Examination forms of M.A. / Double M.A. External 2012

Examination forms of M.A. / Double M.A. External 15th MARCH to 31st MARCH 2012

Aggregate Demand and Aggregate Supply

ISLM aggregates the economy into a market for money balances, a market for goods and services, and a residual market that it ignores by invoking Walras' Law. Since part of the residual market is the labor market, and because adjustment in this market is slow, ISLM would be a better model if it could capture what is happening in the resource markets. Aggregate supply-aggregate demand analysis makes this incorporation. The aggregate demand curve is derived from the ISLM model. In the illustration below, equilibrium income is Y1 when the price level is P1. Let the price level rise to a higher level, from P1 to P2. At the higher level, with a constant amount of money, purchasing power is cut. The fixed number of dollars no longer buys as much. The effects on the LM curve are identical to what happens when prices remain fixed and the amount of money falls. The LM curve, in either case, shifts left, interest rates rise, and income falls. The output levels at both P1 and P2 are shown in the bottom part of the illustration. The aggregate demand curve connects them with points that other price levels generate.

The aggregate supply curve comes from the resource market. Though these markets may adjust slowly, when they finally do fully adjust, price level should have little or no effect on the amount of resources supplied. If a doubling of all prices and wages results in more or less output, someone is suffering from money illusion. The person believes either that he is better off at a higher nominal (but same real) wage, or that he is worse off with higher prices that have been fully compensated with higher wages. If people realize that money is merely an intermediary, and ultimately goods trade for goods, price level should not matter. The point of the last paragraph is important enough to explain in a more concrete manner. Suppose Edward has a paper route and at the end of each week his income is $25.00. He spends his entire income on 15 hamburgers that cost $1.00 each and 20 soft drinks that cost $.50 each. One day Edward wakes up and finds that his weekly income has doubled to $50, but all prices have also doubled. Is he any better or worse off? Clearly he is not. A week of delivering newspapers still trades for 15 hamburgers and 20 soft drinks. He has no reason to work either more or less. If behavior does not change when price level does, output will not depend on price level. The result will be the perfectly vertical aggregate supply curve shown in the illustration above. In the long run, when prices and wages fully adjust to any change in total spending, resources and output determine output. In the short-run, however, an adjustment process that is not instantaneous seems more appropriate. Prices can be sticky, especially in resource markets. Expected rates of inflation can affect the way prices are set. Once we allow these possibilities, we have a system in which it may take years to reach long-run equilibrium. It is even possible that the system will never reach equilibrium, but, as the business-cycle writers thought, will fluctuate forever in the adjustment process. Once we add stickiness to prices and give a role to expected inflation, a change in spending will not simply move the economy up or down a vertical aggregate-supply curve. The upward-sloping curve below shows what is likely in the short run. A change in spending will move the aggregate-demand curve. If the short-run aggregate-supply curve is fairly flat, there will be a large change in output and a small change in price level.

Aggregate supply and aggregate demand is an attractive framework because it is simple, with the same structure as supply and demand. However, the assumptions behind aggregate supply and aggregate demand are totally different from those behind supply and demand, that is, aggregate supply and aggregate demand curves are not obtained by adding up all the supply and demand curves in an economy. If they were, one would expect that the long-run aggregate-supply curve would be flatter than the short-run aggregate-supply curve, as is the case with a normal supply curve. But the aggregate supply curve grows steeper the longer the time for adjustment. Aggregate supply and aggregate demand is more general than ISLM, and overcomes some of the limitations of ISLM. It includes price level as a variable, and it shows that resource markets matter. It also lets one consider cases in which disturbances originate in a resource market, such as a disruption of oil supplies, which ISLM cannot handle. Aggregate supply and aggregate demand gives insight into the adjustment process. Observation of the real world tells us that when spending suddenly changes, output changes initially more than prices, and only after considerable delay do prices change more than output. Aggregate supply and aggregate demand yields this pattern. Aggregate demand and aggregate supply show an adjustment process. It does this with a series of short-run equilibria. Alfred Marshall originated this technique with regular supply and demand. He had three periods: the market period or the very short run, in which output was fixed; the short run, in which capital was fixed but utilization of capital was not; and the long run, in which nothing was fixed. So far the expositions of aggregate supply and aggregate demand have been fuzzy about what is fixed in the short run that is not fixed in the long run. This fuzziness remains as a problem of aggregate demand and aggregate supply.

Price Discrimination

 Price Discrimination Most businesses charge different prices to different groups of consumers for what is more or less the same good or service! This is price discrimination and it has become widespread in nearly every market. This note looks at variations of price discrimination and evaluates who gains and who loses? What is price discrimination? Price discrimination or yield management occurs when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with costs. It is important to stress that charging different prices for similar goods is not pure price discrimination. We must be careful to distinguish between price discrimination and product differentiation – differentiation of the product gives the supplier greater control over price and the potential to charge consumers a premium price because of actual or perceived differences in the quality / performance of a good or service. Conditions necessary for price discrimination to work Essentially there are two main conditions required for discriminatory pricing Differences in price elasticity of demand between markets: There must be a different price elasticity of demand from each group of consumers. The firm is then able to charge a higher price to the group with a more price inelastic demand and a relatively lower price to the group with a more elastic demand. By adopting such a strategy, the firm can increase its total revenue and profits (i.e. achieve a higher level of producer surplus). To profit maximise, the firm will seek to set marginal revenue = to marginal cost in each separate (segmented) market. Barriers to prevent consumers switching from one supplier to another: The firm must be able to prevent “market seepage” or “consumer switching” – defined as a process whereby consumers who have purchased a good or service at a lower price are able to re-sell it to those consumers who would have normally paid the expensive price. This can be done in a number of ways, – and is probably easier to achieve with the provision of a unique service such as a haircut rather than with the exchange of tangible goods. Seepage might be prevented by selling a product to consumers at unique and different points in time – for example with the use of time specific airline tickets that cannot be resold under any circumstances. Examples of price discrimination Price discrimination is an extremely common type of pricing strategy operated by virtually every business with some discretionary pricing power. It is a classic part of price competition between firms seeking a market advantage or to protect an established market position. (a) Perfect Price Discrimination – charging whatever the market will bear Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the whole market into each individual consumer and charges them the price they are willing and able to pay. If successful, the firm can extract all consumer surplus that lies beneath the demand curve and turn it into extra producer revenue (or producer surplus). This is impossible to achieve unless the firm knows every consumer’s preferences and, as a result, is unlikely to occur in the real world. The transactions costs involved in finding out through market research what each buyer is prepared to pay is the main block or barrier to a businesses engaging in this form of price discrimination. If the monopolist is able to perfectly segment the market, then the average revenue curve effectively becomes the marginal revenue curve for the firm. The monopolist will continue to see extra units as long as the extra revenue exceeds the marginal cost of production. The reality is that, although optimal pricing can and does take place in the real world, most suppliers and consumers prefer to work with price lists and price menus from which trade can take place rather than having to negotiate a price for each unit of a product bought and sold. Second Degree Price Discrimination This type of price discrimination involves businesses selling off packages of a product deemed to be surplus capacity at lower prices than the previously published/advertised price. Examples of this can often be found in the hotel and airline industries where spare rooms and seats are sold on a last minute standby basis. In these types of industry, the fixed costs of production are high. At the same time the marginal or variable costs are small and predictable. If there are unsold airline tickets or hotel rooms, it is often in the businesses best interest to offload any spare capacity at a discount prices, always providing that the cheaper price that adds to revenue at least covers the marginal cost of each unit. There is nearly always some supplementary profit to be made from this strategy. And, it can also be an effective way of securing additional market share within an oligopoly as the main suppliers’ battle for market dominance. Firms may be quite happy to accept a smaller profit margin if it means that they manage to steal an advantage on their rival firms. The expansion of e-commerce by both well established businesses and new entrants to online retailing has seen a further growth in second degree price discrimination. Early-bird discounts – extra cash-flow The low cost airlines follow a different pricing strategy to the one outlined above. Customers booking early with carriers such as EasyJet will normally find lower prices if they are prepared to commit themselves to a flight by booking early. This gives the airline the advantage of knowing how full their flights are likely to be and a source of cash-flow in the weeks and months prior to the service being provided. Closer to the date and time of the scheduled service, the price rises, on the simple justification that consumer’s demand for a flight becomes more inelastic the nearer to the time of the service. People who book late often regard travel to their intended destination as a necessity and they are therefore likely to be willing and able to pay a much higher price very close to departure. Airlines call this price discrimination yield management – but despite the fancy name, at the heart of this pricing strategy is the simple but important concept – price elasticity of demand! Peak and Off-Peak Pricing Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing and in the travel sector. Telephone and electricity companies separate markets by time: There are three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity during the night. At off-peak times, there is plenty of spare capacity and marginal costs of production are low (the supply curve is elastic) whereas at peak times when demand is high, we expect that short run supply becomes relatively inelastic as the supplier reaches capacity constraints. A combination of higher demand and rising costs forces up the profit maximising price. Third Degree (Multi-Market) Price Discrimination This is the most frequently found form of price discrimination and involves charging different prices for the same product in different segments of the market. The key is that third degree discrimination is linked directly to consumers’ willingness and ability to pay for a good or service. It means that the prices charged may bear little or no relation to the cost of production. The market is usually separated in two ways: by time or by geography. For example, exporters may charge a higher price in overseas markets if demand is estimated to be more inelastic than it is in home markets. MC=AC The internet and price discrimination A number of recent research papers have argued that the rapid expansion of e-commerce using the internet is giving manufacturers unprecedented opportunities to experiment with different forms of price discrimination. Consumers on the net often provide suppliers with a huge amount of information about themselves and their buying habits that then give sellers scope for discriminatory pricing. For example Dell Computer charges different prices for the same computer on its web pages, depending on whether the buyer is a state or local government, or a small business. Two Part Pricing Tariffs Another pricing policy common to industries with pricing power is to set a two-part tariff for consumers. A fixed fee is charged (often with the justification of it contributing to the fixed costs of supply) and then a supplementary “variable” charge based on the number of units consumed. There are plenty of examples of this including taxi fares, amusement park entrance charges and the fixed charges set by the utilities (gas, water and electricity). Price discrimination can come from varying the fixed charge to different segments of the market and in varying the charges on marginal units consumed (e.g. discrimination by time). Product-line pricing Product line pricing is also becoming an increasingly common feature of many markets, particularly manufactured products where there are many closely connected complementary products that consumers may be enticed to buy. It is frequently observed that a producer may manufacture many related products. They may choose to charge one low price for the core product (accepting a lower mark-up or profit on cost) as a means of attracting customers to the components / accessories that have a much higher mark-up or profit margin. Manufacturers charge low prices for the razors but high prices for the razor blades – a good example of product line pricing Good examples include manufacturers of cars, cameras, razors and games consoles. Indeed discriminatory pricing techniques may take the form of offering the core product as a “loss-leader” (i.e. priced below average cost) to induce consumers to then buy the complementary products once they have been “captured”. Consider the cost of computer games consoles or Mach3 Razors contrasted with the prices of the games software and the replacement blades! The Consequences of Price Discrimination - Welfare and Efficiency Arguments To what extent does price discrimination help to achieve a more efficient allocation of resources? There are arguments on both sides of the coin – indeed the impact of price discrimination on welfare seems bound to be ambiguous. The impact on consumer welfare Consumer surplus is reduced in most cases - representing a loss of consumer welfare. For the majority of consumers, the price charged is significantly above marginal cost of production. Those consumers in segments of the market where demand is inelastic would probably prefer a return to uniform pricing by firms with monopoly power! Their welfare is reduced and monopoly pricing power is being exploited. However some consumers who can buy the product at a lower price may benefit. Previously they may have been excluded from consuming it. Low-income consumers may be “priced into the market” if the supplier is willing and able to charge them a lower price. Good examples to use here might include legal and medical services where charges are dependent on income levels. Greater access to these services may yield external benefits (positive externalities) which then have implications for the overall level of social welfare and the equity with which scarce resources are allocated. Producer surplus and the use of profit Price discrimination is clearly in the interests of businesses who achieve higher profits. A discriminating monopoly is extracting consumer surplus and turning it into extra supernormal profit. Of course businesses may not be driven solely by the aim of maximising profit. A company will maximise its revenues if it can extract from each customer the maximum amount that person is willing to pay. Price discrimination also might be used as a predatory pricing tactic – i.e. setting prices below cost to certain customers in order to harm competition at the supplier’s level and thereby increase a firm’s market power. This type of anti-competitive practice is difficult to prove, but would certainly come under the scrutiny of the UK and European Union competition authorities. A converse argument to this is that price discrimination may be a way of making a market more contestable in the long run. The low cost airlines have been hugely successful partly on the back of extensive use of price discrimination among consumers. The profits made in one market may allow firms to cross-subsidise loss-making activities/services that have important social benefits. For example profits made on commuter rail or bus services may allow transport companies to support loss making rural or night-time services. Without the ability to price discriminate these services may have to be with drawn and employment might suffer. In many cases, aggressive price discrimination is seen as inimical to business survival during a recession or sudden market downturn. An increase in total output resulting from selling extra units at a lower price might help a monopoly supplier to exploit economies of scale thereby reducing long run average costs. 

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Classical Economics

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  Classical Economics

 The Quantity Theory of Money The Quantity Theory of Money seeks to establish that, in the long run, the price level/ rate of inflation is determined by the level/ rate of increase of the money supply. Although the Quantity Theory of Money is an extremely old proposition, it was first formalised in the early part of the 20th century by Yale economist, Irving Fisher and later by a group of Cambridge economists, Alfred Marshall and most notably A. C. Pigou. (a) Fisher’s Transactions Approach This approach first emerged in Fisher’s book The Purchasing Power of Money (1911). For most economists of that period, money was viewed solely as a means of exchange. The only reason for holding money was to facilitate transactions. Fisher’s analysis commences with a simple identity (a statement that is by definition true), sometimes referred to as the equation of exchange.

MVt ≡ PT where  M = Money Supply  Vt = Transactions Velocity of Circulation of money (the number of times the money stock changes hands per period).  P = Price level.  T = The number of Transactions undertaken per period Note that MVt = money stock * number of times the money stock is spent per period = total spending per period. PT = Price of goods & services * volume of goods & services bought per period = total expenditure per period. Thus, at first sight, the Quantity Theory is an innocuous tautology. To turn this identity into a theory of price determination, Fisher made further assumptions about the nature of each variable.  M, the money stock was taken to be exogenously determined by the monetary authorities  and independent of the other 3 variables  Vt, the velocity of circulation was assumed to be more or less constant and was determined by conditions in the financial system that tend to change very slowly. Again, V was thought to be independent of M, P & T.  T, the number of transactions per period was also taken as fixed. Recall that Classical scholars believed that in the long term, output tended to be at or near the ECONOMICS KHALID AZIZ 0322-3385752 full employment level. The number of transactions was viewed as fixed at any given level of income. 

P, the price level was determined by the interaction of the 3 other factors. Thus, MVt = PT This suggests that the price level is determined by the money supply. Note, T is likely to be extremely difficult to calculate or even conceptualize and V is not an independent variable. Vt is a residual which is generally derived given knowledge of the other 3. i.e. Vt = (PT)/M. (b) The Cambridge Cash Balance Approach. Fisher’s approach can be viewed as deterministic. Essentially, Fisher argued that, given the full employment volume of transactions and the speed with which the financial system could process payments, the quantity of money that agents required to hold was effectively determined. Marshall, Pigou and colleagues took a radically different tack. Like Fisher, the Cambridge School assumed that money was only held to expedite transactions and had no further purpose. Thus, if the money supply increased, agents holding the increased money stock would seek to get rid of it. However, the emphasis in this approach concentrated on establishing the quantity of money that agents would voluntarily desire to hold. The Cambridge school were in effect attempting to set out a theory of the demand for money.

David Laidler (1985) puts it thus “In the Cambridge approach the principle determinant of people’s “taste” for money holding is the fact that it is a convenient asset to have, being universally acceptable in exchange for goods and services. The more transactions an individual has to undertake, the more cash he will want to hold and to this extent the approach is similar to Fisher. The emphasis, however, is on want to hold, rather than have to hold; and this is the basic difference between Cambridge monetary theory and the Fisher framework.” The Cambridge approach emphasises that there are alternatives to holding money in the shape of shares and bonds. These assets yield a return which can be viewed as the opportunity cost of holding money. As interest rates rise, agents will economise on money holdings and vice versa. Another factor that will influence money holdings is the expected rate of inflation. If inflation is expected to be high, then the purchasing power of money will fall. This will prompt agents to buy securities or commodities as a hedge against inflation. ECONOMICS KHALID AZIZ 0322-3385752

We can set out the Cambridge cash balance approach as follows MD = kPy MD = MS Where k = k(E(inf), r, u) This sets out that MD is some fraction k of nominal GDP where k depends on expected inflation, interest rates/returns and u, a set of unspecified factors which may influence money demand. Note that r is a vector of returns reflecting an appreciation that agents had a choice of assets such as shares and bonds. The Cambridge cash balance equation can be recast to facilitate comparison with Fisher’s equation of exchange. MS = kPy = (1/V)Py. In this formulation, V can be construed as the income velocity of circulation. As with the Fisher approach, k was not regarded as fixed but rather was viewed as a stable and predictable function of its determinants. In the long run, changes in the money stock would eventually lead to proportional changes in the price level. The Cambridge approach is universally regarded as the superior account and it forms the basis of later developments in the demand for money by Keynes, Milton Friedman and others. (c) The Transmission Mechanism

The transmission mechanism sets out the process by which a change in the money stock affects economic activity. In the classical context this requires a clear explanation of how ΔM → ΔP. Classical economists argued that there would be both a direct and indirect mechanism. The direct mechanism is the direct influence of a change in M on expenditure and the price level whilst the indirect mechanism operates through the interest rate. To understand this fully, we must be more specific about the definition of money. Money can be narrowly conceived of as notes & coins in circulation. However, bank deposits can also be properly regarded as a component of the money stock. Classical economists focussed on the ability of banks to create money through the expansion of loans. Fisher restated his equation of exchange to incorporate the banking sector. Thus, PT ≡ MV + M’V’ ECONOMICS KHALID AZIZ 0322-3385752 Where M is quantity of currency (termed primary money by Fisher) V is the velocity of circulation of currency M’ is the quantity of bank deposits and V’ is the velocity of circulation of deposit money Assume that M (the quantity of primary money) rises. This could be achieved by the central bank buying bonds and securities from the non bank private sector and paying for these purchases with cash. This would raise prices directly via the direct mechanism. Fisher demonstrated that the emergence of inflation would result in a divergence between the real and nominal rates of interest. Rt = rt + ΔPe t where R is the nominal rate of interest, r is the real rate of interest and ΔPe t is the expected rate of inflation The Classical theorists viewed the interest rate as ‘the reward for waiting’.

If agents were to be persuaded to forego current consumption, they would require to be compensated with greater a greater volume of consumption in a later period. Thus, the real rate of interest reflects the reward in terms of actual goods and services required to persuade agents to save. If r = 5%, this suggests that agents require a 5% more goods and services in future if they are to be tempted to forego 1 unit of current consumption. Note that in the preceding account, prices remained constant. If prices are rising by 5%, the nominal rate of interest would have to be 10% in order to ensure a 5% rise in actual goods and services as a reward for waiting. Hence, Fisher argued that an increase in the primary money stock would initially serve to drive up prices. The increase in inflation would cause the nominal rate of interest to rise above the real rate. However, Fisher contended that the rise in the nominal rate would be insufficient to maintain the real rate at its equilibrium level.

Thus, following a price increase, the real rate of interest would fall. This would result in an increase in the demand for loans by borrowers. Fisher argued that banks would increase the volume of loans at the lower real rate thus increasing the volume of deposits, M’. The expenditure made possible by these loans drives up the price level. Although in the short run, this increased spending may increase the number of transactions, the long run impact of the direct and indirect mechanisms would result in a rise in the price level proportional to the rise in the money supply. Other classical writers such as Knut Wicksell envisaged a role for bank behaviour leading to changes in M resulting in changes in r.

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