SAQ's Flashcards
How do economists define efficiency for an economy? Why do markets not achieve it and when is it not desirable?
Pareto efficiency occurs when it is impossible to make anyone better off without making someone else worse off. [50%]
A market economy would be Pareto efficient if there is everywhere perfect competition (including for all inter-temporal contigencies) and no externalities. This idealisedstate is never reached due to dis-equilibrium, imperfect competition, transactions costs, externalities, imperfect information, public/collective goods and other ‘missing’ markets. [25%]
As Pareto inefficient means that someone can be made better off without anyone being made worse off. It is commonly accepted that such inefficient outcomes are to be avoided. But not every Pareto efficient outcome will be regarded as desirable. Ethics, equity and feasibility are commonly as important
What is the formula for point elasticity of demand? What is the range of elasticity over a straight-line demand curve? List the major determinant of price elasticity
Point elasticity of demand applies when the price change is small. Its formula is:
(image)
where X and P represent the initial quantity and price respectively, and the triangle means ‘change in’.
Strictly the change should be infinitesimal, or ÎX/ ÎP = dX/dP
The formula indicates that point elasticity can be calculated by multiplying the inverse of the slope of the demand curve at a particular point by the corresponding ratio of P to X - hence the term ‘point elasticity’. [50%]
A straight-line demand curve has a constant slope, but the elasticity will change at every point. The elasticity increases as the price increases. At price p=0, elasticity=0; as p rises, elasticity is initially less than unity. As p continues to rise elasticity hits (minus) unity, and then becomes greater than unity. Eventually elasticity grows to infinity where the demand curve hits the y-axis (zero consumption). [25%]
The major determinants of price elasticity is: substitutability - the ease with which one good can be substituted for another. The more and closer substitutes available for a good, the more elastic the demand tends to be. [25%]
What is the opportunity cost of owning a bar of gold?
Opportunity cost is the cost of something in terms of the best alternative forgone. [25%]
Gold is an extremely durable asset and historically a good ‘store of value’. Current consumption is forgone by owning gold, and the timing of consumption may have a utility, but the value of the gold is not ‘lost’ i.e. wealth is transferred to the future. [25%]
There are other financial assets available for carrying wealth through time; hence the return available from these other assets (dividends, interest) is forgone by holding gold. [25%]
Part of the overall return to holding gold will depend on movements in the price of gold. So the expected capital appreciation on gold and other assets would have to be compared to see if the expected gain from holding wealth in gold exceeds the expected overall opportunity cost. [25%]
Give economic reasons why banning the sale of ivory might endanger elephants as a species.
By making it, in effect, illegal to rear elephants as a ‘cash crop’ this decreases the incentive to breed and protect elephants as an asset. It may also decrease the return to protecting elephants from poachers. [50%]
Banning sales will reduce ivory supply and could drive-up its price. Hence increasing the incentive to poach elephants. [25%]
The banning of ivory sales may reduce its demand by increasing awareness of ethical considerations. But this may not result in more elephants; there would certainly be less not more cows if the sale of dairy and beef products were banned! [25%]
. What are likely to be the short-run and long-run effects on price of levying a tax on the profits of a perfectly competitive industry?
Post-tax profit will still be greatest when pre-tax profit is maximized. That is, as a profit tax does not affect variable costs, or revenues, the profit maximizing output will be unaltered. Hence, the price will not be affected in the short-run. [50%]
If the industry was earning zero pure/normal profits before the tax, then it will be earning negative/sub-normal profits after the tax. Firms will thus leave the industry in the long-run until output has decreased enough to raise price back to Average Total Cost enough to allow zero/normal profits to be earned again. [50%]
Describe the difference between adaptive and rational expectations in relation to inflation?
Adaptive expectations adjust to inflation on the basis of current and past inflation. Hence, if inflation is increasing expectations will tend to lag behind the current level of inflation, depending on the weights given to past and present values. [50 %]
In rational expectations all available information is used to anticipate changes in inflation, if information is unbiased and agents rational then on average expectations will equal the actual rate. [50%]
Explain what happens to the UK exchange rate if domestic interest rates rise? Specify an assumption that you have made in your reasoning.
A positive interest rate difference will quickly attract ‘footloose’ capital to take advantage of higher interest rates in the UK. The demand for sterling, and sale of other currencies, will drive up its value against other currencies (if more ambiguous terms such as ‘appreciation’ or ‘up or down’ is used there should also be an indication that this denotes the strengthening of the pound). [75%]
Inflationary and exchange rate expectations do not offset the expected interest differential. [25%]
Is street lighting a public good and would it be sensible to charge for its use?
Public goods are non-rival and non-excludable. Street lighting is non-rival but tolls could be charged for its use, so it is not a pure public good. [50%]
Tolls, unless through a technology such as GPS, would have high transaction costs as barriers to non-paying vehicles would have to be in place. Also, unless there was a mechanism to turn the lights on and off when in use or not, there is no marginal costs for the use of the lighting, hence a positive charge would mean a Pareto welfare loss. But alternative funding could also cause a welfare loss unless it is funded by a lump sum tax that everyone was willing to pay for the lighting. [50%]
An econometrician obtains data on the amount of income tax evaded by a set of individuals. A regression analysis generates the following fitted equation (t-stats beneath the coefficients):
(image)
where: E = amount of income tax evaded
MRT = marginal tax rate
Y = income
F = fine per £ of evaded tax.
Describe the results from this fitted equation.
The observations that can be made are: The signs on the explanatory variables suggest that tax evasion increases with the marginal rate of tax, increases with the level of income, falls with the level of fine. [50%]
Income and fine are statistically significant (the t-statistic is above 2). The marginal rate of tax is insignificant. [25%]
The specification is logarithmic in E and Y. Therefore the elasticity of evasion with respect to income is less than 1. A smaller proportion of income is evaded as income rises. [25%
Name 5 types of PED
What is predatory pricing?
Predatory pricing , also known as undercutting, is a pricing strategy in which a product or service is set at a very low price with the intention to drive competitors out of the market or to create barriers to entry for potential new competitors.
Theoretically, if competitors or potential competitors cannot sustain equal or lower prices without losing money, they go out of business or choose not to enter the business. The so-called predatory merchant then theoretically has fewer competitors or even is a de facto monopoly.
What is Quantitative easing?
Quantitative easing (QE), also known as large-scale asset purchases, is an expansionary monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to stimulate the economy and increase liquidity.
An unconventional form of monetary policy, it is usually used when inflation is very low or negative, and standard expansionary monetary policy has become ineffective.
A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other financial institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the money supply.
This differs from the more usual policy of buying or selling short-term government bonds to keep interbank interest rates at a specified target value
What is price penetration?
Penetration pricing is a pricing strategy where the price of a product is initially set low to rapidly reach a wide fraction of the market and initiate word of mouth.
The strategy works on the expectation that customers will switch to the new brand because of the lower price. Penetration pricing is most commonly associated with marketing objectives of enlarging market share and exploiting economies of scale or experience.
If R-squared = 0.1366, what does this mean?
The number tells us that 13.66% of the variance of the response variable (say E= income tax evasion) is explained by the regression model.
Price/Point elasticity of demand example
There are two possible ways of calculating elasticity of demand — price (or point) elasticity of demand and arc elasticity of demand. Price elasticity of demand measures the responsiveness of quantity demanded to a price. It takes the elasticity of demand at a particular point on the demand curve, or between two points on the curve. The price elasticity of demand can be calculated as:
PEd = % change in qty demanded / % change in price
For example, if the price of a product decreases from $10 to $8, leading to an increase in quantity demanded from 40 to 60 units, then the price elasticity of demand can be calculated as:
% change in quantity demanded = (Qd2 – Qd1)/Qd1 = (60 – 40)/40 = 0.5
% change in price = (P2 – P1)/P1 = (8 – 10)/10 = -0.2
Therefore, PEd = 0.5/-0.2 = 2.5 (since we’re concerned with the absolute values in price elasticity, the negative sign is ignored).
We can conclude that the price elasticity of this good when price decreases from $10 to $8 is 2.5
Name one issue with the price elasticty of demand formula
One of the problems with the price elasticity of demand formula is that it gives different values depending on whether price rises or falls. If we were to use different start and end points in our example above, that is, assume price increased from $8 to $10 and quantity demanded decreased from 60 to 40, the Ped will be:
% change in quantity demanded = (40 – 60)/60 = -0.33
% change in price = (10 – 8)/8 = 0.25
PEd = -0.33/0.25 = 1.32, which is much different from 2.5.
What can be used to eliminate the issues regarding PED?
To eliminate this problem, the arc elasticity can be used. Arc elasticity measures elasticity at the midpoint between two selected points on the demand curve by using a midpoint between the two points. The arc elasticity of demand can be calculated as:
Arc Ed = [(Qd2 – Qd1) / midpoint Qd] ÷ [(P2 – P1) / midpoint P]
Let’s calculate the arc elasticity following the example presented above.
Midpoint Qd = (Qd1 + Qd2)/2 = (40 + 60)/2 = 50
Midpoint Price = (P1 + P2)/2 = (10 + 8)/2 = 9
% change in qty demanded = (60 – 40)/50 = 0.4
% change in price = (8 – 10)/9 = -0.22
Arc Ed = 0.4/-0.22 = 1.82
name one benefit of using arc elasticities
When we use arc elasticities we do not need to worry about which point is the starting point and which point is the ending point since the arc elasticity gives the same value for elasticity whether prices rise or fall. Therefore, the arc elasticity is more useful than the price elasticity when there is a considerable change in price.
What is a merit good?
A merit good has two characteristics:
- People do not realise the true personal benefit. For example, people underestimate the benefit of education or getting a vaccination.
- Usually, these goods also have a positive externality.
Therefore in a free market, there will be under consumption of merit goods.
exemples - Healthcare (think - vaccinations), Museums (educational benefits), and education (People may undervalue the benefits of studying, and decide to leave school early or not get good grades.)
What is a demerit good?
A demerit good has two characteristics:
A good which harms the consumer. For example, people don’t realise or ignore the costs of doing something e.g. smoking, drugs.
Usually, these goods also have negative externalities. If you smoke you harm yourself, but also the smoke negatively affects other people.
Therefore in a free market, there will be overconsumption of these goods
examples -
Smoking – People underestimate health costs or risks of getting addicted.
Drinking – Health costs to drinkers. Costs to society include more expenditure on health care and policing.
Taking drugs – Health costs to drug users – people underestimate risks of getting addicted. External costs of more crime.
Value judgement on merit goods example
Merit and demerit goods involve making a value judgement that something is good or bad for you. Classification is not always straightforward. For example:
Cannabis
Cannabis is widely considered a demerit good – it contributes to lung cancer and can lead to psychological problems, such as paranoia.
However, supporters of cannabis might argue cannabis is a harmless drug which can help people deal with physical pain and enjoy life more.
Contraception
Supporters of family planning may argue contraception is a merit good because contraception can involve personal costs of unwanted pregnancy.
The Catholic church views contraception as a sin and may argue it is actually a demerit good because its use encourages sexual promiscuity and undermines family values.
What is consumer soverignty?
Consumer sovereignty is the idea that it is consumers who influence production decisions. The spending power of consumers means effectively they ‘vote’ for goods. Firms will respond to consumer preferences and produce the goods demanded by consumers. It is a manifestation of the ‘invisible hand’
Others argue that consumer sovereignty is a myth. Firms produce goods and use marketing techniques to sell consumers good they don’t really need or want.
In practice, there is an element of both. Firms may market new goods successfully like an iPod. But, if consumers are not impressed the good will not sell. There are countless new products, which never catch off.
What is diseconomies of scale?
Diseconomies of scale are the cost disadvantages that firms and governments accrue due to increase in firm size or output, resulting in production of goods and services at increased per-unit costs. This typically follows the law of diminishing returns, where further increase in size of output will result in even greater increase in average cost.
Name some causes of diseconomies of scale.
- Communication costs - more employees mean less one-on-one communication.
- Duplication of effort - when organisations grow to thousands of workers, it is inevitable that someone, or even a team, will take on a function that is already being handled by another person or team
- Office Politics - a manager might intentionally promote an incompetent worker, knowing that the worker will never be able to compete for the manager’s job. This type of behavior only makes sense in a company with multiple levels of management. The more levels there are, the more opportunity for this behavior.
- Top-heavy companies - as a firm grows and covers a larger geographical area and/or employs more people, a principal–agent problem arises, leading to lower productivity.
