March, 2012 | The Economics Classroom

Measuring the Macroeconomic Objectives: Economic Growth, Unemployment and Inflation

Macroeconomics provides government policymakers with a set of tools that can be employed to help achieve certain macroeconomic objectives deemed desirable for a nation. For an economy to be considered healthy, three objectives must be met:

  • Economic growth: defined as an increase in the nation’s output of goods and services over time
  • Low unemployment: meaning that nearly everyone who is willing and able to work should be able to find a job, and
  • Low inflation: meaning that the average price level of the nation’s goods and services should not increase too rapidly over time.

Measuring these three objectives requires the use of some simple mathematical formulas. Once they are known, we can use the basic production possibilities curve diagram to illustrate their effect on a nation’s potential output and its current equilibrium level of output.

This lesson will define the three macroeconomic objectives, show how it can be determined whether or not they are being achieved, and use a PPC model to illustrate them.

The Kinked Demand Curve Model of Oligopoly Pricing

In our previous lesson on oligopoly, we showed how payoff matrices and game theory could be used to analyze the strategic, interdependent behavior of two firms when deciding the price they would charge. In this lesson we take a graphical approach to oligopoly, and seek to explain why prices tend not to fluctuate up or down in oligopolistic markets.

We will look at two firms, Swisscom and Orange, which provide cell service to customers in Switzerland. Why does Swisscom have very little incentive to decrease its prices, and also a strong incentive not to raise its prices? The answer requires us to make assumptions about how the competitor, Orange, would respond to a change in Swisscom’s prices.

What emerges is a kinked demand curve, highly elastic at prices above the current equilibrium and highly inelastic at prices below the current equilibrium. Along with this kinked demand curve comes a kinked marginal revenue curve, with a vertical section. The implication is that even as an oligopolist’s costs rise and fall in the short-run, its level of output and price tends to remain stable.

 

Intro to Game Theory – The Prisoner’s Dilemma as a Model for Oligopoly Behavior

Two men are in custody for a crime they may or may not have committed: armed robbery. The police have the men in separate cells and have told them the following:

Confess to the crime of armed robbery and we will let you off with a light term of three years in jail with parole after one year.

Remain silent and we will throw everything we have at you, you will get 10 years in jail, because we promise you, your accomplice will talk.

However, if you both remain silent, we have to let you go with a slap on the wrist, just six months in jail for trespassing.

With this information in mind, the men, who are unable to communicate with one another both confess and get three years in jail. Why didn’t they both remain silent, though, and get just six months in jail?

This story is what’s known as the Prisoner’s Dilemma. It is a popular story used by economists to illustrate the challenges faced by non-collusive oligopolistic firms in deciding how to determine what prices to set for their products, whether to advertise or not to advertise, and many other strategic decisions that will affect the level of profits being earned.

The oligopoly market structure, more than any other, requires that firms act strategically, taking into account the decisions of their competitors, on whom they are highly inter-dependent. This lesson will apply the Prisoner’s Dilemma game to two firms deciding whether to charge a high price or a low price for their output, and analyze the most likely outcome in such a game. As we will see, without the ability to collude with one another, the strategic behavior of oligopolistic firms tends to result in an outcome that is not optimal for the sellers, but may benefit consumers.

 

Monopolistic Competition

Having now studied perfect competition and Pure Monopoly, we will now step back towards the competitive end of the spectrum of market structures and examine monopolistic competition. A monopolistically competitive market is one with many small firms each selling differentiated products. The entry barriers are low, but firms do have some price making power. Since each firm’s output is slightly different from each other firm’s, the individual sellers will face a downward sloping demand curve, much like a monopolist. But since entry barriers are low, the chance of an individual firm earning economic profits in the long-run is small.

This lesson will introduce the characteristics of monopolistic competition and provide a detailed graphical analysis of an individual firm in a monopolistically competitive market. We will look at the market for restaurants, which shows may of the characteristics of the market structure.

In the end we will determine whether monopolistically competitive markets are efficient by examining the firm’s average total cost and its marginal cost compared to the price in the long-run equilibrium.

 

Price Discrimination and its Effects on Efficiency in Monopolistic Markets

Discrimination is never considered a good thing, is it? Discriminating based on race, gender, or age is usually frowned upon. But in the business world, it is all too common. Consider some of the following example of price discrimination by businesses:

  • Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
  • Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
  • Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
  • Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
  • Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
  • Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a round-trip ticket that departs and returns during the week.

Price discrimination occurs any time a firm with market power charges different prices to consumers based on their willingness to pay or their sensitivity to price changes.

The results of price discrimination are not all bad, either. In fact, such practices usually result in a higher level of output than would be achieved if a firm charged a single price to all consumers. As a result, more people can afford to buy the good in question and a greater level of allocative efficiency is achieved.

This lesson will define price discrimination, outline the conditions necessary for it to occur, and explain the different degrees of price discrimination. We will then illustrate the effect of perfect price discrimination and attempt to conclude whether or not it is good overall for society by looking at the effect it has on consumers and producers.

 

Natural Monopoly and the need for Government Regulation

In most cases, it can be argued that increased competition in a market will lead to an increase in efficiency, benefiting society and consumers. More competition, it can be argued, puts downward pressure on prices and forces firms to use their resources in a more efficient manner, encouraging firms to reduce their average total costs.

But what if the total demand for a good in a particular market is not high enough to necessitate more than one firm producing the good in question? In other words, what if having more than one firm means that each individual producer will have higher average total costs than a single firm would have? Such a scenario exists if the market demand curve intersects a monopolist’s average total cost curve in the range in which economies of scale are experienced, in other words where ATC it still decreasing. This is known as a natural monopoly.

Such industries exist, particularly in the case of large utilities such as water, electricity, natural gas, sewage and garbage collection. Think about the town you live in: how many firms can you choose to buy your electricity from? The answer is most likely ONE. Would you be better off if the answer were 100? Probably not. Here’s why: If 100 firms competed to provide electricity to your city, no single firm would achieve the economies of scale needed to lower its average total cost to a level that would allow it to provide electricity at the low, desirable rates that you currently pay. With 100 firms providing electricity, each firm would have much higher average costs and therefore would have to charge higher prices to their consumers! Competition would drive the price UP, instead of DOWN, like it is supposed to do, due to the significant economies of scale, namely the huge fixed costs of capital and infrastructure, needed to provide a utility such as electricity.

The problem with natural monopolies is that if they are left unregulated, they will produce much less and charge a price much higher than what is socially optimal (where marginal benefit equals marginal cost). Thus arises the need for regulation. This lesson will explain the theory of natural monopolies and examine the use of subsidies and price controls to promote a more socially optimal outcome in such industries.

After watching this lesson, read and respond to the discussion questions for the following blog post:  Monopoly prices – to regulate or not to regulate, that is the question!

 

Balance of Payments and Exchange Rates – AP Free Response Questions

This lesson presents worked solutions to three AP Free Response Questions on Balance of Payments and Exchange Rates. You may wish to download and attempt these questions yourself before watching the video. Here is the original quiz I gave my AP Macro students: AP Macro Balance of Payments Quiz

The original AP Questions and others can be found on the College Board Site: AP Macroeconomics – Sample questions and Scoring guidelines

The quiz covers the following questions:

  • 2011 Form B Question #2
  • 2008 Question #2
  • 2007 Form B Question #3

Profit Maximization, Revenue Maximization and PED in Pure Monopoly

A monopolist, having total control over the level of output it produces and the price it charges, will generally be interested in maximizing its profits. But what if a firm decides that it is revenues that should be maximized instead?

This lesson will examine the profit maximization rule as it applies to a pure monopolist, and introduce the revenue maximization rule, which tells a monopolist the quantity it should produce at in order to earn the maximum level of revenues possible. We will examine the level of economic profits earned at one level compared to the other. Additionally, we will look at the price elasticity of demand for a monopolist’s product by revisiting the total revenue test of elasticity.


Introduction to Pure Monopoly

After studying the theories of perfect competition, we now transition into the opposite extreme in the spectrum of competition between firms. ‘Mono’ means ‘one’ and ‘poly’ means ‘seller’. A monopolistic market, therefore, is one in which only a single seller produces the output for the entire market. Examples of pure monopolies are rare, but they do exist; some examples include:

  • Utility companies, such as water and electricity, in particular towns,
  • Cell service providers in some countries
  • Professional sports teams (the Denver Broncos are the only professional football team in Denver)
  • Microsoft (a near monopolist in PC operating systems)

There have been many monopolies in various markets throughout history, but often such firms get broken up into smaller firms, sometimes due to government intervention aimed at increasing competition to lower prices for consumers.

That brings us to some of the characteristics of monopolistic markets: Besides there being just one seller, such firms are also price-makers, they face a downward sloping demand curve (compared to the PC firm’s perfectly elastic demand), and there are high barriers to entry, enabling monopolists to earn economic profits in the long-run. In addition, the marginal revenue a firm receives for additional units of output is always lower than the price it is selling the output for. This last characteristic may sound mundane, but in fact it is the reason monopolists will always charge higher prices and produce at lower quantities than perfectly competitive markets.

This lesson will introduce some of the characteristics of monopolies and use a demand schedule to derive the demand and marginal revenue curves for a hypothetical monopolistic airplane manufacturer. We will then place cost curves on the graph to determine the profit maximizing quantity a monopolist should produce at, and we’ll briefly examine the level of output and price as it would compare to a perfectly competitive market.