charge on some discos and lounges plus a charge on menu; the membership of fitness clubs. , ;
P MC

membership fee

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D=MUV 0 Q

Tie-in Contract () It is an offer to sell a good or service on the condition that the buyers had to buy another good or service at a price at the same time. , Examples include the computer hardware and software; the restaurant snacks before a meal. ; The price of the tie-in good equal to or a bit lower than the consumers surplus. ()

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