Factor Markets and Market Failure

What are private goods?

The analysis of market behaviour typically assumes that the goods in question are private goods The characteristics are: they are excludable...if you have it no one else can.....and sole use (rival) ....if you use it no one else can

What is a product market vs a factor market?

A product market refers to a place where goods and services are bought and sold A factor market refers to the employment of factors of production, such as labour, capital and land.

How can we judge if and what type of government intervention is needed?

To assess the efficiency or desirability of market outcomes, we need to know what the appropriate criteria are to make that assessment Efficiency might be judged according to whether we are producing output at the lowest possible cost, but desirability is another matter and should be judged more broadly, perhaps according to whether market outcomes are in line with consumer preferences Similarly, in judging whether government intervention is needed to improve a market outcome, we need a clear idea of what we mean by an "improvement" and whether the policy makes us "better off" In so far as society is a collection of individuals, we need to consider how to make the step from judging the impact on individuals to judging the impact on society?

What type of system can we implement for collective agreements?

To avoid anarchy, we need a political system for collective agreements We could have a system based on a form of Democracy in which individual rights are paramount, or we could have some sort of Communist or Socialist system in which collective rights are paramount, as well as or in place of individual rights

How does a firm determine how much labour and capital to employ / hire?

To determine how much labour and capital to employ, the firm has to compare the return from hiring an extra input with the cost

How much extra labour or capital should a firm employ?

To determine how much labour and capital to employ, the firm has to compare the return from hiring each extra input with the cost The money return from hiring an extra unit of labour is the extra output produced (MPL) multiplied by the extra revenue that this extra output yields, which is marginal revenue (MR) This money return is called the marginal revenue product of labour MRPL MRPL = MPL x MR Similar reasoning holds for capital and we can calculate a marginal revenue product of capital if we know the MPK and MR MRPK MRPK = MPK x MR

What is the marginal productivity theory of factor pricing?

The firm's objective is to maximize profits so it will hire extra inputs so long as they add more to revenues than to cost This is the same as saying that the firm will hire extra inputs so long as the money return is greater than the money cost The marginal productivity theory of factor pricing is that firms hire extra inputs until the marginal revenue product of each input is just equal to its cost, which means that the price (cost) of each factor is determined at the point where the price is equal to the marginal revenue product For labour, W = MRPL = MPL x MR For capital, R = MRPK = MPK x MR If MPL is greater than wage cost, you should hire extra labour. If MPL is less than wage cost, you shouldn't be hiring that labour. MPL is positive — as you hire more labour, you get more output. But it is also diminishing as you hire more units of labour, you will get diminishing returns for their use.

What is the cost of hiring an extra unit of labour?

The money cost of hiring an extra unit of labour is the current wage rate W W is the cost of hiring an extra unit of labour

What is the impact of a tariff on imports?

A tariff is equivalent to a tax which pushes up the market price from Pw to Pt Domestic production rises from Q1 to Q2 and imports shrink from Q2 - Q1 to Q4 - Q3 We might decide that production of d in the domestic market, world price of Pw is low — where we think domestic price should be higher than the free market. Tariff = tax on imports . Consumers are losing more than producers are gaining. Tariff = Pt — Pw, additional gain. We are getting tariff revenue equal to the quantity of imports x tariff. If we factor this in as a gain — the net loss to the economy are abd and ecf. Initial calculation is an overestimate of the loss.

What happens when prosperity falls despite capital accumulation and technological progress in the Long Run?

Here is a story where prosperity is falling despite capital accumulation and technological process. Increases in capital and technology are raising the productivity of labour, shifting the labour demand curve out to the right. But increase in labour supply is dominating and employment is rising. Overall level of prosperity will be declining because of the diminishing marginal productivity of labour, which is not being offset enough by capital accumulation and technological progress.

What are externalities?

Externalities are costs (or benefits) which are not included in private market calculations. They are external to the price system Market outcomes (price and output) reflect private cost and private benefit calculations... MC and ATC for the firm and consumer assessments of marginal benefits and hence willingness to pay There may be other externality costs and benefits, which are not included in these calculations Examples: Pollution Global warming Health risks Civilizing benefits of education Environmental aesthetics

How do we measure consumer surplus?

How is the consumer surplus calculation made in practice? What information is needed? Current market price and quantity: P = £120, Q = 100 New price after the policy change: P = £100 Price elasticity of demand: e = - 2.0 Calculation of the area: ∆CS = (£20 x 100) + ½ (£20 x 40) = £2400 Interpretation of the result? What does a gain of £2400 mean? Note first that this is per period, so it is, say, £2400 per month. But how big is this gain? It should be expressed relative to something, so that we can judge the magnitude. We could express it relative to the the original value of output, as £2400/(£120 x 100) = £2400/£12,000 = 20%. The judgement is that consumer welfare would be increased by the equivalent of 20% of market output. Or we could express ∆CS as the percentage increase in CS. Whatever the normalisation, it should provide an understandable interpretation of what the result means.

Up to what point will a firm hire labour?

In any given product market, each firm will hire labour up to the point at which the MRPL is just equal to the prevailing wage rate.

What are public goods?

In contrast, public goods are goods that are non-excludable ......people can't be excluded from consuming it and if it is provided for some it is effectively provided for all...and non-rival .....consumption buy one person doesn't reduce the consumption possibilities of others Examples include national defence, police Pure cases are limited, but lots of partial examples......roads, in the absence of congestion, are non-rival, but there may be an exclusion mechanism, such as a toll

What are markets?

It is important to remember that markets are man-made institutions and that all markets operate within a legal, social and political framework

What is utility?

The welfare of society is in some sense the sum of the welfare of the individuals in society We could think of welfare in terms of utility and then judge whether any policy change (or change in economic circumstances) would make us "better off" by assessing whether it generates a higher level of utility Utilitarian philosophers (such as Jeremy Bentham) thought that utility could be measured on a cardinal (numerical) measuring scale and that the utility of society was simply the sum of all the individual quantities According to this view, we can assess whether a policy change is good for society by calculating the numerical impact on utility But most people would accept that utility can't be measured on a cardinal scale

How do we combat the free rider problem?

There is also likely to be a Free Rider Problem And would we really be happy to have a private police force? The easiest way is for the government to organise finance provision via taxation This is an imposed non-market solution Not everyone will be happy with the decision....but that's (political) life!

Why do wage rates differ?

1) human capital (knowledge and skill set) 2) working conditions 3) discrimination 4) government action Labour demand might be high on the left — as either the price is high or labour productivity is high. Larger investment to become a lawyer might justify higher wage rates.

Why do changes in labour demand occur?

1. A rise in the level of consumer demand for a product which means that a business needs to take on more workers (see below on the concept of derived demand) 2. A change in the price of the good or service that labour is making 3. An increase in the productivity of labour which makes using labour more cost efficient than using capital equipment 4. A government employment subsidy which allows a business to employ more workers 5. A change in the cost of capital equipment (a substitute for labour) e.g. consider the effects of robot technologies

How can one illustrate and explain pareto and compensation criteria?

A Pareto improvement occurs when a change in allocation harms no one and helps at least one person, given an initial allocation of goods for a set of persons (in this case from 1 > 2, both A and B are better off) Wealth can be redistributed anywhere along the read line — e.g. if moved from 1 > 3, B could compensate A, moving wealth up to 2 for both, in which case they both become better off.

What are the social costs of monopoly power?

A competitive industry has lots of small firms producing at P = MC, at point b, with price at Pc and output at Qc. Price is at its lowest possible level and consumer surplus is maximised, at a b Pc and all units are produced for which MB > MC. Assuming no change in production cost conditions, if the industry is controlled by a single firm, the monopoly maximises profits by setting price at Pm and restricting output to Qm, where MR = MC. Units are lost for which MB > MC and consumer surplus is reduced to adPm. The loss of consumer surplus is Pm d b Pc. This offset by monopoly profits Pm d c Pc. But the gain to the firm is less than the loss to consumers and hence the deadweight loss to society is the triangle bcd.

What is the production process?

A firm is basically an entity that generates value in the production process.

What is Arrow's Impossibility Theorem?

A mathematical result showing that, under certain assumed conditions, there is no scheme for aggregating individual preferences into a valid set of social preferences Kenneth Arrow examined whether it is possible to derive a social welfare function that reflects and is consistent with the values or preferences of the individuals in society Under a series of reasonable assumptions, Arrow demonstrated that it isn't possible to derive such a welfare function without violating the preferences of at least some individuals and that consistent outcomes can't be achieved without imposing dictatorial solutions on some people The problem is a general problem affecting collective decisions and it can be illustrated by looking at the problems that can arise in connection with voting when people have different preferences about the outcomes

What is producer surplus?

Alongside consumer surplus, we can also derive a measure of producer surplus, which can be used to show how price changes affect producer well being. Producer surplus is the revenue that producers receive in excess of the minimum amount needed to cover all the costs attached to production. This is equivalent to the profit (or rent) that firms receive over and above what is needed to keep them in production.

What is Rawl's Criterion?

American philosopher John Rawls suggests income distribution is important Would you vote for policy changes which improved the lot of the rich or the poor (if you are rich, you will likely vote in favour of rich, if poor, you will likely vote in favour of poor) Suppose when you vote or a policy change you did not know whether you would be in a high income or low income group You are shrouded in a "veil of ignorance" You might well decide to support policies which improve the lot of the poor, just in case you end up in that group when the veil of ignorance is lifted It's an attempt to get away from self-interest and recognise the importance of the distribution of income

How does consumer surplus come about?

Because consumers have different tastes and preferences, the value placed on a particular good may differ significantly between consumers These different valuations imply differences in the prices that consumers are willing to pay to obtain the same product For a particular brand of clothing, for example, one person might be prepared to pay a maximum of say $100, rather than go without it, whereas another consumer would pay no more than $30 for the same item Although consumers may differ in the value they place on the marginal benefit from having a product, in most cases there is a common market price that everyone pays (ignoring discounts, special purchasing arrangements, and the like) The fact that people pay the same price for things they value differently gives rise to the notion of consumer surplus In any market, consumer surplus is equivalent to the difference between the maximum price that consumers would be prepared to pay to obtain units of the product and the market price actually paid

How do we do cost benefit calculations in practice?

But how do we do cost-benefit calculations in practice. Where do we get the valuations from? Ask individuals? Impose values? Any other ways? In practice it is easy to end up with arbitrary valuations that get adjusted to fit what you wanted in the first place (temptation to overstate externality costs and understate the benefits and vice versa). This is why it is easy to get disagreement about whether a project is desirable Current UK Examples: HS2, Heathrow (new runway) And in healthcare: NICE, QALYS (difficulty of valuing what a life is worth)

What are market solutions to externalities?

Can markets solve the externality problem, without government involvement? Suppose you have a factory polluting a local community...can the firm and the citizens achieve a bargaining solution? (i.e. persuade them to stop polluting) Suppose there are no property rights to clean air. If the citizens value clean air, they could bribe the firm to cut production or install anti-pollution equipment The maximum amount they would be prepared to pay is the value they place on clean air Suppose the citizens hold the property right to clean air.....the firm could bribe the citizens to accept pollution The maximum amount the firm would pay is the extra profit it would earn

When can changes in relative wages occur?

Changes in relative wages can occur in response to changes in the availability of different kinds of labour, relative changes in labour productivity across sectors and changes in relative prices

Consider a competitive market in which total private production costs are described by the equation TPC = 18Q. The market is competitive, and all firms sell units of output at the competitive market price P = MC. The marginal values that consumers attach to additional units of output are shown by the (inverse) market demand curve P = 50 - 2Q. There is also an externality cost attached to production, and total externality cost at any level of output is described by the equation TEC = Q2. Use this information to calculate the competitive market output level and the socially efficient output level. What is the tax per unit of output that would generate the socially efficient level of output?

Competitive market output is at P=MC. TC = 18Q and MC = dTC/dQ=18. P = 50-2Q. Hence profit max implies 50-2Q= 18 and hence 2Q = 32 and Q =16. The socially efficient level of output is at P = MSC. MSC = MC + MEC = 18 + 2Q. For P = MSC we have 50-2Q =18 + 2Q and hence 4Q = 32 and Q = 8. To generate the socially efficient level of output price has to rise from the competitive price at Q = 16 to the price which generates the socially efficient output Q= 8. Given the demand curve p=50 -2Q, the competitive price is 50-32 = 18 and the socially efficient price is 50- 16 =34, so the tax is 34-18 =16. Another way of putting this is to say that the tax should cover MEC, and since MEC is 2Q, at the socially efficient output level Q =8, MEC is 16, which is the level at which the tax should be set.

What is a numerical example of Competitive and Socially Optimal Output Rates?

Consider a market in which the marginal benefits in consumption are described by the (inverse) market demand curve: P = 200 - 2Q The market is competitive and firms supply additional units of output at a constant marginal (private) cost: MC = 40 There is also a marginal externality cost (MEC) attached to each additional unit: MEC = 2Q The competitive market output level is determined at P = MC and so we have 200 - 2Q = 40 and hence 2Q = 160 and Q = 80 The socially optimal output rate includes the externality cost, which implies P = MSC = MC + MEC and therefore 200 - 2Q = 40 + 2Q and hence 4Q = 160 and Q = 40 We can also calculate the unit tax needed to achieve the socially optimal output rate by comparing the competitive price with the price needed to reach the socially optimal output rate When Q is at the competitive rate 80 the market price is 200 - (2 x 80) = 40 (which is also MC) For Q to be at the socially optimal rate 40 the price has to be 200 - (2 x 40) = 120 The unit tax needed to raise the price to the socially optimal level is the difference between these two prices, which is 80. Another way of putting this is to say that the amount needed to raise P from P = MC (40) to P = MSC (40 +2Q) is simply the tax needed to cover MEC at the Q = 40 output rate, which is a tax of 2 x 40 = 80

What is consumer surplus?

Consumer surplus = Difference between what a consumer is willing to pay for a good and the amount actually paid Consumer surplus is the total benefit from the consumption of a product, less the total cost of purchasing it. Here, the consumer surplus associated with six concert tickets (purchased at $14 per ticket) is given by the yellow-shaded area: $6 + $5 + $4 + $3 + $2 + $1 = $21

How can we diagrammatically illustrate and describe consumer surplus?

Consumer surplus measures the money value that consumers receive over and above what they pay for to obtain units of X, shown as the area below the demand curve above the market price. When the market price is lower consumers are better off because they can buy more units a cheaper price. The change in consumer surplus provides a money measure of how much consumers gain from the price change.

How is labour and capital productivity measured?

If a firm hires an extra unit of capital / labour, how much output will it get?

Why do we use a cost-benefit analysis for externalities?

If externality costs are present, the market solution implies output is too high. If externality benefits are present, the market solution implies output is too low In public sector project appraisal (e.g. a new airport or road) it is argued that the government should include all costs and benefits in the decision, including externality costs and benefits Projects should be approved only if Total Benefit >Total Cost For example, airport or road decisions should include the value of noise, loss of life, pollution, spill-over congestion effects, and so on

How is utility measured?

If utility can be measured at all it can only be done on an ordinal scale, with judgments that X yields more utility than Y without saying how much more (utils)

What happens to labour productivity in the short run?

In the short run K and A are fixed In the long run all factors are variable Output and employment are positively related in the short run Output in the short run is the function of labour — if a firm wants more output, it has to employ more labour A = technology, K = Capital y = f1(L) {K=K1, A = A1} Labour Productivity: Average and Marginal Productivity APL = Y/L ; MPL = ΔY / ΔL In the short run, with K and A fixed, MPL declines as L rises

How do we pay for public goods?

In theory we might be able to determine the optimal provision of public goods if we knew peoples preferences........but do we? Even if we knew what people wanted, how do we pay for them? In theory we could organise a subscription and everyone pays what they think the service is worth...in the previous example group d2 pay more than group d1 because they have a higher valuation In practice this procedure would typically be unworkable, too difficult to organise

Imagine a situation in which the government is considering whether to impose a minimum wage of £8.25 per hour in labour markets. The government has been advised that the current equilibrium wage in the market for unskilled labour is £8.90 per hour and that the demand for "unskilled" labour is elastic with respect to changes in the wage rate. In these circumstances, we would expect the imposition of the minimum wage to generate the following changes in the market for "unskilled" labour: a) a rise in the wage rate and a rise in employment b) a fall in the wage rate and a rise in employment c) a fall in the marginal product of labour and a leftward shift of the labour demand curve d) a rise in the wage rate and a fall in employment e) no change in the wage rate and no change in employment

In this case the minimum wage is a non-binding constraint because it is set below the market wage rate. The forces of demand and supply cause the wage to be set at £8.90 and the minimum of £8.25 is below what firms are willing to pay, which implies it does not affect what firms do The £8.25 would only constrain behaviour if it was set as a maximum rather than a minimum wage, but that is unlikely to happen!

What happens when capital accumulation and technological progress generate rising prosperity in the Long Run?

Increase in labour supply is more than offset by capital accumulation and technological progress raising productivity of labour so employment and wages are rising from W1* to W2* — we are all becoming more prosperous.

Why do changes in labour supply occur?

Key factors affecting labour supply 1. The real wage rate on offer in the industry itself - higher wages raise the prospect of increased factor rewards and should boost the number of people willing and able to work 2. Overtime: Opportunities to boost earnings come through overtime payments, productivity-related pay schemes, and share option schemes 3. Substitute occupations: The real wage rate on offer in competing jobs affects the wage and earnings differential that exists between two or more occupations. For example an increase in the earnings available to trained plumbers and electricians may cause some people to switch their jobs 4. Barriers to entry: Artificial limits to an industry's labour supply (e.g. through the introduction of minimum entry requirements) can restrict labour supply and force pay levels higher - this is the case in professions such as legal services and medicine where there are strict "entry criteria" 5. Improvements in the occupational mobility of labour: For example if more people are trained with the necessary skills required to work in a particular occupation. 6. Non-monetary characteristics of specific jobs - include factors such as the risk with different jobs, the requirement to work anti-social hours or the non-pecuniary benefits that certain jobs provide including job security, working conditions, opportunities for promotion and the chance to live and work overseas, employer-provided in-work training, employer-provided or subsidised health and leisure facilities and other in-work benefits including occupational pension schemes. 7. Net migration of labour - the UK is a member of the European Union single market that enshrines free movement of labour as one of its guiding principles. A rising flow of people seeking work in the UK is making labour migration an important factor in determining the supply of labour available to many industries - be it to relieve shortages of skilled labour in the NHS or education, or to meet the seasonal demand for workers in agriculture and the construction industry.

What happens if there is an increase in labour supply?

Labour demand is downward sloping — lower real wages are required to raise employment. It is downward sloping because MPL is declining when there is a given amount of capital or technology. The average wage level across the economy is W1. Natural population growth, immigration, people working longer hours — leads to an increase in labour. If there is no change in capital or technology, the increased availability of labour will push down the average level of wages.

What does labour demand reflect?

Labour demand reflects the marginal physical productivity of labour and the price at which the product can be sold

What does labour supply in each sector reflect?

Labour supply in each sector reflects the quantity of labour available with the appropriate skills

What are the consequences of externalities?

MSC= MC + Marginal Externality Cost. Free market solution at Q1 is inefficient because MSC > MB. Socially optimal output level is Q2 . What can we do? Marginal Externality Cost (MSC) rising — the more pollution there is, the worse it gets with each additional solution. The social cost is higher than the benefit. Any point beyond Q2, Marginal benefit declining and Marginal social cost rising. Output is too high. Socially efficient output level — Q2.

Suppose the economy can be described by a standard aggregate production of the form Y = f (L, K) A, where Y is real GDP, L is employment, K is the capital stock and A is the level of technology. Further suppose that the marginal productivities of labour and capital are both positive and declining and that marginal productivity factor pricing holds. Assuming no changes in the level of employment or technology, for this economy we would expect an increase in the capital stock to generate: a) a rise in real GDP and a fall in the real wage b) a fall in the real wage and a rise in the real return on capital c) a rise in real GDP and arise in the real return on capital d) a fall in real GDP and a fall in the real return on capital e) a fall in the real return on capital and a rise in the real wage

Marginal productivity factor pricing means that r = MPK and w =MPL. There is no change in employment and diminishing MPK means that the MPK must be falling as K rises and hence the return on capital r must be falling. With more K available, labour is more productive and hence MPL and w are higher. Note GDP would be rising not falling in this example.

When does market failure occur?

Market failure occurs when the production of goods or services causes additional positive or negative externalities on a third party. The price system is an information network that guides price and output decisions Market failure occurs when price signals do not encompass all relevant costs and benefits In such circumstances, price and output decisions may generate "inefficient" outcomes, because they don't include all relevant factors or because the market can't handle provision and pricing problems. For example.... Externalities....costs and benefits that are external to the price system Limited Information...not enough information to make efficient choices Public Goods ....desired goods that markets can't supply or under-supply

What determines the type of system we implement for collective agreements?

Markets are set within a broader political and social context and they can only function effectively if (most) people are prepared to accept the outcomes If market outcomes are perceived to be unfair (poor and rich) or unacceptable (pollution, etc) there may be pressure for change and existing arrangements may be unsustainable Market outcomes are not God-given and we can choose to change market arrangements if we think they are failing to deliver what we want

What do markets depend on?

Markets depend on private property rights (e.g. when you pay a car manufacturer money, you would own the rights to the car), but some Marxists say that "property is theft" and everything should be socially owned

What is the deadweight loss of monopoly?

Monopoly pricing leads to a loss of consumer surplus Part of the loss of consumer surplus is offset by a gain in producer profits This raises income distribution issues, but note that households own firms via pension funds, mutual funds, insurance policies, etc, which means that they enjoy higher returns on their pensions and other investments But Monopoly imposes a deadweight loss, which implies a potential Pareto improvement if competition can be imposed, because the gains of the consumers are bigger than the profit loss to firms.

What are the sources of economic growth?

Overtime, economies get bigger and bigger. Where is the rising production coming from? More employment (L1 — L2) would raise output from Y1 — Y2. But if jsut this happened, with no change in technology and capital, marginal productivity would be declining. Therefore prosperity would be going down. In contrast, if you hold employment at L2 (with no change), you could have output going up from Y3—Y4 through capital accumulation or an advance in technology! Then we would become more prosperous.

What are three key criterion in welfare economics?

Pareto Welfare Criterion....can at least one person made better off with no one else made worse off Compensation Criterion.....can the gainers compensate the losers (i.e. those who are worse off) and still be left better off (potential Pareto improvement) Rawls Criterion......does the change benefit the least well-off

A key difference between a pure private good and a pure public good is that: a) a private good is non-excludable in consumption b) a public good has lower production costs c) a public good is non-rival in consumption d) a private good is a common resource e) a private good is both excludable and non-rival

Private goods are goods which belong only to you when you buy them, and they can't be enjoyed by others if you are using or enjoying them (rival) and you can stop other people from using them because you own them (excludable). For a pure public good, once it is provided for one person it can be enjoyed by others without detracting from your use (non-rival in consumption) and they can't be prevented from using or enjoying it (non-excludable). A good example would be national defence. In practice, many public services have characteristics of both goods.

Does the production function Qt=f(Lt, Kt) At provide any insight about how the factors of production, labour and capital, should be rewarded? And does it suggest anything about how management and entrepreneurship should be rewarded?

Q = f(L, K) A The production function shows that output is produced when L and K are used together in the production process. This raises the question of how these factors should be rewarded, and whether the money received from the sale of the output should go mostly to labour (in the form of wages) or mostly to the owners or providers of capital (in the form of interest, rent and profits). Marxists for example think in terms of a class struggle between labour and capital, and others think for example of a bargaining process between employers and employees. The most widely used economic analysis of this problem is marginal productivity factor pricing, which says that wages are set equal to the marginal revenue product of labour (w=MRPL = MPL x MR = MPL x P for competitive firms) and the return on capital Is equal to the marginal revenue product of capital (r = MRPK= MPK x MR = MPK x P for competitive firms). Entrepreneurship involves setting up the firm and the return to entrepreneurship is presumably connected with the return to capital (the return to money invested in the business. Management (and to some extent entrepreneurship) determines how effectively L and K are used together and in some sense the return should reflect the effectiveness of management in raising the productivity of L and K. It is probably best thought of as part of the return to K, although it could also be regarded as a return taken from both L and K (a part of each of their returns is allocated to management). But it is difficult to pin down exactly what the management contribution is and there may be scope for (and a tendency towards) excessive returns to management, particularly in large firms where shareholders have limited knowledge about what the managers are actually contributing to the firm! The data on this suggests that the return to management in large firms have increased from about 20 times average wages in the 1960s and 70s to around 300 times over recent years, and the question is why? Does this reflect greater managerial efficiency or a greater ability to extort and extract excessive and unnecessary returns from the firm?

What are real wages?

Real wages show the value of wages adjusted for inflation. Real wages are a guide to how living standards have changed. For example, if nominal (actual) wages increased 5%, but inflation was 5%. This would mean the purchasing power of your wages had stayed the same. The net effect would be the same as a wage freeze (0% real increase) However, if wages increase by 2%, and we have an inflation rate of 3%, your real wages is -1%. Prices have risen faster than wages, meaning you are worse off.

What are positive externalities?

Represent the beneficial side effects of public goods, be generated by the private sector, allow someone who did not purchase a good to enjoy part of the benefits of that good Similar reasoning applies if consumption yields a positive externality benefit. In this case marginal social benefit is the private benefit plus the externality benefit: MSB = MPB + Marginal Externality Benefit and the free market solution at Q1 is inefficient because MSB > MC and the socially optimal output level is Q2. MSB = social benefit attached to each additional unit

How would you approach the problem of determining the optimal balance between public and private sector output?

Resources are scarce, so we have to choose how to allocate them among different uses, including the choice between private and public provision. The guiding principle should be to examine costs and benefits. If costs of public sector provision are lower, we would tend to prefer public provision, and vice versa. More generally, we need to look at the cots versus benefits of public and private goods. But note there re political and social considerations. Do we think it is desirable to have a lot of government involvement in the economy or should we be looking to make the state as small as possible, subject to the need for markets to work effectively? Other arguments or considerations? Resources are scarce, so we have to choose how to allocate them among different uses, including the choice between private and public provision. The guiding principle should be to examine costs and benefits. If costs of public sector provision are lower, we would tend to prefer public provision, and vice versa. More generally, we need to look at the cots versus benefits of public and private goods. But note there re political and social considerations. Do we think it is desirable to have a lot of government involvement in the economy or should we be looking to make the state as small as possible, subject to the need for markets to work effectively? Other arguments or considerations?

What do competitive labour markets look like diagrammatically?

Some people value leisure — they might need fewer labour hours or higher wage rate to be incentivised. Others enjoy work or need the money and might want more hours / be willing to work at a lower rate.

What is the paradox of voting?

Suppose we have three voters (1, 2 and 3) who have to choose between outcomes A, B and C If they each have different preferences they can't all have their first choice and we might go for majority voting For example the ordering of preferences might be: 1: A > B > C , 2: A > C > B , 3: C > B > A In this case, the majority vote gives a social choice of A, which satisfies 2/3 of voters, but the minority voter gets his or her least preferred choice Or the ordering of preferences might be 1: A > B > C , 2: B > C > A , 3: C > A > B In this case, there is no majority for any option any social choice (A, B or C ) implies that 2/3 of the voters will be unhappy The more general point is that here is no way to derive a social welfare function that gives outcomes that are consistent with and respect all of underlying individual preferences that the function is supposed to represent Due to this paradox, we a social welfare function is not feasible. We have to use something else.

What are the value judgements, if any, connected with the Pareto welfare criterion?

The Pareto welfare criterion says that a policy change is only allowed if it makes someone better off and no one else is made worse off. Since policy changes in practice generate gainers and losers, the application of the criterion rules out all or most policy changes. This means that the use of the Pareto criterion effectively preserves the status quo, which implies a value judgement, that we rule out change and keep things as they are. In practice, the compensation principle (cost-benefit analysis) is used to make judgements about the relative merits of different policies or projects. The criterion also emphasises individual welfare rather than collective well-being, which leads to the question of whether is such a things as "collective welfare"?

What is an aggregate production function?

The aggregate production function describes how total real gross domestic product (real GDP) in an economy depends on available inputs. Aggregate output (real GDP) depends on the following: Physical capital—machines, production facilities, and so forth that are used in production Labor—the number of hours that are worked in the entire economy Human capital—skills and education embodied in the workforce of the economy Knowledge—basic scientific knowledge, and blueprints that describe the available production processes Social infrastructure—the general business, legal and cultural environment The amount of natural resources available in an economy Anything else that we have not yet included

What does the analysis of the production function show with regards to the level of aggregate output in the economy?

The analysis of the production function shows that the level of aggregate output across the economy (GDP) depends on the level of employment and the productivity of labour. the equilibrium employment level L1 there is a corresponding level of aggregate output Y1 and on the labour market diagram this is effectively shown by the area under the labour demand curve at the equilibrium level of employment L1 because the vertical height of the labour demand curve shows MPL for each person employed, and GDP is the sum of all the individual MPLs. The difference between what labour produces and what is receives in wages is the share of the value of output that accrues to the owners of capital or those who provided the finance for the purchase of capital (paid in the forms of interest, rent and profit). GDP is the area under the labour demand curve between 0 and L1 . GDP is equivalent to the aggregate income available in the economy. Labour receives the rectangle 0W1 x 0L1 and capital income is the remaining triangle. The share of national income received by labour differs between countries. In developed industrial economies it has been in the region of 0.66 - 0.57 over the last 30 years, with the labour share generally falling, particularly over recent years.

How can we apply welfare criteria in practice?

The analysis of welfare criteria can seem rather abstract and the question is, how can we apply them in real world contexts. In practice, policy decisions are typically based on the compensation principle, expressed in the form of cost-benefit analysis The key consideration is how the relevant costs and benefits are measured and what we need are money measures of all relevant costs and benefits As far as possible it would be desirable to base relevant money valuations on market outcomes, which effectively reveal the preferences of consumers and producers via the structure of demand and supply conditions (i.e. what individuals are willing to buy — willingness to pay shows how highly people value things) The most commonly used measures of these money values are consumer surplus and producer surplus

What is the cost of hiring an extra unit of capital?

The cost of capital is the equivalent to a rental cost R, or, if capital is purchased, a user cost, which is equal to the current interest rate cost of obtaining the funds to purchase the capital plus the depreciation rate R is the cost of hiring an extra unit of capital

What does the determination of relative wage reflect?

The determination of relative wage levels reflects the microeconomic interaction of demand and supply forces across the economy For example, we might find that the hourly wage in one sector is say £25 per hour, and the hourly wage in another sector is say £40 per hour, and £100 per hour in another, and so on Relative wages can change over time, as demand and supply conditions change But what determines the average level of wages across the entire economy and what causes the average level to rise or fall? These are macroeconomic questions and to answer them we need to look at production and employment conditions from a macro perspective

According to figures published by the NHS, doctors in the speciality doctor grade in England can earn up to £74,661 per annum, and NHS consultants can earn between £79,860 and £184,998 per annum, depending on length of service and additional performance-related awards. In contrast, hospital cleaners and other domestic staff typically earn between £15,482 and £28,324 per annum (full-time equivalent) depending on the level of seniority. Use the framework of demand and supply to suggest reasons for this significant pay differential between doctors and hospital cleaners.

The simple answer would be that the supply of doctors is low relative to demand and hence the wage is high. The restriction on supply stems from the training and ability needed to become a doctor, while demand is relatively high because we value the service. In the case of hospital cleaners there are many more people able to do the job and demand is relatively low because we are unwilling to pay a high price for the service. But note that other factors may be at work. Doctors may have a powerful union (BMA) that works with the government to restrict medical school places, causing the supply of doctors to be artificially low (the government is reluctant to spend the money needed to train new doctors) . In the UK, the market for medical services is not a free market, but a government-controlled market, which may distort the outcome. Note also that hospital cleaners can be made more productive by investing in capital equipment, and maybe the hospital cleaners should try to form a powerful union and restrict supply to raise wages!

Can the phenomenon of "global warming" be analysed effectively using the externality framework?

The standard externality framework thinks of external costs and benefits in marginal terms, with small changes in output generating marginal changes in costs (MSC) and benefits (MSB). If the impact of global warming is as big as many of the scientists say, it sounds like we are dealing with very large costs and benefits rather than small changes, and marginal analysis might not be so useful. The Stern Report on Climate Change talks in terms of "non-marginal stochastic costs and benefits" the precise measurement of costs and benefits also seems difficult in this case, which makes marginal calculations difficult to achieve.

What are the benefits of trade in imports?

Trade pushes the market price down from Pd to Pw. The result is that consumers gain and producers lose Difference between demand and supply is met by imports from the rest of the world. What is the welfare gain or loss from participating in international trade? Consumers are better off as they are gaining more at a lower price. There is a loss of producer surplus. This is why trade is good for the economy — it raises overall wellbeing by raising consumer surplus more than producer surplus is lost. Picture is ignoring — what if people lose their jobs?

What determines wages?

Wages in each sector of the economy or each occupation are determined by the interaction of labour demand and supply The pattern of wages reflects the pattern of demand and supply interactions

What is the social welfare function?

We have talked loosely about how individuals make consumption choices based on how highly they value different goods and how they choose to buy different according to their preferences, so as to maximises the utility they get from consumption This raises the question of whether it would be possible somehow to add together the preferences of individuals to derive an aggregate picture of how highly the nation (society) values different bundles of goods or different market outcomes? This aggregation of individual preferences would provide the equivalent of a social welfare function, describing society's preferences among different outcomes But given the difficulties in measuring utility it is hard to see how we could make inter-personal comparisons of utility and reach definite conclusions about whether one situation is better than another

Why do we need government involvement to support markets?

We need government involvement to support markets, with laws, police, armed forces, etc. If we all agree about the way society should work there is no major problem But suppose a significant number don't like market outcomes and want to change them Society (and markets) can only operate if we have a system to resolve conflicts

What determines the prevailing wage rate?

We need to look at labour demand and labour supply in the relevant labour market The market demand for labour is the total amount of labour that firms in that market wish to employ The market supply of labour is the total amount of labour that households offer to firm in that market The equilibrium wage rate is the wage that balances demand and supply

What is welfare economics?

Welfare economics is the branch of the subject which deals with most of these issues In the absence of a social welfare function, in order to assess whether something is "good" or "bad" and whether or not policy changes are desirable, we need a set of welfare criteria or rules to guide choices

What determines the level of wages and employement?

What we need to consider is what determines the level of wages and the level of employment, both for the firm and across the economy We examine behaviour in competitive markets, where firms are price takers When the firm is a price taker, we know that MR = P The marginal revenue product of labour is MRPL = MPL x MR And with MR = P we have, MRPL = MPL x P So the profit maximizing employment level is W = MRPL = MPL x P Keep hiring more people until W = MPRL MPL must be going down as more labour is hired.

What happens if there is an increase in labour productivity?

Where does the increase in labour productivity come from? Having more capital (enables labour to get more done) Having more advanced technology (people become more skilled, gives us better ways to do things) If you look back over history, as technology has become more advanced, yes some jobs have been lost, but then people move to work in other parts of the economy, and the technological advancements create many jobs.

What happens when there is an increase in labour productivity?

Where does the increase in labour productivity come from? Having more capital (enables labour to get more done) Having more advanced technology (people become more skilled, gives us better ways to do things) If you look back over history, as technology has become more advanced, yes some jobs have been lost, but then people move to work in other parts of the economy, and the technological advancements create many jobs.

What bargaining problems might arise?

While a market solution to the externality problem is theoretically possible, in practice there are many obstacles Do we know how highly individuals in the community value the benefit of clean air How do we organise collection and payment What if some people choose to act as FREE RIDERS? They want the outcome but think that others will pay for it What if the externality costs are spread over a large geographical region. How do we identify interested parties? Who organises and supervises the bargaining process These and other problems make market solutions difficult...often easier to impose a government sponsored solution

Is innovation greater or lesser under a monopoly?

Would costs be lower if the competitive industry was under the control of a single firm, or would costs be higher under monopoly because competition is absent? Would innovation be greater or lesser under monopoly? Joseph Schumpeter argued that competition reduces the incentive for innovation and monopoly encourages firms to innovate Kenneth Arrow argued competition encourages innovation (continaully haivng to change, move and develop) and monopoly restricts innovation as it makes firms lazy