Word of the Day

Laffer curve

The Laffer Curve shows how a government’s tax revenue changes with changes in the average tax rate.

·       When the average tax rate is 0%, tax revenues are 0.

·       Tax revenues are also 0 when the average tax rate is 100%.

·       Tax revenues are maximised at the highest point on the curve, in this case it’s at a 50% average tax rate.

·       As the average tax rate increases, tax revenues rise until a certain point whereby after, there is no longer an incentive to produce output and people work less or do more to avoid paying the tax which reduces total revenue because the opportunity cost of paying the tax rises.

·       The Laffer Curve suggests that total tax revenues will increase at a lower tax rate, therefore cutting taxes will increase total tax revenues and create a virtuous cycle.

·       Reducing the tax rate creates incentives to work and produce output, stimulating economic growth, thus increasing total tax revenues.

RSAnimate

A video by the RSA providing food for thought.... One word for it, brilliant!

Do check out the other RSAnimates, they are fantastic!

Perfect Competition Long Run Equillibrium

Long run equilibrium

Because supernormal profits can be made in the short run, new firms enter the market.

When new firms enter the market, market supply increases from MS1 to MS2 which drives the price down from P1 to P2. There is a new equilibrium of price P2 and quantity Q2. For the individual firm in the market (diagram on the right), the firm now charges price P2 leading to MR and AR moving down to P2 as well. Point Y is the profit maximisation point (MR2=MC), therefore the firm will sell at quantity Q2 and total revenue gained is the rectangular area P2YQ2O. Because AC=MC, the rectangular for the firm’s total costs is P2YQ2O as well. This means that supernormal profits are not being made, only normal profits are being made. Costs per unit are equal to revenue per unit and so the firm is unable to make supernormal profits in the long run. Price = Long run ACs as well.

Furthermore, the firm is producing fewer units of output. Because there are no supernormal profits being made by firms within the market, there is no incentive for firms to enter or exit the market and the market is said to be at rest.

Efficiency

In the LR in a perfectly competitive market, there is….

·       Productive efficiency because the firm is producing at AC’s lowest point (Q2). The firm is producing at its cost minimising point. Resources are used efficiently.

·       Allocative efficiency because firms are allocating the same amount of extra cost (MC) to customers as customers are allocating extra revenue to firms (P). Therefore P=MC, so it is allocatively efficient.

A perfectly competitive market is the only type of market structure where it is possible to be both allocatively and productively efficient.

This model of a perfectly competitive market is a theoretical extreme and is used to judge how closely real world industries approximate to this even if they are not truly competitive. This model, although unrealistic, holds the strong argument that resources are allocated efficiently and firms make beneficial exchanges which enable it to be efficient. The model provides a benchmark in which imperfectly competitive markets can be compared and contrasted.

Word of the Day

Interest Rate

The cost of borrowing and the reward for saving. The interest rate in the UK has remained 0.5% since March 2009 and is likely to remain at this rate until at least the end of the year. The US interest rate will remain 0.25% until mid-2013. A low interest rate is supposed to lead to an increase in AD, thus is the Central Bank's attempt to try and revive the economy. A high interest rate attempts to increase savings and reduce consumption, thus lowering AD.

Perfect Competition Short Run Equilibrium

Assumptions behind a perfectly competitive market (conditions):

·       Large number of buyers and sellers with insignificant market share.

·       Freedom of entry and exit into the market. There are no barriers to entry and exit in the long run, the market is open to new suppliers.

·       Consumers have perfect knowledge about prices.

·       All firms have equal access to resources (e.g. technology) – perfect factor mobility.

·       Homogenous products that are perfect substitutes for one another.

·       Independent action by firms will not influence the market price as each individual firm is too small. This means that the firm is a price taker.

·       No externalities of production or consumption.

Perfectly competitive markets are rare, however close examples include:

·       Foreign currency – homogenous product, each trader is relatively small in the market and the trader has to take the given price.

·       Fruits and vegetables – homogenous product, firms are price takers, large number of buyers and sellers…etc.

When the firm is a price taker, there is little percentage difference in prices within the market. But most firms sell at the prevailing, ruling market price.

Short run equilibrium

The market ruling price is P1, at equilibrium. The diagram on the left illustrates the whole market, while on the right is the diagram showing the individual firm in the market. As the firm is a price taker, AR=MR=P which also equals market demand because there is lack of brand loyalty, making the demand curve perfectly elastic, and because the firm cannot influence the price.

From the diagram on the right of the individual firm, the firm is producing at profit maximisation, Q1. The shaded area shows the abnormal/supernormal profits being made since the area OP1XQ1 shows total revenue and OP2YQ1 shows total costs. Profits = revenue – costs, therefore profits are equal to OP1XQ1 - OP2YQ1, supernormal profits. The firm is only able to make abnormal profits in the short run in a perfectly competitive market because new firms are attracted by the prospects of making abnormal profits in the long run and enter the market, this erodes the abnormal profits.

However, not all firms make abnormal profits in a perfectly competitive market in the short run. This depends on the position of the AC curve.

For the firm above, there are subnormal profits being made because average costs are greater than average revenues. Selling at the market ruling price of P1 will therefore only enable the firm to make subnormal profits.

Case Study for the Office of Fair Trading

The OFT has fined 9 companies a total of £50m for price fixing of dairy products in 2002 to 2003. Arla, Asda, Dairy Crest, McLelland, Safeway (now Morrisons), Sainsbury's, Tesco, The Cheese Company and Wiseman are the dairy producers/supermarkets involved who fixed the price of milk, cheese, butter and other dairy products.

This is a good case study to mention in the exam to discuss why firms would want to engage in collusive agreements (see cartel although this isn't necessarily a cartel, it displays characteristics) and the effectiveness of regulatory bodies in protecting consumers against anti-competitive practices.

UK Economic Growth

Yesterday it was announced that the US Federal Reserve (Central Bank) will keep US interest rates at 0.25% until at least mid 2013. It has been 0.25% since December 2008 and the main reasoning behind this is to try and prevent the US economy from undergoing a double dip recession. Because of this, the Bank of England are likely to keep interest rates in the UK 0.5% until the end of the year. See article for more and watch the video for what Mervyn King (Governor of the Bank of England) had to say.

There are fears that many major economies may face double dip recessions and this risk is heightened by the turmoil in the EU which poses great risk to the UK economy in terms of the banking system and how it will affect UK banks. Furthermore, the rate of inflation is likely to increase to 5% or higher at some point this year before dropping down, affecting disposable incomes and thus decreasing consumption.