Jan 30

Perfect competition I

Even though perfect competition is hard to come by, it’s a good starting point to understand market structures. It’s been used to analyse markets for centuries. From Adam Smith and his invisible hand, to economists such as Edward Chamberlin and Joan Robinson, who analysed different market structures, perfect competition has been used to compare different competitive situations, and to understand how marketplaces work. A deep understanding of how competitive markets work and are formed is the cornerstone to understand why it’s so hard to reach them.

In this first Learning Path on perfect competition, we’ll start by analysing firms’ cost structure, before analysing their interaction in the market. We’ll learn about:

Perfect competition, a basic definition.

The firm:

Period analysis, in order to understand how time affects cost functions;

Short run cost analysis, how fixed factors determine cost structures;

Long run cost analysis, which considers variable factors.

The industry and the market:

Supply and demand, the basics of how markets work;

Short run supply curve, or how firms react to changes in market supply or demand;

Long run supply curve, which considers also potential entry of new firms.

Jan 23

Lope Gallego

Giffen good

Giffen’s paradox is an economic term named after the British economist and statistician Robert Giffen. The law of demand states that when the price of a commodity falls, the demand for it rises. However Giffen’s Paradox is an exception to this law. This is, Giffen goods are those goods whose demand moves in the same direction as the price variation. In other words, raising the price of the good will increase its demand. Consequently any Giffen good has an upward-sloping demand curve.

Alfred Marshall coined this term in his third edition of his “Principles of Economics”, 1895, where he wrote:

“As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.”

Jan 23

Lope Gallego

Robert Giffen

Robert Giffen, 1837-1910, was a Scottish economist and statistician who also had a great reputation in the fields of finance and taxation. He also participated in the editing process in numerous publication, such as the Daily News, The Economist and The Times. However, Robert Giffen is mostly known for giving name to the concept Giffen goods.

It was Alfred Marshall who, in the third edition of his “Principles of Economics”,1895, wrote:

In other words, Giffen goods are those inferior goods whose demand moves in the same direction as the price variation. This meaning, raising the price of the good will increase its demand.

Jan 23

Lope Gallego

Gottfried von Haberler

Gottfried Haberler

Gottfried von Haberler, 1900-1995, was an Austrian-American economist that specially known for his original contribution in the fields of international trade and business cycles.

He studied at the University of Vienna where he was in contact with other Austrian School economist such as Friedrich von Wieser and Ludwig von Mises and became close friends with other renowned economists in the decades to come: F.A. Hayek, Oskar Morgenstern, and Fritz Machlup. He later went to the United States where he held positions at Harvard University, where he worked with Joseph Schumpeter, and later as consultant and scholar in Washington D.C.

Haberler reformulated David Ricardo’s theory of comparative advantage in his work “The Theory of International Trade”, 1931, in an Austrian School view by using an opportunity cost view instead of the labour theory of value. In addition, he demonstrated that international trade increases economic efficiency and high living standards, and so he was a fervent defender of free trade.

Concerning business cycles, Haberler wrote “Money and Business Cycle”, 1932, which can be seen as an excellent exposition of the Austrian theory of the trade cycle. Other great contributions includes his critic to the Keynesian theory of the liquidity trap in his paper “Money and the Business Cycle”. His argument would later be further developed by the economist Arthur Cecil Pigou into the economic term known as the Pigou effect.

Jan 23

Lope Gallego

Abram Bergson

Abram Bergson, 1914-2003, was an American economist that worked for many governmental and federal agencies including the Russian Economic subdivision of the Office of Strategic Services. He was also a professor at Columbia University, Texas and Harvard. His main area of research was welfare economics but he also provided a lot of research and studies of the Soviet Union economy, marked by a combination of encyclopaedic knowledge of Soviet statistics, theoretical analysis and immense industry knowledge.

Concerning welfare economics, in Bergson’s famous paper “A Reformulation of Certain Aspects of Welfare Economics”, 1938, he defined and discussed the concept of an individualistic social welfare function. This function enables the necessary conditions for an economic optimum to be calculated without the assumption of cardinal utility. Furthermore, the function is used as a way to prioritise and establish an order of preference between different situations that meet the requirements of Vilfredo Pareto for social optima. Bergson postulated the need to explicitly accept judgments of value as a way to develop indifference functions. This concept was subsequently utilised and developed by Paul Samuelson and became an integral part of the welfare economics literature.

Jan 23

Lope Gallego

Roy Harrod

Roy F. Harrod Roy Forbes Harrod, 1900-1978, was an English economist, friend and a follower of John Maynard Keynes. He published a wide variety of economic papers, many of which were on economic growth, but he also conducted research on currency and inflation. In addition, he also wrote about memory and the theory of knowledge, reflecting on probability as a limitation to induction. Through his works underlines a dynamic view of the economy, more sophisticated and realistic, therefore, than the static view of most theorists.

However, Harrod is best known for his work “The life of John Maynard Keynes”, 1951, a biography of his fellow. He is also known for developing what is nowadays known as the Harrod–Domar model that was initially proposed by him in 1939 and later developed independently by Evsey Domar. This theory was a pioneering mathematical model about the dynamics of economic growth that laid the foundations of the economic growth theory after World War II.

Jan 23

Lope Gallego

C.3 Short run cost analysis

Description

This video explains how costs behave in the short run, and analyses when a company should start producing.

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In the short run, fixed costs include capital, K, whereas labour, L, is considered variable. Fixed costs are usually represented as a horizontal line and do not vary whatever level of production we achieve.

The video shows two phases. In the first phase (I), variable costs (and therefore total costs, seeing as fixed costs are a constant) grow slower than growth at first, before reaching a point of inflection (II) and beginning to grow much faster than the output they are capable of generating.

This is related with returns to scale. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase II corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.

If we translate this into average and marginal costs, an optimal level is reached along the stretch between which marginal costs are equal to average variable and fixed costs respectively.

Learn more by reading the dictionary entry.

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Jan 23

Lope Gallego

C.2 Average and marginal cost

Description

This video explains how average and marginal costs are calculated. Starting from fixed and variable costs, we analyse how average and marginal costs behave.

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Average costs are those associated to one unit of production. Costs per unit grow quicker as production increases, so we find the arithmetic average as the sum of costs divided by the sum of production.

Marginal costs are also a very important concept in Economics because they show costs at a very specific point in time: they show the cost associated with producing one additional unit at any given production level.

Learn more by reading the dictionary entry.

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Jan 23

Lope Gallego

C.1 Fixed and variable costs

Description

This video explains how different types of costs affect the production process. We start by explaining the main characteristics of fixed and variable costs, and how these form total cost. Finally, we explain its relationship with returns to scale.

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When analysing costs, the first thing to know is that there are fixed and variable costs:

Fixed costs: fixed costs cannot be altered in short run. They mainly include things like rent, repayments on technology, etc., which require time to change, and are often associated with indirect production costs (all that which is not a direct input). They do not depend on the level of production and cannot be adjusted accordingly.

Variable costs: variable costs depend on the level of production, and can include things such as direct inputs (raw materials) and contracted labour hours (not fixed salaries).

The way in which fixed and variable costs affect production is related with returns to scale. The video shows three phases. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase III corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.

Learn more by reading the dictionary entry.

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Jan 23

Lope Gallego

B.6 Production possibility frontier

Description

This video explains how to build and analyse the production possibility frontier. We start by explaining the very basics about the production possibility frontier. Then, we show the relation between the marginal rate of transformation and the production possibility frontier. Finally, we explain how to use the Edgeworth box to derive the production possibility frontier.

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The production possibility frontier represents the quantity of output that can be obtained for a certain quantity of inputs using a given technology. Depending on the technology, the production possibility frontier will have different shapes.

The production possibility frontier can be derived from the contract curve on an Edgeworth box. The isoquants determine how much a certain input has to increase in order to compensate the decrease in the other input, maintaining the quantity of output produced unaltered. The slope of these curves is given by the marginal rate of technical substitution of each output.

The points where the isoquants of different outputs combination intersect, which are Pareto-optimal, allow us to draw the contract curve, from which the production possibility frontier can be derived. Since the technology is given, only one production possibility frontier can be derived from the contract curve (as opposed to the case of the utility possibility frontier).

Learn more by reading the dictionary entry.

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