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WORKSHOP 2

Introduction to Financial Economics (FINN 1061)

2023-2024

Solution 2

a.    The effect of falling production costs in the market for smartphones results in a shift to the right in the supply curve, as shown in Figure 1. As a result, the equilibrium price of smartphones declines and the equilibrium quantity increases.

Figure 1

b.    The decline in the price of smartphones increases consumer surplus from area A to A + B+ C + D, an increase of the amount B + C + D. Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price).

After the shift in supply, producer surplus is areas E  + F  + G. Therefore, producer surplus changes by the amount F + G – B, which maybe positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus.

Since consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total surplus rises by C + D + F + G.

c.     If the supply of smartphones is very price elastic, then the shift of the supply curve benefits consumers most. To take the most dramatic case, suppose the supply curve were horizontal, as shown in Figure 2. Then there is no producer surplus at all.

Consumers capture all the benefits of falling production costs, with consumer surplus rising from area A to area A + B.

Question 3

The government decides to introduce a minimum wage legislation. Suppose that the labour market is perfectly competitive.

a.    What is the impact on employment?

b.    Analyse  the welfare  effects of the minimum wage legislation. Can you claim that the minimum wage policy is definitely beneficial for workers?

Solution 3

a.    Notice that, in the labour market, we say that firms demand labour while workers supply labour. After the introduction of the minimum wage legislation, the quantity of labour demanded by the firms drops to  L ′′  (Figure  3).  However,  at  the  minimum  wage, the quantity of labour supplied by the workers is higher than the quantity demanded. This results in unemployment.

Figure 3

b.    Before the introduction of the minimum wage, firms have a surplus of A + B + C since they are willing to pay workers more than the wage that they actually have to pay to the workers. Workers have a surplus of D + E + F, since they receive a wage that is higher than the one they are prepared to accept.

After the introduction of the minimum wage, firms’ surplus drops to A. On the other hand, the surplus that workers now get is B + D + F. While the change in surplus for the firms is negative (−B  −  C), for the workers is actually  ambiguous  (B  −  E). Therefore,  the policy is definitely beneficial only for some workers (the ones who keep their job). Overall, the policy implies a deadweight loss in the market is equal to C + E.

Question 4

Minnie’s Mineral Springs,a single-price monopoly, faces the market demand schedule:

a.   Find the total revenue function for Minnie’s Mineral Springs.

b.   Find the marginal revenue function and draw a graph of the demand curve and the marginal revenue curve.

Minnie’s Mineral Springs faces the above total cost schedule.

c.      Calculate Minnie’s profit-maximising output and price.

d.     Calculate the economic profit and the producer surplus of the firm. Explain the relationship between the two.

Solution 4

a.      From the demand schedule, it can be observed that the demand function of Mineral Spring is p = 10 - 2q. As TR = p . q, thenTR (q) = (10 - 2q) q = 10q - 2q2.

b.     As marginal revenue gives us the additional revenue from the sale of an additional bottle for any quantity, it can be found by differentiating the total revenue function with respect to q which gives MR(q) = 10 - 4q. Or, you can simply state that the marginal revenue function has the same intercept but twice the slope of the demand curve.

c.      It can be verified that total costs satisfy the following equation: TC(q) = 1  + 2q. Therefore, marginal cost is equal to MC (q) = MC = 2. The firm maximises when MR = MC. Therefore, 10 - 4q = 2 which givesq = 2. The price can be found by substituting the optimal quantity into the demand function, which gives p = 6.

Question 6

A large share of the world’s supply of diamonds comes from Russia and South Africa. Suppose that the marginal cost of mining diamonds is constant at €1,000 per diamond, and the demand for diamonds is described by the following schedule:

a.      If there were many suppliers of diamonds, what would be the price and quantity?

b.     If there was only one supplier of diamonds, what would be the price and quantity?

c.      If Russia  and South Africa formed a cartel, what would be the price and quantity? If the countries split the market evenly, what would be South Africa’s production and profit? What would happen to South Africa’s profit if it increased its production by 1,000 while Russia stuck to the cartel agreement?

d.     Use your answer to part (c) to explain why cartel agreements are often not successful.

Solution 6

a.      If there were many suppliers of diamonds, price would equal marginal cost (€1,000), so the quantity would be 12,000.

b.     With only one supplier of diamonds, quantity would be set where marginal cost equals marginal revenue. The following table shows marginal revenue:

Table 4: Revenues in the Diamond Markets

However, it maybe argued that consumers aren’t better off because monopolies can experience and exploit economies of scale. In an industry with high fixed costs, a single firm can gain lower long-run average costs – through exploiting economies of scale. This is particularly important for firms operating in a natural monopoly (e.g., rail infrastructure, gas network). For example, it would make no sense to have many  small  companies  providing tap water because  these  small firms would be  duplicating investment and infrastructure. The large-scale infrastructure makes it more efficient to just have one firm – a monopoly. A natural monopoly, like the water and sewage system (South-West water), can prevent  the  duplication  of  infrastructure  and  thus  reduce  potential  costs  to  consumers.  Natural monopolies that are run by non-profit organisations and local governments can afford to keep prices low enough to provide services to most of the public. When monopolies are privately owned by for- profit organisations, prices can become significantly higher than in a competitive market. As a result of higher prices, fewer consumers can afford the good or service, which can be detrimental in a rural or impoverished setting.

In summary, while only a few factors are mentioned above, the associated benefits may vary depending on the industry that has amonopoly. For example, we see in big tech some of the issues that have arisen from firms with large market control, however in the case of natural monopolies they maybe seen as beneficial. The government could regulate these markets to stop these firms having too much power, this may have made the market more contestable for other smaller firms. These firms are very difficult to regulate because the power they hold is so significant they can influence politics.